s a result of the current economic slowdown, many taxpayers who own and operate sole proprietorships, partnerships, limited liability companies and S corporations face the prospect of financial hardship. These tough times may result in business losses. Congress offers taxpayers who experience such losses some important tax relief. Under the Internal Revenue Code, taxpayers may carry back these losses and get a tax refund or carry them forward and reduce their future tax liability. CPAs who know the net operating loss (NOL) rules can maximize benefits for their individual taxpayer clients—many of whom are small-business owners.
This article analyzes the use of NOLs by individual taxpayers. It summarizes the important aspects of the rules as well as the guidelines CPAs use to compute and report a taxpayer’s NOLs. It also offers taxpayers several planning strategies to maximize the utility of such losses. Although the proper use of NOLs requires careful attention to detail, the rewards are well worth the investment.
THE NOL RULES
The rules for NOLs are found in IRC section 172. They have been part of the code’s fabric for almost a century, and for good reason. They help taxpayers who experience large fluctuations of income and losses to better handle their tax burdens. Rather than imposing artificial annual tax accounting periods, these rules essentially permit taxpayers who experience losses to average their income over several years.
The IRC accomplishes this feat by allowing taxpayers who experience losses to amend prior years’ tax returns to account for these losses and, to the extent the losses remain unabsorbed, include them on future years’ returns. More specifically, the IRC allows taxpayers to carry back NOLs and deduct them in the two preceding tax years and to carry forward the remaining balance and deduct it from taxable income in the 20 succeeding tax years. (For certain so-called eligible losses—losses of property arising from fire, storm, shipwreck or other casualty or from theft—the code provides a special three-year carryback period.)
Conceptually, the notion of an NOL is relatively straightforward. It generally represents losses arising from a trade or business that exceed a taxpayer’s current income. A taxpayer’s NOL equals losses minus income. The difficulties a CPA may face in computing a taxpayer’s NOL, however, lie not in the concept but in the details. The next section explains how taxpayers must modify their “losses” to determine whether all, some or none constitutes an NOL.
COMPUTING A TAXPAYER’S NOL
In designing the NOL rules, Congress wanted to ensure that a taxpayer’s losses were business- rather than nonbusiness-related. (The IRC provides an exception for casualty and theft losses, which it treats as business-related.) One of the critical steps a CPA must follow in computing a taxpayer’s NOL, therefore, is to isolate business from nonbusiness deductions. To accomplish this, the code requires CPAs to make several modifications to a taxpayer’s otherwise allowable deductions and exclusions; the major ones are described below.
The IRC first disallows an NOL deduction the taxpayer experienced in another tax year. Next, it disallows the deduction for personal exemptions under IRC section 151. Finally, nonbusiness deductions are limited to the amount of nonbusiness income. Common examples of these include medical expenses, alimony, charitable contributions, investment interest, qualified residence interest, IRA contributions and—for nonitemizing taxpayers—the standard deduction. Nonbusiness income includes dividends, annuities, interest on investments and royalties.
There are two limitations on the use of capital losses. First, nonbusiness capital losses are limited to the amount of a taxpayer’s nonbusiness capital gains. Nonbusiness capital losses and gains generally relate to a taxpayer’s personal investments. Then, business capital losses are limited to the sum of (1) business capital gains and (2) the amount, if any, of the taxpayer’s nonbusiness capital gains not required to offset either nonbusiness capital losses or ordinary nonbusiness deductions. (To the extent nonbusiness capital gains exceed nonbusiness capital losses, the code says the taxpayer can use the excess to absorb additional nonbusiness deductions and business capital losses.)
CPAs also should add back to income any gains excluded under IRC section 1202. This section allows taxpayers who own “qualified small-business stock” for more than five years to exclude 50% of any gain recognized on the sale or exchange of such stock.
Making these loss modifications is burdensome and complex, particularly distinguishing between business and nonbusiness income and deductions and business and nonbusiness capital gains and losses. But once a practitioner has done so, computing a taxpayer’s NOL is then a breeze. This is particularly true because computer software greatly alleviates the number-crunching drudgery commonly associated with NOL calculations.
