Net Operating Losses of Individuals

1
Net Operating Losses of Individuals

• BUS 225K
• Professor Nellen

2
Agenda

• Relevance
• Basic definitions
• Rationale
• History
• 172 Overview
• Mechanics calculation and c/o
• State tax considerations
• Policy perspectives

3
Relevance

• Can enable taxpayers to maximize use of
  deductions and losses not limited to a single
  year perspective
• Planning considerations
• If individual might have NOL, consider moving
  items that dont go into an NOL into another year
  if possible.
• Carryback or only forward
• State income tax treatment
• What is approaching end of c/f period and still
  have large NOL/

4
Basic definitions

• NOL what arises in a year if certain losses and
  deductions exceed ones income.
• NOLD the deduction you can take in another year
  because of an NOL
• Carryover an NOL is generally allowed to be
  carried back and then forward. The length of any
  carryback and carryforward period has changed
  over time.

5
Rationale

• To ameliorate the effect of an annual accounting
  period.
• To recognize the exigencies of business.
• Improve equity and fairness some businesses may
  have less steady business cycles than others.
• The calculation rules vary for corporations and
  other taxpayers.
• Generally, the rules are easier for corporations.
• Congress does not find that certain personal or
  sometimes non-cash deductions of individuals
  should generate an NOL, but that instead, for
  such deductions, each year should stand on its
  own.

6
Why allow a carryback?

• Because past or future income/profits must cover
  the NOL, both a carryback and carryforward period
  are justified. In contrast to a carryfoward, a
  carryback has the advantage of better recognizing
  the time value of money.

7
History - 1

• Originally, calculation of NOL took an economic
  income approach, changing to a taxable income
  approach with IRC of 1939 (Callanan Road
  Improvement, 404 F2d 1119 (2nd Cir. 1968)).

8
History - 2

• Revenue Act of 1918 first time NOL c/o allowed
• c/b 1 year and then forward 1 year.
• Ending of WWI expectation of business losses
  (The Yale Law Journal, April 1932, p. 900).
• The net loss had to result from either a
  business regularly carried on or bona fide sale
  of assets acquired after April 5, 1917 for
  production of war items.
• Loss was equal to allowable deductions over gross
  income plus tax-exempt interest income.
• NOL carryforward extended by later tax acts but
  omitted in National Industrial Recovery Act of
  1933.
• 1939 - 2-year carryforward enacted.
• 1942 - 2-year carryback added (Appleby, 116 FSupp
  410 (Ct. Cl. 1953)).
• Later - various changes made including wrt types
  of losses covered and carryover periods.
• Today, 172 generally allows NOL to be carried
  back 2 years and then forward 20 years (prior to
  this change by Taxpayer Relief Act of 1997 (PL
  105-34 8/5/97) periods were 3 and 15,
  respectively).

9
172 Overview

• Need to calculate the NOL
• Carry it back 2 years (generally) unless timely
  elect to forego c/b period (172(b)(3))
• In any year, could have both a c/b and a c/f to
  that year. The total of these amounts is the
  NOLD.
• Need recordkeeping to track NOL for both
  regular tax and AMT purposes.
• Many special rules included in 172 for certain
  entities or types of losses

10
172 Mechanics

• (a) Deduction allowed. 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.

11
NOL Defined

• 172(c) Net operating loss defined. For
  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).

12
Modifications for Individuals

• Add back to negative taxable income
• Any NOLD
• Excess of capital losses over capital gains
• QSBS gain exclusion of 1202 allowed
• Personal exemptions
• Excess of nonbusiness deductions over nonbusiness
  income
• G/L from disposition of business property subject
  to depreciation and real property used in trade
  or business are considered business income and
  deductions
• Treat personal casualty losses are business (so
  can generate an NOL)
• Charitable contributions considered non-business.
• Alimony paid non-business (Monfore, TCM
  1988-197)
• 404 deductions (deferred comp plans) of an EE
  nonbusiness
• State income taxes attributable to Schedule C
  business business
• Deductible moving expenses business (Rev Rul.
  72-195)
• Employee business expenses business
• Employee wages business (1.172-3)
• Rental of a residence business (Lagreide, 23 TC
  508 (1954))
• Standard deduction nonbusiness
• Manufacturing deduction of 199

13
Example from Pub 536

• Excess of deductions over income 11,300
• To determine NOL that can be c/b, need to apply
  172(d) modifications to 11,300

14
Example - continued

• Excess ded over income (11,300)
• Modifications
• Personal exemptions 3,500
• STCL (non-business) 1,000
• Excess non-business deductions(5,450) over
  non-business income (425)
  5,025
• NOL to c/b or c/f 1,775

15
What to do with NOL

• Attach statement to timely filed return
  (including extensions) electing to forego c/b
  period (172(b)(3))
• Generally no revocable
• Also applies to AMT NOL (Rev Rul 87-44)
• File amended returns for prior years (carryback
  to earliest year first)
• Must file within 3 years of the filing date (incl
  extension) for the NOL return)
• Refigure prior year TI (will be adjustments to
  AGI based figures except charitable contributions
  (170(d) and 1.170A-10(d)) and SE tax
  (1402(a)(4))
• File Form 1045, Application for Tentative Refund
• IRC 6411 must file within 1 year after end of
  NOL year
• Complete the worksheets to figure refund
• IRS to process form within 90 days

16
Questions

• Will a passive activity loss increase an NOL?
• Bob had NOL in 2009 and wants to carry it back
  using Form 1045. What is deadline to file that
  form?
• If Bobs 2009 return is audited by IRS, can they
  also adjust his 2007 and 2008 returns if they
  find an error with the NOL (and he carried it
  back)?
• If it looks like the Smiths will have an NOL for
  current year, what planning advice should you
  give them?

17
Example

• Does Abigail have NOL for 2007?
• Wages 30,000
• Interest income 100
• Schedule C (45,000)
• Schedule A (12,000) (incl 2K casualty)
• Personal exemp ( 3,400)
• Capital gain 1,500
• TI (28,800)

18
State tax considerations

• States might not conform to federal calculation
  and c/o rules.
• CA 2008 law change suspend NOL for large t/p
  for 2008 and 2009 to help address budget
  shortfall. Also conformed the c/b and c/f
  periods to match federal (starting in 2011).
• NJ 2008 extended corporate NOL c/f from 7 to 20
  to help states business climate.

19
Policy perspectives

• Loophole?
• Sometimes c/o referred to such by lawmakers and
  others
• What is appropriate c/b and c/f period?
• Time value of money
• Some recognition wrt carrybacks, but not
  carryfowards
• Should c/f amounts be increased for an interest
  factor?
• Flat tax promoted by Drs. Hall and Rabushka
  allows
• Unlimited carryforward of the excess of
  deductions over income (The Flat Tax, pg 216).
• Carryforward increased by an interest factor to
  recognize time value of money of postponed
  deductions.

20
Summary

• NOL exists for fairness, ameliorate effect of
  annual accounting period.
• But, for individuals, not all expenditures or
  losses create an NOL, so planning is important,
  where possible.
• 3 possibilities if have NOL, planning important
  including consideration of rate in past and in
  future
• Recordkeeping important
• If not sure if something goes into NOL, research
  it. Lots of guidance accumulated over the years.
• Watch out for possible federal and state changes,
  particularly state.