Net Operating Losses Making the Right Choice Slides
Net Operating Losses - Making the Right Choice Stuart Sobel Tax Media Network, Inc. www.taxmedianetwork.com
Course Topics • Introduction • History and background of the net operating loss • Definitions • Internal Revenue code section 172 overview • Net operating loss – carryback provisions • Net operating loss – carryforward provisions
Course Topics (cont.) • Electing to forgo the carryback in exchange for the carryforward • Exceptions to the 2-year carryback period • Casualty and theft losses • Farming losses • Form 982 – impact of discharge of indebtedness • Net operating losses for individuals
Course Topics (cont.) Filing Form 1045 or Form 843 Changes in marital filing status Pass-through entities – limitation of losses C corporation losses including the filing of Form 1139 • Form 1138 – extensions for filing • Changes in corporate status • Summary • • • • •
Introduction • Downturn of the economy has resulted in losses for many once profitable businesses. • NOLs are created when business losses exceed business and nonbusiness income. • Individuals get losses from Schedules A, C, E, and F.
Introduction (cont.) • Not all losses are allowed in computing the loss deduction including the following examples: – Deductions for exemptions – Capital losses in excess of gains – Section 1202 deductions from sale of qualified nonbusiness stock – Nonbusiness deductions in excess of nonbusiness income – Section 199 domestic production activities deduction
Introduction (cont.) • Schedule A on Form 1040 has some business deductions that are eligible. • NOLs create tax refunds from prior years or tax reductions in future years • Practitioners must explain choices to their clients – opportunities and pitfalls • Making the proper selection
5 Basic Steps to Using an NOL • Complete the current year tax return • Calculate the NOL • Determine which option is best – carryback or carry forward? • Deduct the NOL in the carryback or carryforward year • Determine if there is unused NOL
History and Background of NOL • Income tax created by the 16th Amendment in 1913 • Congress added NOL deduction in 1918 • Originally was to carry back one year and/or carry forward one year – 1939 – two-year carryforward – 1942 – two-year carryback – 1947 – code section 172 allows carryback for two years and carryforward for 20 years
History (cont.) • Congress wanted to create equity because of tax impact in certain accounting periods • States do not always recognize NOLs • Changes have occurred allowing lengthier carrybacks in order to obtain more money today rather than tax savings in the future
Definitions • Net operating loss (NOL): the result of specific losses and deductions exceeding a taxpayer’s income • Net operating loss deduction (NOLD): the allowable deduction that can be claimed in a prior or future year because of the NOL • Net operating loss carryover: the loss deduction that may be carried forward for a specific period of time
IRS Code Section 172 • Code section 172(a): • There shall be allowed as a deduction for the taxable year an amount equal to the aggregate of (1) the net operating loss carryovers to such year plus (2) the net operating loss carrybacks to such year. For purposes of this subtitle the term “net operating loss deduction” means the deduction allowed by this subsection.
IRS Code Section 172 • Section 172(c): • For the purposes of this section, the term “net operating loss” means the excess of the deductions allowed by this chapter over the gross income. Such excess shall be computed with the modifications specified in subsection (d).
IRS Code Section 172 Section 172(d) modifications: Add back to negative taxable income any NOLD Excess of capital losses over capital gains QSBS gain exclusion of section 1202 Personal exemption Excess of nonbusiness deductions over nonbusiness income • Manufacturing deduction of section 199 • • • • • • •
NOL Carrybacks and Carryforwards • Default election is to carry the loss back two years. – If loss year is 2011, loss is first applied to 2009 – If loss is carried back to a year closed by statute of limitations, only the NOL changes may be included in the refund claim
• IRS is allowed to make adjustments up to the refund claim
NOL Carrybacks and Carryforwards (cont.) • Taxpayers may waive the carryback period and carry the NOL forward. • Make election on the NOL-year return by attaching a statement to Form 1040 and checking the box on Schedule K of Form 1120 for corporations. • While election should be timely and made by the due date, an amended return filed within six months is also permitted. • Election is irrevocable
Exceptions to 2-Year Carryback Period • REITs not permitted to have carrybacks • Eligible small business (ESB) losses – 3, 4, or 5 years • Casualty and theft losses – 3 years • Federally declared disasters – 3 years • Farming losses – 5 years
Eligible Small Business • An eligible small business (ESB) is one whose average annual gross receipts are $15 million or less for the 3-year period ending with the tax year of the NOL. In determining whether a partnership, corporation, or sole proprietorship qualifies as an ESB, the gross receipts test applies at the entity or sole proprietorship level. If an entity is a member of a group of companies treated as a single employer under the Code, aggregation rules apply to determine whether the partnership, corporation, or sole proprietorship meets the gross receipts test.
