Once upon a time when I decided to sit for the Enrolled Agents exam, taking all four parts (in 2005 there were four parts) at once, I decided I should study strategically, putting more emphasis on the areas I thought IRS would be more likely to test because they were areas more likely to be audited. That worked well – except when it came to the alternative minimum tax (AMT) and net operating losses (NOLs). Few areas seemed to have such a high degree of patches, redirections, and changes in tax law.
I understand the basic rule for NOLs – expenses exceed taxable revenue for the year, creating negative taxable income. The idea is to provide tax relief to tax payments and reduce the need to make tax payments in future periods. The benefit to taxpayers is to be able to reduce the tax bill in years when a loss is not incurred for their business or trade.
The difficulty arises when you try to apply tax law to the carry back or carry forward of NOLs. It seems from the inception of NOL rules in 1918 as a temporary post-WWI relief measure, the number of years allowable for carryback or carryover purposes depended on Congressional winds, generally in response to economic upheavals.
In 1950 the two-year carryback and carryover periods were replaced by a one-year carryback period and a five-year carryover period. In 1976 Congress extended the five-year carryover to seven years and included the election to relinquish carryback periods and carry forward the loss only. In 1997 the carryover period was extended to 20 years. By 2002 NOL rules changed again to allow carryback of five years, mostly to alleviate the adverse affects of September 11, 2001. 2009 saw the increase of the carryback period to 3, 4, or 5 years.
Form 1045, Application for Tentative Refund, completed to carry back net operating losses at the individual level, is confusing at best and terrifying at its worst.
As a preparer you have to pay attention to changes in the tax law to know whether you can carry the loss back 2, 3, or 5 years. You also have to know what qualifies as a net operating loss and whether or not the taxpayer actually has an NOL. For example, the fact that you as an individual have more itemized deductions than you do income to take them against does not mean you have an NOL.
Unfortunately, calculating the net operating loss is not as simple as plugging figures into a form. Several modifications must be made, including (for individual filers):
1. Personal and dependency exemptions cannot be used.
2. Net operating losses from a different year cannot be used.
3. Nonbusiness capital losses, those arising outside your trade or business, can only be used against nonbusiness capital gains.
4. Nonbusiness deductions, such as charitable donations, deductible medical expenses, mortgage interest, alimony, etc., can only be used against nonbusiness income.
Once it is decided the taxpayer does indeed have a net operating loss, a decision has to be made whether to carry the NOL back to prior years or to carry it forward. If the taxpayer elects to waive the carryback period, however, once the election is made it is irrevocable. Consulting a tax professional for assistance in making this decision would be wise.
The application of an NOL to prior years is a multi-step, complicated calculation which requires the adjustment and refiguring of a number of things, such as taxes owed and the taxable income in the carryback year, not to mention many of the deductions taken in that year.
For those new to the 1045 the first quandary is which year goes in what column. Instructions for the 1045 state to begin with the earliest year. Thus if this is 2010 and you want to carry the NOL back 3 years, you would begin with 2007.
The mechanics of carrying an NOL to a prior year become involved. The tax for the prior year must be refigured by re-computing the adjusted gross income for that year. Then any items limited by the AGI must be recomputed, such as allowances for passive activities, taxable SSB, IRA deductions, and excludable savings bond interest. Next, the taxable income is refigured to reflect changes in itemized deductions for medical expenses, casualty losses, and miscellaneous itemized deductions. If AMT applied to the taxpayer it will also come into play.
Estates and trusts, as well as corporations, may also make use of net operating losses. Corporations wishing to carry back NOLs against prior years file Form 1139, Corporation Application for Tentative Refund. Preparers should be aware that rules for carrybacks may differ.
For more information about NOLs, please see
v IRS Publication 536, Net Operating Losses (NOLs) for Individuals, Estates, and Trusts,
v IRS Instructions for Form 1045, Application for Tentative Refund,
v IRS Instructions for Form 1139, Corporation Application for Tentative Refund,
v RIA Checkpoint website (available from the main face of Drake Software),
v RIA’s Federal Tax Coordinator and Federal Tax Handbook, and
v IRS Publication 334, Tax Guide for Small Businesses.
Posted by Merry Broughton