Exhibit 1 shows an example of how a taxpayer computes an NOL.
The first step in reporting a taxpayer’s NOL is to determine the carryback and carryover periods. As stated earlier, the general rule is that a taxpayer may carry back an NOL to each of the two taxable years preceding the loss and carry it forward to each of the 20 taxable years following the loss. For example, a taxpayer who experiences a loss in 2001 may carry it back to 1999 and forward to 2021.
A taxpayer must carry an NOL to the earliest tax years to which it can be carried back or carried over. If the NOL is not fully absorbed in the carryback or carryover year, the taxpayer must then carry it over to the next earliest tax year. This process repeats itself until the NOL is either fully absorbed or the carryover period expires.
If a taxpayer carries an NOL back, it will cause an adjustment to his or her adjusted gross income. This, in turn, will affect deductions for items (such as medical expenses) that the law curtails based on a taxpayer’s AGI. A taxpayer’s charitable deductions, however, are determined without regard to AGI as modified by the NOL carryback. Exhibit 2 offers an example that illustrates how a taxpayer computes a tax refund when he or she carries back an NOL.
Taxpayers carrying back their losses have a choice. They may file a Form 1040X, Amended U.S. Individual Income Tax Return, within three years of the due date, including extensions, for filing the return for the loss year. For instance, if a taxpayer incurs a loss in 2001 and the tax return is due April 15, 2002, he or she must file an amended tax return reflecting the carryback for 1999 by April 15, 2005.
Taxpayers carrying back their losses may alternatively file for a refund using Form 1045, Application for Tentative Refund, which is due on or after the filing of the return for the loss year and within 12 months after the loss year. Using the example of a taxpayer who sustained a loss in 2001, he or she must submit this return on or after April 15, 2002, but no later than December 31, 2002.
Taxpayers who carry NOLs forward must report this negative figure on line 21, marked “Other Income,” on form 1040. In addition, the regulations require that taxpayers who claim NOLs supply a detailed statement that sets forth all material and pertinent facts relating to the deduction.
Taxpayers who experience NOLs must plan carefully for their use. Here are some of the important factors they and their CPAs should consider.
Carryback waiver. Taxpayers may elect to waive their right to carry back their losses. Once made, this election is irrevocable. Taxpayers who make this election are restricted to carrying their losses forward. Due to the time value of money, the tax savings associated with making this election rarely make sense. Indeed, taxpayers should consider making it only when their taxable income is relatively low in the two years preceding the loss year and they expect significant taxable income in subsequent years.
Business vs. nonbusiness. Taxpayers should classify as much income as possible as nonbusiness so they can absorb otherwise “wasted” nonbusiness deductions they cannot use to offset business income. One commonly overlooked source of nonbusiness income is from passive interests in partnerships, limited liability companies and S corporations.
Other taxes. When CPAs compute taxpayers’ NOLs, they must consider the impact, if any, of the alternative minimum tax and state income tax laws. Under the AMT rules, use of an NOL is limited to 90% of a taxpayer’s income (after the taxpayer has modified the NOL for the adjustments under IRC sections 56 and 57 and preference items under section 58). State tax laws frequently permit NOLs to be carried forward only and often for much shorter periods than the IRC allows. Indeed, some states make no provision at all for taxpayers to use NOLs.
Which form? Taxpayers generally prefer to file form 1045 instead of form 1040X because submitting this form usually is a much faster procedure than filing an amended return.
Federal legislators continue to debate what additional government initiatives may be needed to jump-start the economy following the passage of the 2001 tax act and the World Trade Center disaster. If any new efforts are forthcoming or if the business cycle naturally takes a turn for the better, taxpayers’ economic prospects will likely brighten. This will be particularly good news for taxpayers who have taken the proper steps to compute and document their NOLs. They will be in the enviable position of being able to capitalize on these losses and shelter their otherwise taxable income.