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Once you've determined the amount of any net operating loss (NOL) in your sole proprietorship business, you need to decide whether to carry the loss backwards (and claim a retroactive refund), or forward.
Net operating losses may generally be carried back for two years (or for three years, in the case of a casualty loss) before the year of the loss, which is called the NOL year.
A loss is used to offset the taxable income of previous years, with the earliest year offset first. Any unused portion of the loss may be carried forward for up to 20 years after the NOL year.
Whichever form you use to claim the carryback, you must use Schedule A of Form 1045 to compute the amount of the NOL. If the entire loss isn't used up within the permitted period, no further net operating loss carryover is permitted.
If you like, you can elect to forgo the carryback period, instead choosing to deduct the net operating loss only over the next 20 years in the future. If so, you must attach a statement to your tax return for the NOL year, or to an amended return for that year filed within six months of its due date excluding extensions. The statement must assert that you are electing to forgo the carryback period under Section 172(b)(3) of the Internal Revenue Code.
Mechanics of a carryback. When you carry back an NOL, you must refigure your tax for the carryback year by recomputing your adjusted gross income (AGI) for that year. Then you must recompute any items that were limited by your AGI amount, such as the special allowance for passive activities, taxable Social Security benefits, IRA deductions, and excludable savings bond interest.
Next, refigure your taxable income, if needed, to reflect the change in your itemized deductions for medical expenses, casualty losses, miscellaneous itemized deductions, and the overall limit on itemized deductions and phaseout of personal exemptions for higher-income taxpayers. You will also have to refigure your AMT, if it applied to you. However, do not refigure your self-employment tax for the carryback year.
If you don't use up your entire NOL in the carryback years, you may have a carryover, and you'll need to use Schedule B of Form 1045 to compute the amount.
If you carry forward an NOL, things are a little simpler. You would list your NOL figure as a negative amount on the "other income" line of Form 1040, and attach a statement showing how you computed the NOL.