Tax Umbrella: Definition, Meaning & Examples

KEY TAKEAWAYS

• The tax code contains a clause known as a tax umbrella that permits future tax payments to be decreased in light of past losses or tax liabilities.
• A tax umbrella’s objective is to assist a struggling business in becoming profitable and sustainable without having to shoulder a significant tax burden by creating a tax shelter for profits earned in current and future tax years. A tax shelter is a legal method taxpayers use to reduce their tax liability.
• Because losses from the prior period can be utilized to offset earnings from subsequent periods. It is also known as an “umbrella” strategy.
• The amount of a loss that businesses and individuals can use to reduce their taxes in a given year is capped.

What Is a Tax Umbrella?

A tax umbrella refers to the process by which a business uses losses from prior years to reduce taxes due on profits made in subsequent years. Tax umbrellas are situations where a business or person uses a tax law provision to their advantage to lower their tax obligation. Future tax payments are reduced through tax loss carry forwards.

How Does a Tax Umbrella Work

In other terms, a tax umbrella is a loss that lowers a business’s tax obligation. This often happens when a company’s taxable income is less than its tax deductions, frequently as a result of expenses exceeding revenues. Individuals might also use tax havens to balance their future investment gains with their past investment losses.

The amount of a loss that businesses and individuals can use to reduce their taxes in a given year is capped. Any remaining loss can be carried forward and used to reduce taxes on gains in upcoming years. Investors can also build tax havens to lower their future capital gains taxes and carry forward losses from selling investments.

Why Does a Tax Umbrella Matter?

Tax awnings serve as safeguards for future tax relief for companies, making them significant valuable assets for businesses. Tax umbrellas actually allow businesses to pay taxes when they are profitable and receive some relief when they are not.

It is crucial for investors and businesses to consult with expert tax accountants when evaluating tax umbrellas because the ways in which tax umbrellas apply to persons and businesses, as well as the laws and regulations regulating tax umbrellas, differ by state.

It should be noted that capital and net operating losses can be carried forward indefinitely. They cannot, however, be carried back. The CARES Act of 2020 allowed NOLs to be carried back for 5 years and carried forward indefinitely for tax years 2018-2020. The IRS limits the excess loss claim at the lesser of $3,000 or your total net loss.

Summary

A tax umbrella is a loss carried forward from previous years that lowers a company’s taxable income for the current year. A net operating loss (NOL) happens when deductions exceed operating income. The excess business loss and net operating loss (NOL) limitation rules were added in 2018 as part of the Tax Cuts and Jobs Act. The limitations were on hold during the pandemic, however they were fully reinstated in the tax year 2021. After applying the excess business loss deduction, the NOL deduction can’t exceed 80% of taxable income.

Future tax reduction for businesses is provided via tax umbrellas. The widespread consensus is that businesses receive tax relief when they lose money and pay taxes when they make money. State tax umbrella laws differ, but typically a carryforward from the previous two or three years can apply up to the next seven years.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.

Written by Sandra Habiger, CPA

Sandra Habiger is a Chartered Professional Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Alongside her accounting practice, Sandra is a Money and Life Coach for women in business.