NET OPERATING LOSSES FINAL COPYRIGHT 2015 LGUTEF. Learning Objectives. Introduction

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1 NET OPERATING LOSSES Steps for NOL Deduction NOL Carried between Joint and Separate Returns Special Issues in NOL Calculations Making Optimal Use of an NOL Deduction Appendix Learning Objectives After completing this session, participants will be able to perform the following job-related actions: Determine which taxpayers can and cannot carry a net operating loss (NOL) to other tax years Understand how taxable income is adjusted to compute an NOL Compute the amount of NOL that is absorbed by an intervening year Claim a refund resulting from carrying an NOL back to prior tax years Explain the limits on deducting NOLs carried between MFJ returns and returns that are not MFJ returns of the same spouses Optimize the use of NOLs by shifting income or deductions between tax years Make the best use of NOLs by choosing when to forgo the NOL carryback Introduction A net operating loss (NOL) deduction can offset the sometimes harsh consequences of the annual accounting period used for income taxes. NOL deductions allow taxpayers to carry a tax year s net business loss (after loss deduction limitations such as the at-risk rules, passive loss rules, and hobby loss rules are applied) back, 3, 5, or 10 years, and forward up to 0 years, to offset taxable income in those years. The principle of NOLs is simple, but actual computation of NOL deductions can be complex. Complexity arises because the provisions of I.R.C. 17 remove several other tax benefits before an NOL deduction is calculated. Those benefits are removed by modifying income and deductions in all affected years: 015 Land Grant University Tax Education Foundation, Inc. 39

2 1. Deductions for the NOL year are modified to determine the NOL that can be carried to other years.. Taxable income is modified in the years to which the loss is carried to determine how much of the NOL is absorbed. A refund resulting from carrying NOLs back to prior years can be claimed by filing an amended return for each carryback year or by filing Form 1045, Application for Tentative Refund, for all carryback years. In the carryforward years the NOL deduction is claimed as negative Other income on line 1 of Form The deadlines for filing these forms are discussed under the heading Step 4: Calculate Taxes in Carryback and Carryforward Years later in this chapter. STEPS FOR NOL DEDUCTION Computing an NOL and claiming the NOL deduction requires four successive steps. The process of computing an NOL for an individual taxpayer and claiming the NOL deduction must be carried out in the following four steps. 1. Determine eligibility. Compute the NOL 3. Distribute the NOL to carryback and carryforward years 4. Recalculate taxes in the carryback years and calculate taxes in the carryforward years 40 INTRODUCTION Estate and Trusts The NOL rules for individuals also apply to estates and trusts. If an estate or trust has an NOL carryover from its final year, the beneficiaries of the estate or trust continue to use the carryover NOL until it is absorbed or until the carryforward period expires [I.R.C. 64(h)(1)]. However, if the last year of the carryover period is the last year of the estate or trust, the remaining NOL is an excess deduction of the estate or trust that is distributed to the beneficiaries who succeed to the property of the estate or trust [Treas. Reg. 1.64(h)-(b)]. The excess deduction allocated to a beneficiary can be deducted only in the year it is distributed. If the deduction (when added to other deductions) exceeds the beneficiary s gross income, the excess cannot be carried over to subsequent years [Treas. Reg. 1.64(h)-(a)]. Step 1: Determine Eligibility Generally, taxpayers are allowed to reduce their own income with their own losses from other years. Individuals and C corporations may claim their own NOLs. Partnerships and S corporations, and LLCs that are taxed as partnerships or S corporations, generally cannot claim an NOL deduction. Instead, the partners, members, or shareholders use their separate shares of the partnership, LLC, or S corporation business income and deductions to figure their individual NOLs. Step : Compute the NOL Negative taxable income for the NOL year is modified by removing deductions that are not allowed in computing the NOL. Net Taxable Income Must Be Negative If taxable income for the year is not negative, the taxpayer does not have an NOL for that year. However, a taxpayer with negative taxable income will not necessarily have an NOL for that year, as explained in the following discussion. Items Not Included in NOL Several items that are included in the calculation of taxable income are not included in the NOL calculation. These usually are excluded from the NOL computation for one of two reasons. Generally, only business losses can be carried from one year to another; therefore, with a few exceptions, nonbusiness deductions in excess of nonbusiness income are not included in the NOL.