Election for ESB • The election to use a carryback of more than two years for an ESB may be made by one of two methods. • Method 1. For the year in which the NOL arises, a statement is attached to the timely-filed return, including extensions. The statement must state that the taxpayer is electing to apply IRC §172(b)(1)(H) and specify the length of the NOL carryback period elected by the taxpayer, either three, four, or five years. • Method 2. If the return was filed without an election to apply the new law and the return did not include an election to forgo the carryback period, the IRS permits the taxpayer to make the election by filing one of the appropriate forms applying the NOL carryback period chosen by the taxpayer. This form must be filed within six months of the due date of the return excluding extensions.
Casualty and Theft Losses • Carryback period is 3 years • Only the portion of the NOL attributable to casualty loss is allowed the 3 years • May choose to forgo carryback period
Federally Declared Disasters • Small businesses can claim a 3-year carryback • Not an election but a mandatory default period • May forgo the carryback period
Farming Losses • Qualify for a 5-year carryback • Farming loss is the lesser of – The amount that would be NOL for the tax year if only income and deductions attributable to farming operations were taken into account – NOL for the tax year
Farming Losses (cont.) • A farming operation includes – Cultivation of land; – Raising or harvesting any agricultural or horticultural product; – Operating a nursery or sod farm; – Raising or harvesting trees; or – Raising, shearing, feeding, caring for, training, or managing animals.
Form 982 – Impact of Discharge of Indebtedness • Although income from discharge of debt is usually taxable, debt forgiveness is not taxable when • It is discharged in a bankruptcy proceeding • It occurs while the taxpayer is insolvent • The debt is a qualified farm indebtedness • The debt is a qualified real property business indebtedness • It is a student loan forgiveness resulting from working in a qualified area
Form 982 (cont.) • Taxpayer is required to reduce certain tax attributes by the amount included on the return. • Form 982 must be filed. • NOL must be adjusted for carrybacks and carryforwards. • Adjustments are made to the NOL year first and then to the other years.
NOL for Individuals • If line 41 on Form 1040 is negative, an individual could have an NOL. • Must analyze return to see if an NOL exists • First step is to separate taxpayer’s currentyear return into business and nonbusiness activities.
NOL for Individuals – Calculation • Negative taxable income – add back – Any NOLD – Excess of capital losses over capital gains – QSBS gain exclusion of section 1202 – Personal exemptions – Manufacturing deduction under section 199
Excess of Nonbusiness Deductions over Nonbusiness Income • Gain or loss from disposition of business property subject to depreciation and real property used in a trade or business are considered business income and deductions. • Personal casualty losses are business. • Charitable contributions are nonbusiness • Alimony is nonbusiness • State income taxes attributable to Schedule C business are allowable
Excess of Deductions over Income (cont.) • • • • •
Deductible moving expenses are business. Employee business expenses Employee wages are business. Rental of residence used for business Standard deduction is nonbusiness.
Form 1045 or Form 843 • Once NOL is determined for current tax year, must determine required carryback period. • Previous tax returns for the carryback period must be compared to taxpayer’s projected future income and tax liabilities. • Practitioner should advise taxpayer, but the ultimate decision to carry back or carry forward is ultimately the taxpayer’s. • Individual taxpayer has option of filing for refund using Form 1045 or filing amended returns for each year in the carryback period.
