A tax loss carryforward is a technique used in accounting, which can allow you to report losses up to seven years after they occur (in most cases) to minimize paying taxes in a year when a company or an individual has had a high profit. Sometimes this occurs naturally as a result of limits on the amount of loss that can be deducted in a certain year. People or businesses then carry forward the amount above that limit to the next year to reduce overall tax payments. At other times, when tax amounts are low, part or all of losses may be deducted in a year when someone or some business makes more profit.
Use of the tax loss carryforward is legal, though critics of a tax system sometimes scrutinize its use. “Saving” a huge loss year to mitigate taxation on huge profits in a subsequent year may significantly lower payments in the year that the technique is used. There are some drawbacks to saving loss amounts, though. A person wanting to employ this method is banking on having a profitable year where not claiming all current tax loss at present is worth it. If that profitable year never occurs, you may still pay more taxes in a year when your profits weren’t high than you would if you didn’t use a tax loss carryforward to mitigate those taxes when they first occurred.
Sometimes you have no choice on when to use the tax loss carryforward. If you are an independent contractor and file Schedule C along with your Internal Revenue Service (IRS) 1040, your losses in a year may be higher than your gains. According to US tax law, any amount of loss above an amount that zeroes out your profits completely is carried forward to the next year, provided you remember to claim it. Especially in the fledgling years of your work as an independent contractor, carryforwards may provide a means to reduce overall taxes paid. Setting up a business as an independent contractor, with all its inherent costs like purchasing equipment, may be more expensive than the money you will make from that business in the first few years you operate.
There can be some negative consequences of using a tax loss carryforward, especially for large businesses. If you “save” some of your losses to report in another year, your profit and loss statement could end up looking unattractive to investors or purchasers of company stock. Unless investors realize you have used a carryforward, they may assess your business as being not worthy of investment because it is not posting good profits. For those businesses that sell stock, carryforwards may discourage people from purchasing stock in your business or reduce overall stock price.