3 Items that carry to another tax year under another carryover rule such as capital loss carryovers are excluded from the NOL calculation to avoid duplication. The following items are excluded from the NOL by adding them back to the taxpayer s negative taxable income [I.R.C. 17(d)]: 1. Dependent and personal exemption deductions Schedule A (Form 1045) Calculation Form 1045 includes Schedule A as a worksheet for the calculation of an NOL. Instead of starting with negative taxable income and then adding back the personal and dependent exemptions deduction, Schedule A (Form 1045) begins with the taxpayer s income before the personal and dependent exemptions deduction is subtracted. Consequently, it is not added back on Schedule A (Form 1045) to compute the NOL.. Nonbusiness deductions in excess of nonbusiness income 3. Capital losses in excess of capital gains 4. The exclusion of 50% of the gain from I.R.C. 10 stock (qualified small business stock) 5. An NOL deduction carried from another year 6. The I.R.C. 199 domestic production activities deduction If the sum of the items that are added back is greater than the negative taxable income, there is no NOL for the year. Example.1 Adding Back Nonbusiness Deductions Paige Turner s taxable income for 015 before deducting exemptions is a negative $10,000 due to both business losses and nonbusiness deductions. If her nonbusiness deductions exceed her nonbusiness income by $6,000, she must add that $6,000 back to her negative $10,000 taxable income, which reduces her NOL to $4,000. If Paige s nonbusiness deductions exceed her nonbusiness income by more than her $10,000 negative taxable income, she does not have an NOL. Business Income and Deductions Income and deductions are business income and deductions if they arise from a trade or business. This includes gain or loss from the disposition of both real property used in a trade or business and depreciable property used in a trade or business [I.R.C. 17(d)(4)(A)]. Employment is treated as a trade or business, which means wages are business income and deductible employee expenses are business deductions. The exception to the business connection requirement is that deductions attributable to casualty and theft losses from property held for personal use or for investment are treated as business losses for the NOL calculation even though they are not connected with a trade or business [I.R.C. 17(d)(4)(C)]. Effect of Business or Nonbusiness Classification Classifying ordinary income and capital gain as nonbusiness is advantageous to the taxpayer because it reduces the amount of nonbusiness deductions that must be added back to compute the NOL. Similarly, classifying deductions and capital losses as business is advantageous to the taxpayer. Example. Business and Nonbusiness Income and Deductions Neil Down, who is not married and does not itemize deductions, realized a $10,000 loss from his sole-proprietor auto parts business in 015. However, due to other income and deductions, as shown in Figure.1, his taxable income for 015 was negative $13,800. FIGURE.1 Neil Down s 015 Taxable Income Income or Deduction Amount Business loss ($10,000) Wage income 6,000 Investment income 500 Adjusted gross income ($3,500) Personal exemption deduction (4,000) Standard deduction (6,300) Taxable income ($13,800) Step : Compute the NOL 41

4 In calculating his NOL, Neil is not allowed to deduct his personal exemption deduction. He can deduct $500 of his standard deduction because he has $500 of nonbusiness (investment) income. Consequently, Neil adds back his $4,000 personal exemption deduction and $5,800 ($6,300 $500) of his standard deduction to his negative $13,800 taxable income to compute his $4,000 ( $13,800 + $4,000 + $5,800) NOL. Other Ways to Look at the NOL Note that the $4,000 NOL equals the sum of Neil s negative $3,500 AGI and the $500 portion of his standard deduction that is allowed by his $500 investment income. His NOL could also be viewed as his $10,000 business loss reduced by his $6,000 wage income. Farm and Fishing Income Averaging FINAL COPYRIGHT 015 LGUTEF An NOL that is carried to a base year under the I.R.C income averaging rules is allowed in full when computing the taxable income for the base year even if the deductions exceed gross income and the result is negative taxable income. However, any NOL that may provide a tax benefit in another tax year must be added back to calculate base year taxable income [Treas. Reg (d)()(i)(A)] for any subsequent years income averaging calculations. This prevents taxpayers from getting a double benefit from an NOL. Farm Income Averaging Election Example See pages of the 009 National Income Tax Workbook for an example of the interaction of the NOL rules and the farm income averaging rules. 