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When a business experiences a net financial loss in a given year, it may be advantageous in some cases, for tax purposes, to claim that loss in future years. This accounting technique is called a loss carryforward, because the tax loss is “carried forward” to a future tax year. Generally accepted accounting practices allow for the loss to carry forward for up to seven years, and in some cases up to 15 years. Using the loss carryforward technique is ethical and legal, and sometimes even necessary, but it must be used wisely.
The purpose of the loss carryforward is for a business to reduce its tax liability. For example, if a company experiences a negative net operating income (NOI) in a given year, but then has a positive NOI in one of the next several years, the company can claim the loss in one of the profitable years, thereby reducing the taxes paid on the profits of that year. This technique is especially useful in businesses and sectors that are typically cyclical, such as the transportation industry. Individuals may also take advantage of the loss carryforward. Any net capital losses which exceed $3,000 US Dollars (USD) may be carried to future years to offset later taxes on capital gains or ordinary income. In any one year, the amount of capital losses that can be used to offset capital gains is unlimited.
There is a small amount of risk associated with a loss carryforward, however. For an individual or company to claim a loss in a later, profitable year, that profitable year must occur. If the company is suffering financially and may not be around in several years, this would be an important consideration. Or, if several unprofitable years follow, the opportunity to carry forward the loss will be gone. Saving the loss from one year for later use is often a wise choice, though, if profits are in the forecast.
Large corporations may want to think twice before employing the loss carryforward, as things can get more complicated as the size of the company increases. For example, a corporation whose shares are publicly traded will need to carefully consider the effect that a loss carryforward might have on its stock. The profits and losses reported to the Internal Revenue Service (IRS) are the same that the public shareholders see. While it may be advantageous to seem only slightly profitable to the IRS, this may confuse or worry shareholders who are not aware that the carryforward has taken place. A company whose profits look oddly low to an investor may have a harder time attracting investors to buy its shares.