Important Change

New 5-year carryback for net operating losses (NOLs).   If you have an NOL from a tax year ending during 2002, you must generally carry back the entire amount of the NOL to the 5 tax years before the NOL year (the carryback period). However, you still can choose to use a carryback period of 2 or, if applicable, 3 tax years before the NOL year. You also can choose not to carry back an NOL and only carry it forward. For more information, see When To Use an NOL, later.

Important Reminder

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Introduction

If your deductions for the year are more than your income for the year, you may have a net operating loss (NOL). You can use an NOL by deducting it from your income in another year or years.

What this publication covers.   This publication discusses NOLs for individuals, estates, and trusts. It covers:

• How to figure an NOL,
• When to use an NOL,
• How to claim an NOL deduction, and
• How to figure an NOL carryover.

To have an NOL, your loss must generally be caused by deductions from your:

• Trade or business,
• Work as an employee,
• Casualty and theft losses,
• Moving expenses, or
• Rental property.

A loss from operating a business is the most common reason for an NOL.

Partnerships and S corporations generally cannot use an NOL. However, partners or shareholders can use their separate shares of the partnership's or S corporation's business income and business deductions to figure their individual NOLs.

What is not covered in this publication?   The following topics are not covered in this publication.

• Bankruptcies. See Publication 908, Bankruptcy Tax Guide.
• NOLs of Corporations. See Publication 542, Corporations.
• Specified liability losses. See the instructions for Form 1045, Application for Tentative Refund.
• Farming losses. See Publication 225, Farmer's Tax Guide.

Comments and suggestions.   We welcome your comments about this publication and your suggestions for future editions.

You can e-mail us while visiting our web site at www.irs.gov.

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Internal Revenue Service
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Useful Items

You may want to see:

Form (and Instructions)

• 1040X   Amended U.S. Individual Income Tax Return
• 1045   Application for Tentative Refund

See How To Get Tax Help near the end of this publication for information about getting these forms.

NOL Steps

Figure and use your NOL through the following steps.

Step 1.   Complete your tax return for the year. You may have an NOL if a negative figure appears on the line below:

• Individuals - line 35 of Form 1040.
• Estates and trusts - line 22 of Form 1041.

If the amount on that line is zero or more, stop here - you do not have an NOL.

Step 2.   Determine whether you have an NOL and its amount. See How To Figure an NOL, later. If you do not have an NOL, stop here.

Step 3.   Decide whether to carry the NOL back to a past year or to waive the carryback period and instead carry the NOL forward to a future year. See When To Use an NOL, later.

Step 4.   Deduct the NOL in the carryback or carryforward year. See How To Claim an NOL Deduction, later. If your NOL deduction is equal to or less than your taxable income without the deduction, stop here - you have used up your NOL.

Step 5.   Determine the amount of your unused NOL. See How To Figure an NOL Carryover, later. Carry over the unused NOL to the next carryback or carryforward year and begin again at Step 4.

Note.   If your NOL deduction includes more than one NOL amount, apply Step 5 separately to each NOL amount, starting with the amount from the earliest year.

How To Figure an NOL

If your deductions for the year are more than your income for the year, you have a potential NOL.

There are rules that limit what you can deduct when figuring an NOL. In general, you cannot deduct the following items when figuring an NOL.

• Personal exemptions.
• Capital losses in excess of capital gains.
• The section 1202 exclusion of 50% of the gain from the sale or exchange of qualified small business stock.
• Nonbusiness deductions in excess of nonbusiness income.
• Net operating loss deduction.

Schedule A (Form 1045).   Use Schedule A (Form 1045) to figure an NOL. The following discussion explains Schedule A and includes an illustrated example.

First, complete lines 1-3 of Schedule A, using amounts from your return. If line 3 is a negative amount, you have a potential NOL.

Next, complete the rest of Schedule A to figure your NOL. Adjust the amount on line 3 for deductions that are allowed when figuring your taxable income but not allowed when figuring an NOL. The following discussions explain these adjustments.

Adjustment for exemptions (line 4).   You cannot deduct your personal exemption or your exemptions for dependents. An estate or trust cannot deduct its exemption amount. Your adjustment is the total amount you deducted for exemptions.

Adjustment for nonbusiness deductions (line 12).   The amount of your nonbusiness deductions (line 9) is limited to the total of:

1. Your nonbusiness capital gains less your nonbusiness capital losses (not including any section 1202 exclusion shown as a loss on Schedule D, Form 1040) (line 8), and
2. Your nonbusiness income other than capital gains (line 10).