4 STEPS FOR NOL DEDUCTION Suspended Deductions Deductions that are suspended by rules such as the limit on charitable contribution deductions, passive activity losses, amount at risk, or basis in a pass-through entity get no special treatment under the NOL rules in the year they are suspended. Because they are not used to compute taxable income in the year they are suspended, they are not added back to compute the NOL for that year. If they are allowed as a deduction in a later year, they reduce taxable income for that year and are subject to the rules for including deductions in the NOL in that year. Schedule A (Form 1045) Schedule A NOL (Form 1045) is an excellent worksheet for computing the NOL, not only for filing Form 1045 but also for filing amended returns for the carryback years. To aid in the completion of Schedule A NOL (Form 1045), a set of four worksheets is included in the appendix of this chapter. They are filled in for the facts in the NOL-planning case study later in this chapter. NOL Worksheet 1 computes the nonbusiness and business capital losses that are entered on lines and 11 of Schedule A (Form 1045) respectively. NOL Worksheet computes the nonbusiness and business capital gains that are reported on lines 3 and 1 of Schedule A (Form 1045) respectively. NOL Worksheet 3 computes the nonbusiness deductions that are entered on line 6 of Schedule A (Form 1045), and NOL Worksheet 4 computes the nonbusiness income that is entered on line 7 of Schedule A (Form 1045). Step 3: Distribute the NOL The NOL calculated in Step is then distributed among the years eligible for the NOL deduction from the loss year. Two separate rules make this step a bit complicated. 1. There are several different carryback periods, depending on the source of the NOL.. The amount of the NOL that is absorbed in a carryback or carryforward year is the modified taxable income for that carryback or carryforward year not the taxable income of the carryback or carryforward year.

5 Modifications to taxable income in carryback and carryforward years are explained later in this chapter, but they include adding back the personal and dependent exemption deductions before the NOL deduction is taken. Therefore, the amount of the NOL that is absorbed in a carryback or carryover year is greater than that year s taxable income without regard to the NOL. In other words, taxpayers generally do not fully benefit from the NOL deduction. Taxpayers can elect to forgo the carryback period and carry the NOL forward only. This election must be made on the timely filed original return for the NOL year or on an amended return for the NOL year that is filed within 6 months of the due date of the original return. Intervening Years Open for Audit If the taxpayer does not elect to forgo the carryback, the income and deductions that affect the amount of NOL absorbed in those years are subject to audit until the statute of limitations has run for all of the years to which the NOL is carried [Springfield Railway Co. v. United States, 31 F.d 754 (Ct. Cl. 1963)]. Default Carryback Period ( Years) Generally, an NOL can be carried back to the tax years immediately before the loss year [I.R.C. 17(b)(1)(A)(i)]. If it is not fully absorbed in those years, the excess is carried forward for up to 0 years after the loss year [I.R.C. 17(b)(1)(A)(ii)]. However, longer carryback periods are specified for NOLs that result from specific types of losses. Excess NOL at End of 0-Year Carryforward Period Any NOL that is not absorbed in the carryback and carryforward periods is lost. It cannot be deducted in any other tax year. Casualty, Theft, and Small Business Disaster Losses (3 Years) The carryback period is 3 years for the following eligible losses described in I.R.C. 17(b)(1)(E)(ii): 1. An individual taxpayer s NOL arising from casualty or theft losses. Small business NOLs attributable to federally declared disasters A small business for this rule is a partnership, corporation, or sole proprietorship that had average annual gross receipts of $5 million or less for the 3-year period ending with the loss year [I.R.C. 17(b)(1)(E)(iii)]. Losses are not eligible for this 3-year carryback period if they are eligible for a 5-year carryback as a farming loss. Those rules are discussed later in this section. Farming Losses Attributable to Disasters I.R.C. 17(b)(1)(E)(ii)(III) includes NOLs from farming in the 3-year carryback if they are attributable to federally declared disaster areas. Apparently, the purpose of this provision is to qualify such losses for the 3-year carryback even if the farming business does not meet the average gross receipts test for small businesses. However, the flush sentence that follows I.R.C. 17(b)(1)(E)(ii)(III) excludes farming losses that qualify for the 5-year carryback. The committee reports for the Taxpayer Relief Act of 1998, Pub. L. No , state, The three-year carryback period continues to apply to an NOL incurred in a Presidentially [Editor s note: Presidentially was replaced with federally by the Tax Extenders and Alternative Minimum Tax Relief Act of 008, Pub. L. No , Sec. 706(a)()(D)(v) Div C] declared disaster area if such NOL is not eligible for the five-year carryback period. Because all NOLs from farming that are attributable to federally declared disaster areas are also farming losses that qualify for the 5-year carryback, it appears that no farming losses qualify for the 3-year carryback. Step 3: Distribute the NOL 43

