TFI Tax Facts (77.4): Net Operating Losses in Illinois and Around the Country: Matching Taxes to the Business Cycle
TFI Tax Facts: Net Operating Losses in Illinois and Around the Country: Matching Taxes to the Business Cycle
May 2024 (77.4)
The Net Operating Loss (NOL) deduction is a frequent target of those seeking to increase state revenues by “closing corporate loopholes” or “making businesses pay their fair share.” NOLs are not loopholes, however, and have been adopted by the federal government and every state with a corporate income tax specifically so that businesses do pay their fair tax liability, neither less nor more.
What is an NOL? Put simply, it’s a recognition that businesses have good years and bad ones. Using a 12-month period to evaluate (and tax) a business’s 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. NOLs allow profits and losses earned over the course of a business cycle to offset each other.
This article provides examples of why NOL deductions are necessary from a tax policy perspective, explains the mechanics of Illinois’ NOL calculation and how it has evolved over time, and how Illinois is an outlier compared to other states. We have written about NOLs before—most recently in the October 2021 issue of Tax Facts; this article builds on and updates that research. And, for a detailed discussion of the state’s largest tax expenditures—the top six of which are available only to individuals or charities—see “The Cost of Illinois’ Largest Tax Breaks”, April 2021 Tax Facts.
Governor Pritzker’s budget proposal for the 2025 fiscal year makes changes to, but does not eliminate, Illinois’ current temporary limitation on the use of NOLs, making this discussion particularly timely.
Two Examples
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:
Patty’s Putt-Putt. Patty operates a putt-putt golf course. Her net profits are $10,000 every year, for a total of $100,000 over the 10 years.
Sally’s Start-Up. Sally launches an electric vehicle start-up. Things are rough the first 3 years, and she loses $100,000 each of those years. The business starts to turn around and she breaks even in year 4, followed by 6 profitable years—she has net income of $50,000 in each of years 5 through 8 and $100,000 each in years 9 and 10. Over the 10 years, Sally’s net profits also total $100,000.
In the long run, our two businesses are equally profitable. It should follow, then, that they pay the same amount of tax over that period. For simplicity’s sake we will assume the tax rate is 5%, so the total tax over the 10 years should be $5,000. Let’s look at what happens if NOLs can’t be carried over:
Table 1. Two Hypothetical Businesses , 5% Tax, No NOL Carryovers
Both of the business owners netted $100,000 over the 10-year period, yet as Table 1 shows, the total amount of tax paid is not the same. Patty pays the expected amount of $5,000, but Sally ends up paying taxes equal to 20% of her income—substantially more than the official 5% rate. This is called an “effective” tax rate—comparing the actual tax paid to the taxpayer’s income. To address this inequity and make sure that all similarly situated businesses pay similar amounts of tax, the federal government and every state with an income tax have adopted a net operating loss deduction. If losses incurred in one year can be used to offset income earned in another year, we get a more equitable outcome:
Table 2. Same Businesses, But With NOL Carryforward
Patty’s situation is unchanged; she made money every year and paid tax every year, and there were no losses to carry over. On the other hand, Sally’s 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. As 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.
In other words, the NOL carryover means that, over time, similarly situated taxpayers pay a similar amount (and effective rate) of tax. This is a hallmark of sound tax policy and is why every jurisdiction with a corporate income tax—the United States federal government, 44 states, and the District of Columbia—also has a net operating loss carryover.
The Mechanics of a Net Operating Loss
The basic calculation of an income tax is straightforward: taxable income multiplied by the tax rate. If a taxpayer’s income is zero, or a loss, then no tax is due. That loss amount—the NOL—can be carried forward, or sometimes back, to another tax year to reduce taxable income before 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.
Illinois, like most states, bases its taxable income on what was determined for federal income tax purposes. We have our own net operating loss calculation, however, so any federal NOL deduction taken by an Illinois taxpayer is reversed when calculating Illinois tax liability. (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’s Tax Expenditure Report. There would be other complications, but the concept would almost certainly attract less attention.)