Your adjustment is your nonbusiness deductions that are more than the total of (1) and (2).

Nonbusiness deductions (line 9).   Enter on line 9 deductions that are not connected to your trade or business or your employment. Examples of deductions not related to your trade or business are:

• Alimony,
• Contributions to an IRA or other self-employed retirement plan,
• Itemized deductions (except for casualty and theft losses and any employee business expenses), and
• The standard deduction (if you do not itemize your deductions).

Do not enter business deductions on line 9. These are deductions that are connected to your trade or business. They include the following.

• State income tax on business profits.
• Moving expenses.
• The deduction of one-half of your self-employment tax or your deduction for self-employed health insurance.
• Rental losses.
• Loss on the sale or exchange of business real estate or depreciable property.
• Your share of a business loss from a partnership or S corporation.
• Ordinary loss on the sale or exchange of stock in a small business corporation or a small business investment company.
• If you itemize your deductions, casualty and theft losses (even if they involve nonbusiness property) and employee business expenses (such as union dues, uniforms, tools, education expenses, and travel and transportation expenses).
• Loss on the sale of accounts receivable (if you use an accrual method of accounting).
• Interest and litigation expenses on state and federal income taxes related to your business.
• Unrecovered investment in a pension or annuity claimed on a decedent's final return.
• Payment by a federal employee to buy back sick leave used in an earlier year.

Nonbusiness income (line 10).   Enter on line 10 only income that is not related to your trade or business or your employment. For example, enter your annuity income, dividends, and interest on investments. Also, include your share of nonbusiness income from partnerships and S corporations.

Do not include on line 10 the income you receive from your trade or business or your employment. This includes salaries and wages, self-employment income, and your share of business income from partnerships and S corporations. Also, do not include rental income or ordinary gain from the sale or other disposition of business real estate or depreciable business property.

Adjustment for section 1202 exclusion (line 20).   Enter on line 20 any gain you excluded under section 1202 on the sale or exchange of qualified small business stock.

Adjustments for capital losses (lines 22-25).   The amount deductible for capital losses is limited based on whether the losses are business capital losses or nonbusiness capital losses.

Nonbusiness capital losses.   You can deduct your nonbusiness capital losses (line 5) only up to the amount of your nonbusiness capital gains (line 6), without regard to any section 1202 exclusion. If your nonbusiness capital losses are more than your nonbusiness capital gains, you cannot deduct the excess.

Business capital losses.   You can deduct your business capital losses (line 14) only up to the total of:

• Your nonbusiness capital gains that are more than the total of your nonbusiness capital losses and excess nonbusiness deductions (line 13), and
• Your total business capital gains (line 15), without regard to any section 1202 exclusion.

Line 24.   The adjustment on line 24 is your capital loss deduction (line 22) that is more than your net capital loss, without regard to any section 1202 exclusion (line 21).

Line 25.   The adjustment on line 25 is your nondeductible capital losses (line 18) that are more than the nondeductible net capital loss (line 23) on your return, without regard to any section 1202 exclusion claimed on Schedule D. (You had a nondeductible net capital loss if your net capital loss was more than your capital loss deduction.)

Adjustment for NOL deduction (line 26).   You cannot deduct any NOL carryovers or carrybacks from other years. Your adjustment is the total amount of your NOL deduction for losses from other years.

Illustrated Schedule A (Form 1045)

The following example illustrates how to figure an NOL. It includes filled-in pages 1 and 2 of Form 1040 and Schedule A (Form 1045).

Example.   Glenn Johnson is in the retail record business. He is single and has the following income and deductions on his Form 1040 for 2002.

INCOME
Wages from part-time job	$1,225
Interest on savings	425
Net long-term capital gain on sale of real estate used in business	2,000
Glenn's total income	$3,650
DEDUCTIONS
Net loss from business (gross income of $67,000 minus expenses of $72,000)	$5,000
Net short-term capital loss on sale of stock	1,000
Standard deduction	4,700
Personal exemption	3,000
Glenn's total deductions	$13,700

Form 1040, page 1

Form 1040, page 2

Form 1045, page 2

Glenn's deductions exceed his income by $10,050 ($13,700 - $3,650). However, to figure whether he has an NOL, he must adjust certain deductions. He uses Schedule A (Form 1045) to figure his NOL. See the illustrated Schedule A (Form 1045), later.