6 Allocation to Different Carryback Periods If an NOL results from eligible losses that qualify for the 3-year carryback as well as from losses that qualify only for the -year carryback, the NOL is allocated between the two types of losses and is treated as two separate NOLs [I.R.C. 17(b)(1)(E)(iv)]. Neither I.R.C. 17 nor the regulations under it explain how to allocate the NOL between eligible losses and other losses. IRS Publication 536, Net Operating Losses (NOLs) for Individuals, Estates, and Trusts, and the instructions for Form 1045, Application for a Tentative Refund, explain which losses are eligible for the 3-year carryback but do not explain how to allocate an NOL between the 3-year and the -year carryback. By contrast, I.R.C. 17 gives explicit guidance for allocating an NOL to other types of losses that get special treatment, such as a specified liability loss [I.R.C. 17(f)] and a farming loss [I.R.C. 17(i)(1)]. The general guidance given by I.R.C. 17(b)(1)(E)(ii) for eligible losses is slightly different for casualty and theft losses than for small business disaster losses. Casualty and Theft Losses I.R.C. 17(b)(1)(E)(ii)(I) includes losses of property arising from fire, storm, shipwreck, or other casualty, or from theft in the losses that can be carried back 3 years. Apparently that means an NOL can be allocated to the 3-year carryback to the extent of the casualty or theft loss that is deducted on the return for that tax year. Example.3 Casualty Loss Not Claimed Cherry Pitt, a single taxpayer, had a $700 theft loss from a Ponzi scheme in 015, but her other itemized deductions were only $4,500, so she claimed the $6,300 standard deduction for single taxpayers. She had an NOL in 015 arising from a $10,000 business loss. Her only income was $500 of investment income. Her $19,800 negative taxable income and $10,000 NOL for 015 are calculated as shown in Figure.. 44 STEPS FOR NOL DEDUCTION FIGURE. Cherry Pitt s 015 NOL with Standard Deduction Income, Deduction, or Loss Amount Business loss ($10,000) Investment income 500 Adjusted gross income ($9,500) Personal exemption deduction (4,000) Standard deduction (6,300) Taxable income ($19,800) Add back personal exemption deduction 4,000 Add back excess standard deduction ($6,300 $500) 5,800 NOL ($10,000) Because Cherry s taxable income and NOL are not affected by her $700 theft loss, no portion of her NOL is an eligible casualty loss, and none of her NOL is eligible for the 3-year carryback period. Cherry s $10,000 NOL is eligible for the default -year carryback. Example.4 Itemized Deduction of Casualty Loss Cherry Pitt from Example.3 had a $50,000 theft loss instead of a $700 theft loss, so she itemized her deductions instead of claiming the standard deduction. Her negative $67,550 taxable income and $59,900 NOL for 015 are calculated as shown in Figure.3. FIGURE.3 Cherry Pitt s 015 NOL with Itemized Deductions Income, Deduction, or Loss Amount Business loss ($10,000) Investment income 500 Adjusted gross income ( $9,500) Personal exemption deduction ( 4,000) Theft loss deduction [$50,000 $100 floor (10% x $0 AGI)] ( 49,900) Other itemized deductions (4,500) Taxable income ($67,900) Add back personal exemption deduction 4,000 Add back excess nonbusiness deductions ($4,500 $500) 4,000 NOL ($59,900)

7 Because Cherry s NOL includes the $49,900 theft loss deduction, that much of her NOL is eligible for the 3-year carryback. The remaining $10,000 of her NOL is eligible for the normal -year carryback. Small Business Disaster Losses I.R.C. 17(b)(1)(E)(ii)(II) uses different wording to define a small business NOL that is eligible for the 3-year carryback. It includes net operating losses that are attributable to federally declared disasters. By using the phrase net operating losses rather than losses of property (which is used to define an eligible casualty or theft loss), this provision apparently requires the taxpayer to compute the NOL that would result if only the income and deductions for business activities in the federally declared disaster area were included. 