Having a loss year is never a good thing, and a large loss year is even worse.  With a little planning, though, the lemons of those losses can be made into lemonade.

The federal tax law acknowledges that due to the effects of each tax year being a separate period, a business can have an unfairly high tax situation if it has alternating good and bad years.  To help ameliorate this, the federal tax law incorporates the concept of a net operating loss, or NOL, which allows losses to be carried backward a limited number of years, or carried forward over the next twenty years to offset income.  If an individual receives a loss from a partnership, S corporation, or sole proprietorship that completely eliminates their income for the year, they can also apply these rules.

Sometimes the loss is so large there is no hope to utilize it anywhere in the foreseeable future.  When this occurs, the best solution is to force an income recognition event.  For a corporation this is easier said than done, but there are ways.  For example, changing accounting methods from cash to accrual to recognize receivables may work, and there is always selling investments to recognize gains.

Alternately, individuals often have a large looming tax liability, their retirement funds.  Usually held in a tax deferred account, in the form of a 401(k), traditional IRA, or other retirement vehicle, these accounts represent a large deferred tax liability, ordinarily waiting until the funds are withdrawn at the time of retirement.  If an individual finds themselves in the position of having a substantial NOL, they can put that loss to immediate work by transferring all the retirement assets from tax deferred accounts to Roth accounts.  This makes the deferred income in the retirement accounts taxable immediately, but the income is offset by the NOL, eliminating the tax, and the retirement funds are transferred to an account which is not subject to tax when withdrawn during retirement.

Any attempt to utilize an NOL by creating an income recognition event should be thoroughly vetted by a qualified professional.  There are numerous nuances and pitfalls that need to be considered in this type of planning, and states do not always parallel federal treatment.

If you would like to know more about making the most of a loss please feel free to contact us for a consultation.

Written by Damien Falato, CPA, MST, CGMA, Tax Director