{"id":4038,"date":"2024-05-13T09:21:35","date_gmt":"2024-05-13T14:21:35","guid":{"rendered":"https:\/\/illinoistax.org\/?p=4038"},"modified":"2024-09-17T09:12:40","modified_gmt":"2024-09-17T14:12:40","slug":"tfi-tax-facts-77-4-net-operating-losses-in-illinois-and-around-the-country-matching-taxes-to-the-business-cycle","status":"publish","type":"post","link":"http:\/\/illinoistax.org\/?p=4038","title":{"rendered":"TFI Tax Facts (77.4): Net Operating Losses in Illinois and Around the Country: Matching Taxes to the Business Cycle"},"content":{"rendered":"

TFI Tax Facts: Net Operating Losses in Illinois and Around the Country: Matching Taxes to the Business Cycle<\/u><\/strong><\/h3>\n

May 2024 (77.4)<\/strong><\/p>\n

The Net Operating Loss (NOL) deduction is a frequent target of those seeking to increase state revenues by \u201cclosing corporate loopholes\u201d or \u201cmaking businesses pay their fair share.\u201d\u00a0NOLs are not<\/b> loopholes, however, and have been adopted by the federal government and every state with a corporate income tax specifically so that businesses do<\/i> pay their fair tax liability, neither less nor more.<\/p>\n

What is an NOL? Put simply, it\u2019s a recognition that businesses have good years and bad ones.\u00a0Using a 12-month period to evaluate (and tax) a business\u2019s operations is necessary, of course, but ignores the reality that it can take years for a new business to turn a profit, or for an entire industry to come out of a slump.\u00a0NOLs allow profits and losses earned over the course of a business cycle to offset each other.<\/p>\n

This article provides examples of why NOL deductions are necessary from a tax policy\u00a0perspective, explains the mechanics of Illinois\u2019 NOL calculation and how it has evolved over time, and how Illinois is an outlier compared to other states.\u00a0We have written about NOLs before\u2014most recently in the October 2021 issue of Tax Facts; this article builds on and\u00a0updates that research. And, for a detailed discussion of the state\u2019s largest tax expenditures\u2014the top six of which are available only to individuals or charities\u2014see \u201cThe Cost of Illinois\u2019 Largest Tax Breaks\u201d,\u00a0April 2021 Tax Facts<\/i><\/a><\/span>.<\/p>\n

Governor Pritzker\u2019s budget proposal for the 2025 fiscal year makes changes to, but does not eliminate, Illinois\u2019 current temporary limitation on the use of NOLs, making this discussion particularly timely.<\/p>\n

Two Examples
\n<\/b>To demonstrate why NOL deductions are a standard part of every income tax regime, we take a quick look at two hypothetical businesses and their operations over a 10-year period:<\/p>\n

Patty\u2019s Putt-Putt<\/b>.\u00a0 Patty operates a putt-putt golf course.\u00a0 Her net profits are $10,000 every year, for a total of $100,000 over the 10 years.<\/p>\n

Sally\u2019s Start-Up.<\/b>\u00a0 Sally launches an electric vehicle start-up.\u00a0 Things are rough the first 3 years, and she loses $100,000 each of those years.\u00a0The business starts to turn around and she breaks even in year 4, followed by 6 profitable years\u2014she has net income of $50,000 in each of years 5 through 8 and $100,000 each in years 9 and 10.\u00a0Over the 10 years, Sally\u2019s net profits also total $100,000.<\/p>\n

In the long run, our two businesses are equally profitable.\u00a0It should follow, then, that they pay the same amount of tax over that period. For simplicity\u2019s sake we will assume the tax rate is 5%, so the total tax over the 10 years should be $5,000. Let\u2019s look at what happens if NOLs can\u2019t be carried over:<\/p>\n

Table 1. Two Hypothetical Businesses , 5% Tax, No NOL Carryovers<\/b><\/p>\n

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Both of the business owners netted $100,000 over the 10-year period, yet as Table 1 <\/b>shows, the total amount of tax paid is not the same.\u00a0Patty pays the expected amount of $5,000, but Sally ends up paying taxes equal to 20% of her income\u2014substantially more than the official 5% rate.\u00a0This is called an \u201ceffective\u201d tax rate\u2014comparing the actual tax paid to the taxpayer\u2019s income. To address this inequity and make sure that all similarly situated businesses pay\u00a0similar amounts of tax, the federal government and every state with an income tax have adopted a net operating loss deduction.\u00a0If losses incurred in one year can be used to offset income earned in another year, we get a more equitable outcome:<\/p>\n

Table 2.\u00a0 Same Businesses, But With NOL Carryforward<\/b><\/p>\n

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Patty\u2019s situation is unchanged; she made money every year and paid tax every year, and there were no losses to carry over.\u00a0On the other hand, Sally\u2019s start-up losses carry over from one year to the next and are now available to offset her gains as she works her way out of the hole.\u00a0As a result, when losses can be carried forward, Patty and Sally pay the same amount of tax on the same amount of income when you look at the full 10-year period.<\/p>\n

In other words, the NOL carryover means that, over time, similarly situated taxpayers pay a similar amount (and effective rate) of tax.\u00a0This is a hallmark of sound tax policy and is why every jurisdiction with a corporate income tax\u2014the United States federal government, 44 states, and the District of Columbia\u2014also has a net operating loss carryover.<\/p>\n

The Mechanics of a Net Operating Loss
\n<\/b>The basic calculation of an income tax is straightforward:\u00a0 taxable income multiplied by the tax rate.\u00a0If a taxpayer\u2019s income is zero, or a loss, then no tax is due. That loss amount\u2014the NOL\u2014can be carried forward, or sometimes back, to another tax year to reduce taxable income\u00a0before the tax is calculated. The specifics of the carryover process can get complicated, and in Illinois have changed over the years, so a little more discussion is warranted.<\/p>\n

Illinois, like most states, bases its taxable income on what was determined for federal income tax purposes.\u00a0We have our own net operating loss calculation, however, so any federal NOL deduction taken by an Illinois taxpayer is reversed when calculating Illinois tax\u00a0liability.\u00a0(Ironically, if Illinois simply piggybacked on the federal NOL deduction, there would be no separate Illinois deduction and therefore no amount reported on the Comptroller\u2019s Tax\u00a0Expenditure Report. There would be other complications, but the concept would almost\u00a0certainly attract less attention.)<\/p>\n

In years when a taxpayer\u2019s Illinois taxable income is negative, those losses can be carried over and subtracted from Illinois taxable income in another tax year, or multiple years, until the losses are used up, within certain time limits.\u00a0Over the past decades, the Illinois carryover\u00a0periods have changed:<\/p>\n