3. Allocate the NOL on a pro rata basis using the NOLs calculated in the first two methods as numerators and the total of those NOLs as the denominator. Example.5 Small Business Disaster Loss Doug A. Hole owns and operates a convenience store in Rural County, Anystate. In May 015 there was widespread flooding, and the president declared the area a disaster area. The flood damaged Doug s store, and his business realized a $70,000 loss because the store was closed for several weeks. Doug s wife, Phyl A. Hole, earned $0,000 as a substitute teacher and also operated an Internet retail business. That business realized a $30,000 loss in 015 that was not related to the flood. The couple files a MFJ federal income tax return. Doug and Phyl s $80,000 NOL is computed as shown in Figure.4. FIGURE.4 Doug and Phyl Hole s 015 NOL Other Factors That Might Cause Losses I.R.C. 17(b)(1)(E)(ii)(II) may also require the taxpayer to sort out losses due to the disaster from losses due to other factors such as low prices for output or high prices for inputs. However, that sorting would be very difficult to administer. Because the IRS has not explicitly required that sorting, this discussion assumes it is not required. After the NOL attributable to the federally declared disaster is computed, at least three methods could be used to allocate the total NOL between the disaster NOL that is eligible for the 3-year carryback and the rest of the NOL that is eligible for the -year carryback. Three plausible methods are the following: 1. Allocate the NOL first to the 3-year carryback to the extent of the NOL that would result if only the income and deductions of small businesses that were affected by the disaster are taken into account. [This is the method used by I.R.C. 17(h)(1) to allocate a taxpayer s NOL to a farming loss.]. Allocate the NOL first to the -year carryback to the extent of the NOL that would result if only the businesses that were not affected by the disaster are taken into account. Income, Deduction, or Loss Amount Wages $0,000 Taxable interest 5,500 Convenience store loss (70,000) Internet business loss ( 30,000) Adjusted gross income ($74,500) Standard deduction ( 1,600) Personal exemption deductions ( 8,000) Taxable income ($95,100) Add back excess standard deduction ($1,600 $5,500 nonbusiness income) 7,100 Add back personal exemption 8,000 deductions NOL ($80,000) The possible NOL allocations to the 3-year carryback under each of the three allocation methods are shown in Figure.5. Step 3: Distribute the NOL 45

8 FIGURE.5 Allocation of Doug and Phyl Hole s 015 NOL Allocation Method Allocated to 3-Year Carryback Allocated to -Year Carryback 1. Allocate first $70,000 of NOL to the 3-year carryback $70,000 $10,000. Allocate first $30,000 of NOL to the -year carryback $50,000 $30, Allocate pro rata using NOL for each activity [($70,000 $100,000) $80,000 allocated to 3-year carryback] $56,000 $4,000 Most Advantageous Method The most advantageous method of allocating the NOL between the 3-year carryback and the -year carryback depends on the type and amount of income in the taxpayer s carryback years. If the type and amount of income are about the same in each of the carryback years and the NOL will be fully absorbed in carryback years, the refund will be about the same whether the NOL is carried back 3 years or years. If the NOL will not be fully absorbed in carryback years and the type and amount of income are about the same in each of the carryback years and the carryforward years, carrying the NOL back 3 years allows the taxpayer to realize more of the tax savings as a refund rather than as a reduction of future taxes. Therefore, allocating more to the 3-year carryback would be best for the taxpayer. If the NOL carried to the third year before the loss year is partially wasted because of capital losses or a low tax bracket, it may be best for the taxpayer to allocate as much of the NOL as possible to the -year carryback. Priority in Carryback and Carryforward Years The portion of the NOL that is eligible for the 3-year carryback and the rest of the taxpayer s NOL for the year are treated as separate NOLs for the carryback and carryforward rules [I.R.C. 17(b)(1)(E)(iv) and (h)()]. The eligible loss for the 3-year carryback is taken into account after the rest of the NOL. That means the rest of the NOL will be used first in carryback and carryforward years to which both NOLs are carried. 46 STEPS FOR NOL DEDUCTION Example.6 Order for Applying NOLs Using the first method of allocating the NOL in Example.5, Doug and Phyl carry $70,000 of their 015 NOL back to 01. The amount that is not absorbed in 01 is carried to 013. However, before that remaining amount is applied to 013, the $10,000 -year carryback NOL from 015 is applied to 013. (The absorption rules are discussed later in this chapter.) Ordering Rules Do Not Affect Deduction The ordering rules have no effect on the timing and amount of the NOL deduction because the same total amount of the NOL will be absorbed by each carryback or carryforward year, and both NOLs can be carried forward for up to 0 years after the loss year. Election to Waive the Carryback Because the 3-year carryback is substituted for the -year carryback, an election to forgo the NOL carryback applies to both the portion of the NOL that is carried back years and the portion that is carried back 3 years. Taxpayers cannot choose to forgo the carryback for only the 3-year carryback or only the -year carryback. Farming Loss (5 Years) Taxpayers who have an NOL from a farming business can carry that NOL back 5 years and then forward up to 0 years [I.R.C. 17(b)(1)(F)]. A farming business is a trade or business involving cultivation of land; raising or harvesting of any agricultural or horticultural commodity; operating

