Once you've determined the amount of any net operating loss (NOL) in your sole proprietorship business, you need to decide whether to carry the loss backwards (and claim a retroactive refund), or foward.

Net operating losses may be carried back for two years (or for three years, in the case of a casualty loss) before the year of the loss, which is called the NOL year. The loss is used to offset the taxable income of those previous years, for the earliest year first. Any unused portion of the loss may be carried forward for up to 20 years after the NOL year.

To "carry a loss back," you may file a Form 1045, Application for Tentative Refund within one year of the end of the NOL year, or you can file an amended tax return for the year in question within three years of the NOL year.

 

If your NOL year was 2001 and you filed your tax return on April 15, 2002, you can file Form 1045 any time on or after April 15 of 2002 but before January 1, 2003, to claim a refund for 1999. Or, you can file a 1040X for 1999 any time before April 15 of 2005.

Whichever form you use to claim the carryback, you must use Schedule A of Form 1045 to compute the amount of the NOL. If the entire loss isn't used up within the permitted period, no further net operating loss carryover is permitted.

If you like, you can elect to forgo the carryback period, instead choosing to deduct the net operating loss only over the next 20 years in the future. If so, you must attach a statement to your tax return for the NOL year, or to an amended return for that year filed within six months of its due date excluding extensions. The statement must assert that you are electing to forgo the carryback period under Section 172(b)(3) of the Internal Revenue Code.

 

Save Money Because carrying back a net operating loss to a prior tax year can result in a quick tax refund, it will usually be unwise to pass up the carryback period, unless you're quite sure that your business will be in a higher tax bracket in the future.

Mechanics of a carryback. When you carry back an NOL, you must refigure your tax for the carryback year by recomputing your adjusted gross income (AGI) for that year. Then you must recompute any items that were limited by your AGI amount, such as the special allowance for passive activities, taxable social security benefits, IRA deductions, and excludable savings bond interest.

Next, refigure your taxable income if needed to reflect the change in your itemized deductions for medical expenses, casualty losses, miscellaneous itemized deductions, and the overall limit on itemized deductions and phaseout of personal exemptions for higher-income taxpayers. You will also have to refigure your AMT, if it applied to you. However, do not refigure your self-employment tax for the carryback year.

If you don't use up your entire NOL in the first carryback year, you may have a carryover, and you'll need to use Schedule B of Form 1045 to compute the amount.

If you carry forward an NOL, things are a little simpler. You would list your NOL figure as a negative amount on the "other income" line of Form 1040 (Line 21 on the version of this form for tax year 2001), and attach a statement showing how you computed the NOL.