Net Operating Loss (NOL)
What it is:
How it works (Example):
Net operating losses can be used to reduce future tax payments. For example, let's assume Company XYZ has taxable income of $1,000,000 and tax deductions of $1,300,000. Its net operating loss is $1,000,000 - $1,300,000 = - $300,000.
Company XYZ will probably not have to pay taxes that year (because it didn't have any taxable income). But let's assume that next year, Company XYZ makes a lot more money and records $500,000 of taxable income.
If Company XYZ is taxed at a corporate tax rate of 40%, it would need to pay $500,000 x 40% = $200,000 in taxes. But because it incurred an NOL last year, it can apply that NOL to this year's tax bill, reducing it significantly (or even to $0, depending on the jurisdiction Company XYZ is in). Company XYZ could also carry the NOL "back" and apply it against taxable income in preceding years.
Why it Matters:
NOLs are important because they create future tax relief for companies. The general idea is that when a firm makes money, it pays taxes; when it doesn't make money, it can get some relief. As a result, NOLs in and of themselves are valuable assets. In fact, sometimes companies purchase other companies solely for their NOLs.
The laws on applying NOLs vary by state, but usually an NOL from the last two or three years can be applied up to 20 years in the future, at which point it will expire. There are rules and exceptions for almost any circumstance, so it's best to check with the IRS or a qualified tax accountant when calculating and applying NOLs.