9 a nursery or sod farm; and raising or harvesting of trees bearing fruit, nuts, or other crops, or of ornamental trees. Raising, shearing, feeding, caring for, training, and management of animals are also farming businesses. A farming business does not include contract harvesting of an agricultural or horticultural commodity grown or raised by someone else, or a business in which the taxpayer merely buys or sells plants or animals grown or raised by someone else [I.R.C. 17(h)(1)(A) and 63A(e)(4); Treas. Reg. 1.63A-4(a)(4)]. Allocation of NOL That Includes a Farming Loss I.R.C. 17(h)(1) defines a farming loss that is eligible for the 5-year carryback as the lesser of two amounts: 1. The NOL computed using only the income and deductions attributable to the farming business. The total NOL Therefore, the taxpayer s total NOL is allocated first to the farming loss and then to other losses. Example.7 Farming Loss Sandy Beach owns and operates a crop farm. Her husband, Rocky Beach, owns and operates a trucking business. In 015 extensive and prolonged flooding caused the president to declare their county a disaster area. Due to the flooding Sandy had a $70,000 loss from her farming business, and Rocky had a $30,000 loss from his trucking business. Rocky earned $0,000 in wages from a temporary job, and they earned $5,500 of taxable interest on certificates of deposit. They file a MFJ federal income tax return. Sandy and Rocky Beach s $80,000 NOL for 015 is calculated as shown in Figure.6. FIGURE.6 Sandy and Rocky Beach s 015 NOL Income, Deduction, or Loss Amount Wages $0,000 Taxable interest 5,500 Farming business loss ( 70,000) Trucking business loss ( 30,000) Adjusted gross income ($74,500) Standard deduction ( 1,600) Personal exemption deductions ( 8,000 ) Taxable income ($95,100) Add back excess standard deduction ($1,600 $5,500 nonbusiness income) 7,100 Add back personal exemption 8,000 deductions NOL ($80,000) Question 1. What is the NOL computed using only Sandy s farm income and expenses? Answer 1. It is the $70,000 farming business loss shown in Figure.6. Therefore, $70,000 of their total NOL is a farming loss that is eligible for the 5-year carryback, and the remaining $10,000 NOL is eligible for the 3-year carryback as a small business disaster loss. Question. What is the NOL if Rocky s wages were $35,000 instead of $0,000, a $15,000 increase in their income? Answer. Their total NOL would be $65,000 ($80,000 $15,000). The farming loss NOL eligible for the 5-year carryback is limited to the $65,000 total NOL, and there is no NOL eligible for the 3-year carryback. Farm Loss Excluded from 3-year Carryback The farm loss is excluded from the 3-year carryback even though the farming business is a small business and the loss is attributable to a federally declared disaster [I.R.C. 17(b)(1)(E)]. Step 3: Distribute the NOL 47

10 Election to Waive the 5-year Carryback Taxpayers can elect to waive the 5-year carryback [I.R.C. 17(i)(3)]. If a taxpayer makes that election, the carryback period reverts to years. Example.8 Waiving the 5-Year Carryback If Sandy and Rocky Beach from Example.7 elect to forgo the 5-year carryback of Sandy s $70,000 farming loss, it may be carried back years. The election to forgo the 5-year carryback of the farming loss and use the -year carryback period does not affect the 3-year carryback of the $10,000 small business disaster loss. Sandy and Rocky could also elect to forgo any carryback of their $80,000 NOL. if the act or failure to act that caused the liability occurred at least 3 years before the beginning of the loss year and the taxpayer used accrual accounting during the periods the act or failure to act occurred [I.R.C. 17(f)(1)(B)]. Some expenses that generally qualify are excluded from classification as specified liability losses. The excluded expenses are mining and solid waste disposal costs that the taxpayer elects to deduct under I.R.C. 468(a)(1) and payments to the Nuclear Decommissioning Reserve Fund that the taxpayer elects to deduct under I.R.C. 468A(a). Taxpayers can elect to forgo the 10-year carryback and carry a specified liability loss back years. Specified Liability Losses (10 Years) Taxpayers can carry a specified liability loss back 10 years before the loss year [I.R.C. 17(b)(1)(C)]. A specified liability loss is the portion of an NOL