Annette Nellen

NOL Carryovers: Loophole or Legit

Some people refer to net operating loss (NOL) carryovers as a loophole or consider carrybacks unnecessary. Are these valid complaints?

December 11, 2008
by Annette Nellen, CPA/Esq.

The federal income tax law first allowed for some type of net operating loss (NOL) carryover in 1918. While most states allow NOL carryovers, several do not allow for carrybacks and a few impose a cap on the amount of NOL.

In 2008, some California legislators referred to NOL carryovers as “a loophole” (Senate Majority Caucus, July 2008). Elimination of NOL carrybacks has been suggested as a way to help state budgets (for example, see Mazerov, Now Would be a Good Time for States Still Granting Net Operating Loss “Carryback” Deductions to Eliminate Them, CBPP, February 2008).

This article reviews the history of the federal NOL carryover provision and its rationale to answer the question of whether the ability to carryback and carryforward a NOL is appropriate.

Federal NOL History

A NOL carryover provision began with the Revenue Act of 1918 (Sec. 204). This act temporarily allowed for a NOL to be carried back one year and then forward one year. With World War I ending, there was expectation of business losses (The Yale Law Journal, April 1932). The “net loss” had to result from either a business regularly carried on or the bona fide sale of assets acquired after April 5, 1917 for the production of war items. The loss was equal to allowable deductions over gross income plus tax-exempt interest income.

The NOL carryforward was extended by subsequent tax acts but was omitted in the National Industrial Recovery Act of 1933. In 1939, a two-year carryforward was enacted and in 1942, a two-year carryback was added (Appleby, 116 F. Supp 410 (Ct. Cl. 1953)). Various changes have since been made to the NOL deduction rules of §172 including the types of losses covered and the carryover periods. Today, §172 generally allows an NOL to be carried back two years and then forward 20 years (prior to this change by the Taxpayer Relief Act of 1997 (PL 105-34; 8/5/97) the periods were three years and 15 years, respectively).

Originally, the calculation of a NOL took an economic income approach, changing to a taxable income approach with the IRC of 1939 (Callanan Road Improvement, 404 F2d 1119 (2nd Cir. 1968)). Over the years, changes have also been made to the rules on utilization of a NOL in an ownership change (§382).


Reasons offered to justify a NOL carryover center around fairness and the annual reporting period. The Senate Report to the 1918 Act noted that the NOL provision would address a “grave injustice” that exists when the tax law does not “recognize the exigencies of business” and there are high tax rates (1939-1 (Part 2) CB 122). The Senate Report to the Revenue Act of 1932 described the NOL carryover rules as equitable and fair, providing “essential protection against excessive hardships inherent in a tax based upon an arbitrary annual accounting.” It further noted that a taxpayer’s ability to pay is diminished if it needs the profits of one year to cover losses from a prior year (1939-1 (Part 2) CB 504).

The House Report to the Revenue Bill of 1939 described the carryover rules as provided “in the interest of equity.” Carryover of a NOL would better equalize the taxes of a business with steady net income to one without stable income. “New enterprises and the capital-goods industries are especially subject to wide fluctuation in earnings. It is, therefore, believed that the allowance of a net operating business loss carry-over will greatly aid business and stimulate new enterprises.” (House Rep. No. 855, 76th Cong., as reported in Roberts, 258 F2d 634 (5th Cir. 1958)).

The rationale expressed in 1942 for a carryback period was to provide similar relief when profits were declining to when profits were increasing (Senate Rep. No. 1631, 77th Cong., as reported in Appleby, supra). Per the U.S. Supreme Court, NOL carryovers “ameliorate the unduly drastic consequences of taxing income strictly on an annual basis. They were designed to permit a taxpayer to set off its lean years against its lush years, and to strike something like an average taxable income computed over a period longer than one year.” (Libson Shops, 353 U.S. 382, 386 (1957))

The Joint Committee on Taxation views both carrying NOLs back and forward as normal to an income tax and thus does not treat the standard carryover period as a tax expenditure in its annual report of such items (2008 report (PDF)).

Recent State Changes

In 2008, California suspended NOL usage for large taxpayers for 2008 and 2009 to help address a budget shortfall. However, it also enacted a major change by conforming to the federal carryover periods starting in 2011 (see Franchise Tax Board analysis (PDF) of AB 1452). Prior to this change, California generally only allowed for a 10-year carryforward and no carryback. Despite some lawmakers calling the NOL carryover a loophole, the California Department of Finance treats NOL carryovers as a normal part of an income tax and thus, does not treat them as a tax expenditure
(2008-09 report (PDF)).

In 2008, New Jersey extended its corporate income tax NOL carryforward period from seven years to 20 years (S 2130 (PDF), November 2008). The legislators and governor observed that this change would help the state’s business climate (Governor Corzine press release, November 2008).


For businesses, the generation of a NOL means that deductions exceeded income for that particular tax year. To not allow any benefit for the excess deductions would elevate the significance of the annual accounting period beyond its purpose of administrative convenience.

Businesses differ in terms of business cycles. Also, unusual events can occur that may unexpectedly cause an operational loss in any given year. The annual accounting cycle can be harsh in measuring taxable income when a longer period may have allowed excess deductions to be used against income of prior or future years.

Given that past or future profits must cover the deficit, both a carryback and carryforward period are justified. In contrast to a carryforward, a carryback has the advantage of better recognizing the time value of money. The flat tax promoted by Drs. Hall and Rabushka allows unlimited carryforward of the excess of deductions over income (The Flat Tax (PDF)). In addition, the carryforward amount is increased by an interest factor to recognize the time value of money of postponed deductions. H.R. 1040 (110th Cong.), a version of the flat tax, is similar, but converts the loss into a credit.

As to the appropriate carryover periods, simplicity and sound tax administration seem to warrant specified periods that will enable most businesses to gain some benefit of excess deductions. Industries with long R&D or other start-up periods prefer a long carryforward period, such as biotech in which it may take 15 years to become profitable (Bioworld (PDF), June 2008).

In tough budget times, some states have postponed NOL carryovers. While this may seem like an easy way to generate current revenue, it can pose a hardship on taxpayers generating current profits to cover prior expenses. The reasons supporting NOL carryovers warrant looking for other ways to find revenue.


Are NOLs a loophole or legitimate? The rationale supporting NOL carrybacks and carryforwards clearly make them a legitimate part of an income tax.

Rate this article 5 (excellent) to 1 (poor).
Send your responses here.
Annette Nellen, CPA, Esq., is a tax professor and Director of the MST Program at San José State University. Nellen is an active member of the tax sections of the ABA and AICPA. She serves on the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.