Glenn cannot deduct the following items on Schedule A (Form 1045).

Nonbusiness net short-term capital loss	$1,000
Nonbusiness deductions (standard deduction, $4,700) minus nonbusiness income (interest, $425)	4,275
Personal exemption	3,000
Total adjustments to net loss	$8,275

Therefore, Glenn's NOL for 2002 is figured as follows:

Glenn's total 2002 income		$3,650
Less:
Glenn's original 2002 total deductions	$13,700
Less:
Glenn's total adjustments to net loss (above)	- 8,275	- 5,425
Glenn's NOL for 2002		$1,775

When To Use an NOL

Generally, if you have an NOL for a tax year ending in 2002, you must carry back the entire amount of the NOL to the 5 tax years before the NOL year (the carryback period), and then carry forward any remaining NOL for up to 20 years after the NOL year (the carryforward period). However, you can choose to carry back an NOL to the 2 (or 3, if eligible) years before the NOL year. Any remaining NOL can be carried forward for up to 20 years. You also can choose not to carry back an NOL and only carry it forward. The NOL year is the year in which the NOL occurred. You cannot deduct any part of the NOL remaining after the 20-year carryforward period.

If you elect to apply the 2 (or 3)-year NOL carryback period instead of the 5-year carryback period, attach a statement to your return filed by the due date (including extensions) for the NOL year. This statement must show that you are choosing to use the 2 (or 3)-year carryback period and waiving the 5-year carry back period under section 172(j) of the Internal Revenue Code. If you would like to waive the entire carryback period and only carry forward your NOL, see Waiving the carryback period, later.

Applying the 2 (or 3)-year carryback rules.   Generally, you can choose to carry back any NOL 2 years instead of 5 years. Certain eligible losses qualify for a 3-year carry back period.

Eligible loss.   The carryback period for eligible losses is 3 years. An eligible loss is any part of an NOL that:

• Is from a casualty or theft, or
• Is attributable to a Presidentially declared disaster for a qualified small business.

Qualified small business.   A qualified small business is a sole proprietorship or a partnership that has average annual gross receipts (reduced by returns and allowances) of $5 million or less during the 3-year period ending with the tax year of the NOL. If the business did not exist for this entire 3-year period, use the period the business was in existence.

Waiving the carryback period.   You can choose not to carry back your NOL. If you make this choice, then you can use your NOL only in the 20-year carryforward period. (This choice means you also choose not to carry back any alternative tax NOL.)

To make this choice, attach a statement to your original return filed by the due date (including extensions) for the NOL year. This statement must show that you are choosing to waive the carryback period under section 172(b)(3) of the Internal Revenue Code.

If you filed your return timely but did not file the statement with it, you must file the statement with an amended return for the NOL year within 6 months of the due date of your original return (excluding extensions). Write Filed pursuant to section 301.9100-2 at the top of the statement.

Once you make this choice to waive the carryback period, it is irrevocable. If you choose to waive the carryback period for more than one NOL, you must make a separate choice and attach a separate statement for each NOL year.

Note.   There was a one-time exception to the irrevocable waiver rule. If you previously elected to waive the carryback period for an NOL for any tax year ending in 2001 or 2002, you had until October 31, 2002 to revoke the waiver.

If you do not file this statement on time, you cannot waive the carryback period.

How to carry an NOL back or forward.   If you choose to carry back the NOL, you must first carry the entire NOL to the earliest carryback year. If your NOL is not used up, you can carry the rest to the next earliest carryback year, and so on.

If you do not use up the NOL in the 5 carryback years, carry forward what remains of it to the 20 tax years following the NOL year. Start by carrying it to the first tax year after the NOL year. If you do not use it up, carry the unused part to the next year. Continue to carry any unused part of the NOL until you complete the 20-year carryforward period.

Example.   You started your business as a sole proprietor in 2002 and had a $42,000 NOL for the year. You begin using your NOL in 1997, the fifth year before the NOL year, as shown in the following chart.

Year		Carryback/ Carryover	Unused Loss
1997		$42,000	$40,000
1998		40,000	37,000
1999		37,000	36,000
2000		36,000	34,000
2001	34,000	27,000
2002 (NOL year)
2003		27,000	22,500
2004		22,500	12,700
2005		12,700	4,000
2006		4,000	-0-

If your loss were larger, you could carry it forward until the year 2022. If you still had an unused 2002 carryforward after the year 2022, you could not deduct it.

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