attributable to a product liability loss; to certain reclamation, remediation, or shutdown expenses; or to workers compensation payments. A product liability loss is an amount allowed as a deduction under I.R.C. 16 or 165 that arose from the taxpayer s liability for damage or loss of use of property or for physical injury or emotional harm to individuals because of a defect in a product manufactured, leased, or sold by the taxpayer. The injury, harm, or damage must occur after the taxpayer had completed manufacturing and installing the product and had relinquished possession of it. Expenses incurred in the investigation, settlement, or defense of claims of product liability are also included [I.R.C. 17(f)(1)(A)]. Other specified liabilities are expenses incurred under a federal or state law requiring any of the following five actions: 1. Reclaiming land. Decommissioning a nuclear power plant 3. Dismantling a drilling platform 4. Remediating environmental contamination 5. Making a payment under a workers compensation act The deduction for any of these legally required expenses is a specified liability loss only Election to Forgo Any Carryback Taxpayers who decide to forgo the -year carryback or any of the longer carryback periods must include a statement with the original return for the loss year for which they are waiving the carryback period under I.R.C. 17(b)(3). The original return must be filed by the due date (including extensions) for that year. If the original return was filed by the unextended due date without the election, the taxpayer can make the election on an amended return that is filed within 6 months of the unextended due date. If a taxpayer does not elect out of the carryback, the NOL is absorbed by the carryback years whether or not the NOL deduction is claimed for those years. Example.9 NOL Not Deducted Eileen Forward had a $40,000 NOL in 011. She did not elect to forgo the -year carryback, and she did not claim a refund of her 009 and 010 taxes that would have been reduced by the 011 NOL. If she had claimed the NOL deduction for her 009 and 010 tax years, she would have received a $3,910 refund for 009 and a $,138 refund for 010, and all of the NOL would have been absorbed. Eileen took her 015 tax information to Ardyth Accountant in March 010. Ardyth looked at Eileen s past returns and noticed that she had not claimed the refunds from carrying the 011 NOL back to 009 and 010. Because it is too late to file an amended return for 011, Eileen cannot claim the refunds for 009 and 48 STEPS FOR NOL DEDUCTION

11 010. However, her NOL is still absorbed by her 009 and 010 modified taxable income because she did not elect to forgo the carryback. Therefore, she has no 011 NOL to carry forward to open tax years. Recordkeeping The capital loss deduction, the I.R.C. 10 exclusion, and the DPAD are entered on lines 3, 4, and 5 of Schedule B (Form 1045). Collateral Effect of Modifications The first three modifications to taxable income listed above increase AGI and therefore have a collateral effect on other income, exclusions, and deductions in the carryback or carryforward year. The burden is on the taxpayer to show the amount of NOL that is available to deduct in a carryforward year. If a taxpayer did not deduct an NOL in a closed year, the taxpayer must still keep records of the NOL absorption to verify the NOL carried to each tax year. NOL Absorption The amount of an NOL that is absorbed by a year to which the loss is carried is equal to that year s modified taxable income. Therefore, the amount that is carried to the second eligible year is the beginning NOL minus the first eligible year s modified taxable income. The NOL carried to the third eligible year is the amount carried to the second year minus the second year s modified taxable income. This process is repeated until the NOL is fully absorbed or until it is carried to the last eligible year. Schedule B NOL Carryover (Form 1045) calculates how much of an NOL is absorbed in a carryback or carryforward year and the amount that is still available to carry to the next year. Modifications of Taxable Income Taxable income is modified for purposes of the NOL absorption by adding back the following four items [I.R.C. 17(d)()]: 1. Capital losses deducted in excess of capital gains. The partial exclusion of gain on qualified small business stock under I.R.C The domestic production activities deduction (DPAD) under I.R.C The deduction for personal and dependent exemptions Adjusted Gross Income Adding back capital losses in excess of capital gains, the partial exclusion of I.R.C. 10 gain, and the DPAD increases AGI and thus affects income, exclusions, and deductions that are calculated with reference to AGI. If a taxpayer has any of these three addbacks, the following items must be adjusted after these items are added back. The items in this list must be recalculated in