In years when a taxpayer’s 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. Over the past decades, the Illinois carryover periods have changed:
- From 1999 to 2002, businesses could carry losses back two years and forward 20 years.
- From 2003 to 2020, businesses could carry losses forward 12 years, with no carryback.
- Beginning in 2021, businesses can carry losses forward 20 years.
Illinois has also occasionally suspended the availability of the NOL deduction:
- In 2011, all NOL deductions were suspended.
- From 2012 to 2013, NOL deductions were partially reinstated, with a $100,000 cap.
- For 2021 to 2023, Illinois once again capped the NOL deduction at $100,000.
The changing carryback and carryforward rules are confusing enough, but there are a number of additional wrinkles. The years mentioned above are for calendar year taxpayers; businesses with other fiscal years can have additional complexities. The carryforward period has also been extended for taxpayers impacted by the temporary suspensions in 2011-2014 and 2021-2023, with the intent that the losses would eventually be deductible; just not as quickly. The even more complicated interplay of the loss rules with apportionment and changing unitary business groups is beyond the scope of this article.
The unpredictability and resulting complexity of Illinois’ NOL landscape run afoul of two of the principles of sound taxation. A good tax is one that is predictable, for both taxpayers and taxing bodies, and simple. Change is unavoidable, of course, and an overly simplistic tax code can’t address the complications found in the real world, but Illinois’ frequent changes to the NOL regime have been significant, and run the risk of influencing taxpayer behavior—another tax policy no-no.
How Do Other States and the IRS Handle NOLs? (Spoiler alert: Illinois is an outlier)
The 44 states with a corporate income tax (plus the District of Columbia) all have an NOL deduction, but as with many things in the state tax world, exact NOL treatment varies.
There are two practical issues associated with the treatment of NOLs: 1) when the NOLs can be used; and 2) how much of an NOL can be used in any given year. Seventeen states (plus DC) follow the federal carryover rules on both of these issues: losses cannot be carried back, but NOL carryforwards have no time limitation; and NOLs can only offset 80% of a taxpayer’s current income. This avoids unfair results for businesses in industries with long up-and-down cycles, and is likely to be particularly helpful for those hard-hit by the pandemic or future financial downturns, while also ensuring that profitable taxpayers are paying at least some tax.
Of the states that do not follow the federal NOL rules, there is a fair amount of general alignment. For example, on the timing question, Illinois is one of 16 states with a 20-year NOL carryforward period. Similarly, most states that haven’t followed the federal 80% rule allow taxpayers to use NOLs to offset 100% of their current income, with no limitation. Illinois’ $100,000 per year cap on the use of NOLs makes us an extreme outlier. There are only a few other instances of even remotely similar limitations, and none are as restrictive as Illinois’:
- Pennsylvania has a limitation based on income: a taxpayer can offset only 40% of their income with NOLs carried over from a previous year.
- New Hampshire limits the carryforward NOL deduction to $10 million per year.
- Montana limits the carryback NOL deductions to $500,000 per year, but has no limitation on loss utilization when carrying them forward.
- Idaho also limits carryback NOL deductions, to $100,000 per year, but places no limitation on carryforward amounts.
- California, like Illinois, adopted a temporary NOL cap at the beginning of the pandemic. However, once it was clear that the pandemic was not causing a major hit to the state’s tax revenues, California repealed the limit ahead of schedule, and losses were once again fully deductible in 2022.
Conclusion
It is important that state policymakers periodically evaluate the purpose, effectiveness, and impact of the state’s various tax provisions. Illinois’ net operating loss deduction is a significant tax expenditure, so warrants examination.
The net operating loss deduction is a critical part of every state’s efforts to ensure its income tax applies fairly to all taxpayers, from start-ups to putt-putt courses.
Illinois’ temporary limitation on the use of NOL carryovers makes the state an extreme outlier, and any extension of that limitation merely delays the day when struggling businesses are able to align their tax burdens, and effective tax rates, to those of their more profitable counterparts.