Advantages of Using Form 1045 • IRS has only 90 days to process the form. • One form can be filed for all carryback years. • The form clearly shows which prior-year items are adjusted as a result of the NOL.
Disadvantages of Using Form 1045 • Form must be filed within one year of the last day of the year in which NOL arose. • IRS processing of the form does not signify that the application was accepted as being correct. • If application is disallowed, no suit challenging the disallowance can be brought in any court. • Any amount applied, credited, or refunded based on the form that the IRS later determines to be excessive may be billed as though it was due to a mathematical or clerical error.
Advantages of Using Form 1040X • Deadline for filing Form 1040X to claim a refund for carryback is same date as deadline for changes to NOL year’s return. (Amended return must be filed no later than three years after due date of return for NOL year.) • If the IRS does not process the claim within six months of the date filed, taxpayer may file suit in court. • If the IRS disallows claim, taxpayer has two years from disallowance to file suit.
Disadvantages of Using Form 1040X • Must file separate returns for each carryback year. • May take more than 90 days for the IRS to process the returns and issue refunds. • Problems with manual adjustments to tax software.
NOL Carryforwards – Individuals • If the carryback period is waived or there is any NOL remaining after carryback is applied, the NOL carryforward is entered on line 21 as a negative amount on the following year’s return. • After completing the following year’s return, use IRS Pub. 536 to calculate any remaining carryforward to the next year.
NOL Carryforwards – Individuals (cont.) • When losses for more than one NOL year are carried forward, the earliest year must be used first. • If the statute of limitations on a carryback has expired, the NOL must be calculated and treated as if it had been carried back.
Change in Marital Status • If marital status changes and is not the same for all years involved in calculating the NOL carrybacks and carryforwards, only the spouse who had the loss can take the NOL deduction. • On a joint return the carryback deduction is limited to the income of the spouse with the loss. • The refund for a divorced person filing an NOL carryback against a joint return with a former spouse may be limited as it cannot be more than the taxpayer’s taxes paid on the joint return.
Changes in Filing Status • Married filing separate returns to joint filing: • If the taxpayer files MFS for the NOL year, the loss is treated as a joint loss on the MFJ return to which it is carried.
Changes in Filing Status (cont.) • Joint return to married filing separate returns: • If the taxpayers filed a joint return for the NOL year but are carrying the loss to an MFS return, the NOL must be calculated separately for each spouse. • The NOL is recomputed as if each taxpayer filed MFS in the NOL year.
Death of a Taxpayer • A decedent’s business losses before death are deductible on his or her final tax return only. • No part of the NOL is deductible by the decedent’s estate. • No part may be carried over to subsequent years by the surviving spouse. • The NOL may be carried back to prior years.
Pass-Through Entities • Elections waiving the carryback period are made at the original return. • Tests, such as the gross receipts test for eligible small business carryback, are made at entity level. • Nature of the loss is also determined at entity level. (example: farming losses qualifying for the special 5-year carryback)
Pass-Through Entities (cont.) • Copy of Schedule K-1 from NOL year should be attached to the carryback/carryforward years. • NOLs for partners or shareholders may be limited by basis, at-risk or passive activity losses.
C Corporation Losses • Calculating losses easier than for individual • Income not separated into business and nonbusiness transactions • Required adjustments: – Section 199 domestic production activities deduction – Deductions for dividends received without taxable income limits – Interest expense on corporate equity reduction transactions
NOL Carrybacks – Corporations • May use Form 1120-X or Form 1139 • Form 1139 deadline is one year after the year the NOL is incurred. • Advantages and disadvantages same as those for individuals.
Form 1138 • Extension of Time for Payment of Taxes by a Corporation Expecting a Net Operating Loss Carryback • Corporation expecting to have an NOL in the current year can automatically extend the time for paying all or part of its income tax for the immediately preceding year. • Cannot exceed the expected overpayment from the carryback of the NOL.
Change in Corporate Status • C corporation that elects S corporation status cannot carry any NOL losses forward or back to the S corporation year. • Likewise, if a corporation terminates its S status, no carryforward or carryback from an S corporation is allowed to a C year.
