What is a Tax Umbrella?

A tax umbrella is a negative profit that reduces a company's tax liability. It usually occurs when a company's tax deductions exceed its taxable income (often because expenses exceeded revenues, making the company unprofitable).

How Does a Tax Umbrella Work?

Tax umbrellas reduce future tax payments. For example, let's assume Company XYZ has taxable income of $1 million but expenses of $1.3 million. Its net operating loss is -$300,000 ($1 million - $1.3 million).

Company XYZ probably will 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. Company XYZ is in the 36% tax bracket.

Normally, the company would need to pay $500,000 x .36 = $180,000 in taxes. But because it had a tax umbrella from last year, it can apply that to this year's tax bill, reducing it significantly (or even to $0, depending on the jurisdiction Company XYZ is in).

Similarly, investors can carry forward losses from selling investments and thereby create tax umbrellas that reduce their taxes on future capital gains.

Why Does a Tax Umbrella Matter?

Tax umbrellas create future tax relief for companies. The general idea is that when companies make money, they pay taxes; when they don't make money, they get some relief. The laws on how tax umbrellas apply vary by state, but usually a carryforward from the last two or three years can apply up to the next seven years. After that, the carryforwards 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 tax umbrellas.

As a result, tax umbrellas in and of themselves are valuable assets. In fact, sometimes companies purchase other companies solely for their tax loss carryforwards.

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Paul Tracy
Paul Tracy

Paul has been a respected figure in the financial markets for more than two decades. Prior to starting InvestingAnswers, Paul founded and managed one of the most influential investment research firms in America, with more than 3 million monthly readers.

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