{"id":3098,"date":"2021-10-19T15:43:19","date_gmt":"2021-10-19T20:43:19","guid":{"rendered":"https:\/\/illinoistax.org\/?p=3098"},"modified":"2022-01-19T14:47:41","modified_gmt":"2022-01-19T20:47:41","slug":"net-operating-losses-in-illinois-and-around-the-country-matching-taxes-to-the-business-cycle-carol-portman","status":"publish","type":"post","link":"https:\/\/illinoistax.org\/?p=3098","title":{"rendered":"Net Operating Losses in Illinois and Around the Country: Matching Taxes to the Business Cycle"},"content":{"rendered":"

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

 <\/p>\n

October 2021 (74.6)<\/strong><\/p>\n

by Carol Portman*<\/p>\n

 <\/p>\n

The Net Operating Loss (NOL) deduction is Illinois\u2019 largest single corporate tax expenditure. For a detailed discussion of the state\u2019s largest tax breaks\u2014the top six of which are available only to individuals or charities\u2014see \u201cThe Cost of Illinois\u2019 Largest Tax Breaks\u201d, April 2021 Tax Facts<\/em><\/span><\/a>. The NOL deduction reduced the state\u2019s tax revenues by $383 million, according to the Comptroller\u2019s 2019 Tax Expenditure Report. This large amount, and the fact that it is the largest tax expenditure available to businesses, makes the NOL deduction a frequent target of those seeking to increase state revenues by \u201cclosing corporate loopholes\u201d or \u201cmaking businesses pay their fair share.\u201d\u00a0 NOLs are not loopholes, however, and are in place specifically so that businesses do pay their fair tax liability, neither less nor more.<\/p>\n

What, exactly, is an NOL? Put simply, it\u2019s a recognition that businesses have good years and bad ones.\u00a0\u00a0 Using 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.\u00a0 NOLs allow those profits and losses to offset each other.<\/p>\n

This article provides examples of why NOL deductions are necessary from a tax policy perspective, explains the mechanics of Illinois\u2019 NOL calculation and how it\u2019s evolved over time, and compares Illinois\u2019 treatment to that in other states.\u00a0 We also examine the likely fiscal impact of the latest development, a temporary limitation on the NOL deduction, which will increase the state\u2019s tax revenues now, but reduce them later.<\/p>\n

Three Examples
\n<\/strong>In order to demonstrate why NOL deductions are a standard part of every income tax regime, we will take a quick look at three hypothetical businesses and their operations over a ten-year period:<\/p>\n

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

Sally\u2019s Start-Up.<\/strong>\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.\u00a0 Things start to turn around and she breaks even in year 4, followed by six 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.\u00a0 Sally\u2019s total earnings over the ten years nets out to $100,000.<\/p>\n

\u00a0<\/strong>Marcie\u2019s Cyclical Cycles<\/strong>.\u00a0 Marcie owns and operates a well-established bicycle shop.\u00a0 While Marcie is able to keep her staff employed full-time, interest in the hobby has its ups and downs.\u00a0 As a result, Marcie\u2019s income from the business fluctuates, ranging from $75,000 in income in years 1, 2, 9, and 10 to $100,000 in losses in years 5 and 6.\u00a0 (Years 3, 4, 7, and 8 were all break-even).\u00a0 Marcie also nets income of $100,000 over the ten years.<\/p>\n

In the long run, our three businesses are equally profitable\u2014each of them netted $100,000 in income over the 10 years.\u00a0 It 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 take a look at what actually happens if losses aren\u2019t carried over:<\/p>\n

 <\/p>\n

Table 1.\u00a0 Three Hypothetical Businesses, 5% Tax, No NOL Carryovers.<\/strong><\/p>\n

\"\"<\/p>\n

Each of the 3 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.\u00a0 Only Lucy pays the \u201ccorrect\u201d amount of $5,000.\u00a0 Sally and Marcie end up paying tax rates of 20% and 15%, respectively\u2014substantially more than the official 5% rate.\u00a0 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.\u00a0 If losses incurred in one year can be used to offset income earned in a different year, we get a more equitable outcome:<\/p>\n

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

\"\"<\/p>\n

Patty\u2019s situation is unchanged; she made money every year and paid tax every year, and there were no losses to carry over.\u00a0 On the other hand, Sally\u2019s $300,000 of start-up losses can now offset her gains as she works her way out of the hole.\u00a0 As a result, when losses can be carried forward, Patty and Sally pay the same amount of tax on the same amount of income.\u00a0 Marcie is still paying more tax, although the difference is less extreme and she has loss carryovers that will be available to offset future income.<\/p>\n

In other words, the NOL carryover means the total taxes paid over time is more equitable.\u00a0 Similarly situated taxpayers pay a similar amount of tax.\u00a0 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.<\/p>\n

The Mechanics of a Net Operating Loss
\n<\/strong>The basic calculation of an income tax is straightforward:\u00a0 taxable income multiplied by the tax rate.\u00a0 If 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 before the tax is calculated. If a loss is carried back, as allowed in some states and was permitted in Illinois until 2004, the taxpayer files an amended return and claims a refund of taxes already paid. 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.\u00a0 We have our own net operating loss calculation, however, so federal NOL adjustments are ignored.\u00a0 (Ironically, if we piggybacked on the federal NOL deduction, there would be no Illinois adjustment and no amount reported on the Comptroller\u2019s Tax Expenditure Report. There would be other complications, but the concept would almost certainly 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.\u00a0 Over the past decades, the Illinois carryover periods have changed:<\/p>\n