Summary • Thank you for attending our program. • Stuart Sobel Tax Media Network, Inc. www.taxmedianetwork.com
Course Topics • Introduction • History and background of the net operating loss • Definitions • Internal Revenue code section 172 overview • Net operating loss – carryback provisions • Net operating loss – carryforward provisions
Course Topics (cont.) • Electing to forgo the carryback in exchange for the carryforward • Exceptions to the 2-year carryback period • Casualty and theft losses • Farming losses • Form 982 – impact of discharge of indebtedness • Net operating losses for individuals
Course Topics (cont.) Filing Form 1045 or Form 843 Changes in marital filing status Pass-through entities – limitation of losses C corporation losses including the filing of Form 1139 • Form 1138 – extensions for filing • Changes in corporate status • Summary • • • • •
Introduction • Downturn of the economy has resulted in losses for many once profitable businesses. • NOLs are created when business losses exceed business and nonbusiness income. • Individuals get losses from Schedules A, C, E, and F.
Introduction (cont.) • Not all losses are allowed in computing the loss deduction including the following examples: – Deductions for exemptions – Capital losses in excess of gains – Section 1202 deductions from sale of qualified nonbusiness stock – Nonbusiness deductions in excess of nonbusiness income – Section 199 domestic production activities deduction
Introduction (cont.) • Schedule A on Form 1040 has some business deductions that are eligible. • NOLs create tax refunds from prior years or tax reductions in future years • Practitioners must explain choices to their clients – opportunities and pitfalls • Making the proper selection
5 Basic Steps to Using an NOL • Complete the current year tax return • Calculate the NOL • Determine which option is best – carryback or carry forward? • Deduct the NOL in the carryback or carryforward year • Determine if there is unused NOL
History and Background of NOL • Income tax created by the 16th Amendment in 1913 • Congress added NOL deduction in 1918 • Originally was to carry back one year and/or carry forward one year – 1939 – two-year carryforward – 1942 – two-year carryback – 1947 – code section 172 allows carryback for two years and carryforward for 20 years
History (cont.) • Congress wanted to create equity because of tax impact in certain accounting periods • States do not always recognize NOLs • Changes have occurred allowing lengthier carrybacks in order to obtain more money today rather than tax savings in the future
Definitions • Net operating loss (NOL): the result of specific losses and deductions exceeding a taxpayer’s income • Net operating loss deduction (NOLD): the allowable deduction that can be claimed in a prior or future year because of the NOL • Net operating loss carryover: the loss deduction that may be carried forward for a specific period of time
IRS Code Section 172 • Code section 172(a): • There shall be allowed as a deduction for the taxable year an amount equal to the aggregate of (1) the net operating loss carryovers to such year plus (2) the net operating loss carrybacks to such year. For purposes of this subtitle the term “net operating loss deduction” means the deduction allowed by this subsection.
IRS Code Section 172 • Section 172(c): • For the purposes of this section, the term “net operating loss” means the excess of the deductions allowed by this chapter over the gross income. Such excess shall be computed with the modifications specified in subsection (d).
IRS Code Section 172 Section 172(d) modifications: Add back to negative taxable income any NOLD Excess of capital losses over capital gains QSBS gain exclusion of section 1202 Personal exemption Excess of nonbusiness deductions over nonbusiness income • Manufacturing deduction of section 199 • • • • • • •
NOL Carrybacks and Carryforwards • Default election is to carry the loss back two years. – If loss year is 2011, loss is first applied to 2009 – If loss is carried back to a year closed by statute of limitations, only the NOL changes may be included in the refund claim
• IRS is allowed to make adjustments up to the refund claim
NOL Carrybacks and Carryforwards (cont.) • Taxpayers may waive the carryback period and carry the NOL forward. • Make election on the NOL-year return by attaching a statement to Form 1040 and checking the box on Schedule K of Form 1120 for corporations. • While election should be timely and made by the due date, an amended return filed within six months is also permitted. • Election is irrevocable
Exceptions to 2-Year Carryback Period • REITs not permitted to have carrybacks • Eligible small business (ESB) losses – 3, 4, or 5 years • Casualty and theft losses – 3 years • Federally declared disasters – 3 years • Farming losses – 5 years
Eligible Small Business • An eligible small business (ESB) is one whose average annual gross receipts are $15 million or less for the 3-year period ending with the tax year of the NOL. In determining whether a partnership, corporation, or sole proprietorship qualifies as an ESB, the gross receipts test applies at the entity or sole proprietorship level. If an entity is a member of a group of companies treated as a single employer under the Code, aggregation rules apply to determine whether the partnership, corporation, or sole proprietorship meets the gross receipts test.
