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Net operating losses: Cash in by looking back, not forward

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in Small Business Tax,Small Business Tax Deduction Strategies

The 2003 tax law slashed income taxes for most taxpayers. But what if you show a net operating loss (NOL) and no taxable income at year-end?

For 2003 and 2004, individuals with NOLs will likely do better by carrying them back to previous years, rather than forward to future years. Here's why:

Carry back to higher-taxed years

NOLs could come from an S corporation, a partnership or a sole proprietorship (reported on Schedule C). You can typically carry back such NOLs for two years on amended returns. Or you can waive the carry-back and push NOLs forward for up to 20 years.

It's probably smarter to carry back NOLs from 2003 and 2004 because you'll use the losses in years when tax rates were higher, and NOLs will save you more in taxes.

Example: A $1,000 NOL incurred in 2003 that offsets income taxed at the highest rate for 2001 (39.1 percent) would result in a $391 tax refund. But the same NOL carried forward into 2004 that offsets the highest-taxed income (35 percent) would trigger a $350 tax savings.

That may sound like small potatoes, but magnify the effect when you talk about larger NOLs.

Warning: That rate differential will last only for 2003 and 2004. NOLs arising in 2005 and beyond carry back two years to 2003 and later tax years. So, the tax rates in the loss year and the carry-back year are the same, which eliminates that "tax-rate arbitrage" opportunity.

Cut capital gains taxes, too

Similarly, lower capital gain rates make it more attractive to carry back NOLs.

Reason: NOLs carried into tax years with taxable income allow you to (1) reduce your ordinary income to zero and then (2) use any additional NOL to reduce capital gains. So a NOL that's big enough to reduce all income in a given year eliminates both high- and low-taxed income.

The 2003 tax law made this effect even more pronounced because it increased the spread between the highest income tax rate (35 percent) and the new maximum capital gain rate (15 percent). The greater the spread between the rates, the larger the reduction in the effective tax rate for a taxpayer with blended income classes.

A bonus to your 'bonus depreciation'

Last year's blockbuster tax law also enhanced the Section 179 "expensing" election and the "bonus" depreciation rules.

The Section 179 expansion doesn't help taxpayers with NOLs. NOL taxpayers don't have income, so they can't take the deduction.

Bonus depreciation is another story. That rule accelerates depreciation into the current year, increasing both business deductions and a business loss (if any). Using bonus depreciation in a NOL year effectively "borrows" deductions from future years and increases the current-year NOL, which then carries back to years when the effective tax rates were higher.

So if you had highly taxed income in 2001 or 2002, and you incur a NOL in 2003 or 2004, it may pay to claim maximum bonus depreciation and then look backward.

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