Tricky Tax Rules Regarding Net Operating Losses

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The US economy is still recovering from the 2008 crisis, its worst slump since the Great Depression. Consequently, many long-established businesses will wind up with losses for 2015, as will many new ventures.

Our lawmakers aren't indifferent to the plight of businesses with bottom lines that aren't black. The tax code authorizes relief for businesses that suffer net operating losses (NOLs) when their expenses exceed receipts. Normally, businesses can carry back NOLs for two years.

Section 172 of the Internal Revenue Code specifies two choices – elections, in IRS lingo: One allows businesses to carry NOLs back and offset them against previous years' profits, and then to carry them forward and offset against future years' profits. The second choice allows businesses that forego the carryback route to use their NOLs as offsets against future years' profits only, for 20 years (or for as long a period, up to 20 years, as may be necessary to absorb the entire loss).

Businesses that previously enjoyed profitable years can elect to carry back their 2015 losses for up to two years. The NOL rules help all kinds of ventures – anything from full-time and long-established to part-time and newly launched – and they can be conducted through sole proprietorships, partnerships, or corporations.

Backward or forward? Section 172 allows business owners with NOLs for 2015 to use them first to offset business profits or other kinds of income listed on their returns for up to two years, thereby generating immediate refunds for those years. Note that carrybacks to those years don't decrease self-employment taxes for individuals.

There's another route for business owners who are unable to apply part of their NOLs as an offset because it exceeds income for the earlier years. What they then are allowed to do is apply the unused part – until used up – to offset business profits or other kinds of income listed on returns for the following 20 years. After 20 years, however, unused carryforwards are forfeited. They can't be passed down to heirs.

Section 172 also allows business owners to dispense with carrying back NOLs to any of the earlier years. Instead, they simply carry forward their entire NOL for 20 years. This can be an appropriate tactic for business operators who were in low brackets in earlier years and anticipate rising into loftier brackets in subsequent years. But it's not a worthwhile tactic for those who anticipate skimpy future profits because years could go by before they become able to reap the full benefit of the write-offs.

An example: Sole proprietor Elijah Vennebush has an NOL for 2015; 2013 and 2014 were low-income years. An ebullient Eli expects to go gangbusters for 2016 and later years. In such a scenario, Eli elects to relinquish any carryback. To do so, he attaches a statement to that effect to his return. Eli doesn't have an unlimited time to elect the carryforward of an NOL for 2015. The deadline is the due date, plus extensions, for his return for 2015 – by April 18 for 2016 or Oct. 17 (the 15th falls on a Saturday), if he submits Form 4868, Application for Automatic Extension of Time to File US Individual Income Tax Return, for an automatic six-month extension.

On the other hand, Eli is free to go the carryback route and select the carryback period of two years. As is true of a carryforward, he must decide on a carryback by the due date for his 2015 Form 1040.

The law mandates a strict chronological sequence. Assume Eli decides to carry back and deduct his 2015 NOL on his 2013 return to obtain a refund of 2013's taxes. Only if his NOL surpasses his income in 2013 can he then carry the unused portion of the NOL to 2014. And what if there's still a portion of the 2015 NOL left? He then carries it over to his 2016 return, and so forth.

Audit odds. Taxpayers who decide to claim NOLs should first check to see whether returns for prior years contain any items that might be challenged by the IRS. While filing for a carryback refund doesn't mean that the loss year's return will be bounced automatically for an examination, a refund claim might cause the IRS to scrutinize earlier returns.

About Julian Block

Julian Block

Attorney and author Julian Block is frequently quoted in the New York Times, Wall Street Journal, and the Washington Post. He has been cited as “a leading tax professional” (New York Times), an “accomplished writer on taxes” (Wall Street Journal), and “an authority on tax planning” (Financial Planning magazine). More information about his books can be found at julianblocktaxexpert.com

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