Election for ESB • The election to use a carryback of more than two years for an ESB may be made by one of two methods. • Method 1. For the year in which the NOL arises, a statement is attached to the timely-filed return, including extensions. The statement must state that the taxpayer is electing to apply IRC §172(b)(1)(H) and specify the length of the NOL carryback period elected by the taxpayer, either three, four, or five years. • Method 2. If the return was filed without an election to apply the new law and the return did not include an election to forgo the carryback period, the IRS permits the taxpayer to make the election by filing one of the appropriate forms applying the NOL carryback period chosen by the taxpayer. This form must be filed within six months of the due date of the return excluding extensions.
Casualty and Theft Losses • Carryback period is 3 years • Only the portion of the NOL attributable to casualty loss is allowed the 3 years • May choose to forgo carryback period
Federally Declared Disasters • Small businesses can claim a 3-year carryback • Not an election but a mandatory default period • May forgo the carryback period
Farming Losses • Qualify for a 5-year carryback • Farming loss is the lesser of – The amount that would be NOL for the tax year if only income and deductions attributable to farming operations were taken into account – NOL for the tax year
Farming Losses (cont.) • A farming operation includes – Cultivation of land; – Raising or harvesting any agricultural or horticultural product; – Operating a nursery or sod farm; – Raising or harvesting trees; or – Raising, shearing, feeding, caring for, training, or managing animals.
Form 982 – Impact of Discharge of Indebtedness • Although income from discharge of debt is usually taxable, debt forgiveness is not taxable when • It is discharged in a bankruptcy proceeding • It occurs while the taxpayer is insolvent • The debt is a qualified farm indebtedness • The debt is a qualified real property business indebtedness • It is a student loan forgiveness resulting from working in a qualified area
Form 982 (cont.) • Taxpayer is required to reduce certain tax attributes by the amount included on the return. • Form 982 must be filed. • NOL must be adjusted for carrybacks and carryforwards. • Adjustments are made to the NOL year first and then to the other years.
NOL for Individuals • If line 41 on Form 1040 is negative, an individual could have an NOL. • Must analyze return to see if an NOL exists • First step is to separate taxpayer’s currentyear return into business and nonbusiness activities.
NOL for Individuals – Calculation • Negative taxable income – add back – Any NOLD – Excess of capital losses over capital gains – QSBS gain exclusion of section 1202 – Personal exemptions – Manufacturing deduction under section 199
Excess of Nonbusiness Deductions over Nonbusiness Income • Gain or loss from disposition of business property subject to depreciation and real property used in a trade or business are considered business income and deductions. • Personal casualty losses are business. • Charitable contributions are nonbusiness • Alimony is nonbusiness • State income taxes attributable to Schedule C business are allowable
Excess of Deductions over Income (cont.) • • • • •
Deductible moving expenses are business. Employee business expenses Employee wages are business. Rental of residence used for business Standard deduction is nonbusiness.
Form 1045 or Form 843 • Once NOL is determined for current tax year, must determine required carryback period. • Previous tax returns for the carryback period must be compared to taxpayer’s projected future income and tax liabilities. • Practitioner should advise taxpayer, but the ultimate decision to carry back or carry forward is ultimately the taxpayer’s. • Individual taxpayer has option of filing for refund using Form 1045 or filing amended returns for each year in the carryback period.
Advantages of Using Form 1045 • IRS has only 90 days to process the form. • One form can be filed for all carryback years. • The form clearly shows which prior-year items are adjusted as a result of the NOL.
Disadvantages of Using Form 1045 • Form must be filed within one year of the last day of the year in which NOL arose. • IRS processing of the form does not signify that the application was accepted as being correct. • If application is disallowed, no suit challenging the disallowance can be brought in any court. • Any amount applied, credited, or refunded based on the form that the IRS later determines to be excessive may be billed as though it was due to a mathematical or clerical error.
Advantages of Using Form 1040X • Deadline for filing Form 1040X to claim a refund for carryback is same date as deadline for changes to NOL year’s return. (Amended return must be filed no later than three years after due date of return for NOL year.) • If the IRS does not process the claim within six months of the date filed, taxpayer may file suit in court. • If the IRS disallows claim, taxpayer has two years from disallowance to file suit.
Disadvantages of Using Form 1040X • Must file separate returns for each carryback year. • May take more than 90 days for the IRS to process the returns and issue refunds. • Problems with manual adjustments to tax software.
NOL Carryforwards – Individuals • If the carryback period is waived or there is any NOL remaining after carryback is applied, the NOL carryforward is entered on line 21 as a negative amount on the following year’s return. • After completing the following year’s return, use IRS Pub. 536 to calculate any remaining carryforward to the next year.
NOL Carryforwards – Individuals (cont.) • When losses for more than one NOL year are carried forward, the earliest year must be used first. • If the statute of limitations on a carryback has expired, the NOL must be calculated and treated as if it had been carried back.
Change in Marital Status • If marital status changes and is not the same for all years involved in calculating the NOL carrybacks and carryforwards, only the spouse who had the loss can take the NOL deduction. • On a joint return the carryback deduction is limited to the income of the spouse with the loss. • The refund for a divorced person filing an NOL carryback against a joint return with a former spouse may be limited as it cannot be more than the taxpayer’s taxes paid on the joint return.
Changes in Filing Status • Married filing separate returns to joint filing: • If the taxpayer files MFS for the NOL year, the loss is treated as a joint loss on the MFJ return to which it is carried.
Changes in Filing Status (cont.) • Joint return to married filing separate returns: • If the taxpayers filed a joint return for the NOL year but are carrying the loss to an MFS return, the NOL must be calculated separately for each spouse. • The NOL is recomputed as if each taxpayer filed MFS in the NOL year.
Death of a Taxpayer • A decedent’s business losses before death are deductible on his or her final tax return only. • No part of the NOL is deductible by the decedent’s estate. • No part may be carried over to subsequent years by the surviving spouse. • The NOL may be carried back to prior years.
Pass-Through Entities • Elections waiving the carryback period are made at the original return. • Tests, such as the gross receipts test for eligible small business carryback, are made at entity level. • Nature of the loss is also determined at entity level. (example: farming losses qualifying for the special 5-year carryback)
Pass-Through Entities (cont.) • Copy of Schedule K-1 from NOL year should be attached to the carryback/carryforward years. • NOLs for partners or shareholders may be limited by basis, at-risk or passive activity losses.
C Corporation Losses • Calculating losses easier than for individual • Income not separated into business and nonbusiness transactions • Required adjustments: – Section 199 domestic production activities deduction – Deductions for dividends received without taxable income limits – Interest expense on corporate equity reduction transactions
NOL Carrybacks – Corporations • May use Form 1120-X or Form 1139 • Form 1139 deadline is one year after the year the NOL is incurred. • Advantages and disadvantages same as those for individuals.
Form 1138 • Extension of Time for Payment of Taxes by a Corporation Expecting a Net Operating Loss Carryback • Corporation expecting to have an NOL in the current year can automatically extend the time for paying all or part of its income tax for the immediately preceding year. • Cannot exceed the expected overpayment from the carryback of the NOL.
Change in Corporate Status • C corporation that elects S corporation status cannot carry any NOL losses forward or back to the S corporation year. • Likewise, if a corporation terminates its S status, no carryforward or carryback from an S corporation is allowed to a C year.
Summary • Thank you for attending our program. • Stuart Sobel Tax Media Network, Inc. www.taxmedianetwork.com