the order listed, and, after each is recalculated, the newly modified AGI is used to compute the next item on the list. The seven income, exclusion, and deduction items that are both affected by AGI and affect AGI are as follows: 1. The special allowance for passive activity losses from rental real estate activities. Taxable social security benefits 3. IRA deductions 4. Excludable savings bond interest 5. The exclusion of amounts received under an employer s adoption assistance program 6. The student loan interest deduction 7. The tuition and fees deduction These adjustments to AGI are entered on line 6 of Schedule B (Form 1045). Itemized Deductions If the taxpayer itemized deductions for the intervening year, any itemized deductions that are based on AGI must be recalculated using the modified AGI. The adjustment to itemized deductions is computed on lines 11 through 38 of Schedule B (Form 1045) and is entered on line 7 of that schedule. Farm and Fishing Income Averaging Any reduction or increase in taxable income for the election year or the base years under the Step 3: Distribute the NOL 49

12 income averaging rules of I.R.C. 1301(a) is disregarded in determining the modified taxable income for the tax year in which an NOL carryover is applied. Step 4: Calculate Taxes in Carryback and Carryforward Years If an NOL is carried back, it is claimed as a deduction that reduces taxable income and tax for the carryback year. The recalculation of tax in a carryback year is complicated because the NOL deduction reduces AGI, and that reduction in AGI may affect itemized deductions and personal and dependent exemption deductions. Consequently, the affected deductions must be recalculated. The changes to the deductions are reported on Form 1045 or on an amended return (Form 1040X, Amended U.S. Individual Income Tax Return) for each carryback year. In the carryforward years the deduction is claimed as negative Other income on line 1 of Form Deadline for Form 1045 If an NOL is carried back, the resulting refund can be requested by filing Form 1045 no later than the end of the tax year following the year the NOL occurred. However, Form 1045 cannot be filed before the income tax return is filed for the year the NOL occurred. For example, a calendaryear taxpayer with a 015 NOL may file a Form 1045 application for refund after the 015 income tax return is filed and before December 31, 016. Deadline for Form 1040X The refund from carrying an NOL back can also be claimed by filing a Form 1040X for each of the carryback years. Form 1040X must be filed within 3 years of the due date (including extensions) for the loss-year tax return. For example, a calendar-year taxpayer with a 015 NOL that is carried back to 013 must file Form 1040X for 013 by April 15, 019, if he or she did not have an extension to file the 015 tax return. Election to Forgo the Carryback As noted earlier in this chapter, the election to forgo the carryback must be made on the tax return for the year the NOL occurred or on an amended return for that year filed within 6 months (excluding extensions) of the due date for the original return. A calendar-year taxpayer has until October 17, 016, to elect on an amended return to forgo the carryback of a 015 NOL. If this deadline is not met, the taxpayer cannot forgo the carryback. NOL CARRIED BETWEEN JOINT AND SEPARATE RETURNS If the taxpayer s filing status is not the same in the loss year and in all of the carryback or carryforward years, allocations may be required. Taxpayers who file a MFJ return for at least one of the years involved in an NOL calculation and its carryback or carryforward period and file a MFS return, a MFJ return with a different spouse, or a not-married return for at least one of those years may need to allocate the NOL, income and deductions, or the modified taxable income between the spouses. However, income and deductions on a MFJ return do not have to be allocated when an NOL from a year the same couple filed MFS is carried to the return. Allocation of NOLs from a Joint Return An NOL must be allocated if it is created in a year a married couple files a MFJ return and is carried to a year for which the same spouses did not file MFJ [Treas. Reg (d)]. For example, if an NOL arises while the spouses are married and file MFJ, and it is carried to a year after they are divorced, a portion of the NOL may go to each of the former spouses. The joint NOL is allocated 50 STEPS FOR NOL DEDUCTION

13 between the spouses on a pro rata basis, using the NOLs that would have been generated by each spouse individually if they had filed MFS for the NOL year. The husband s percentage of the joint NOL is calculated by dividing the NOL he would have on a MFS return by the sum of the NOL he would have on a MFS return and the NOL his wife would have on a MFS return. The wife s percentage of the joint NOL is calculated by dividing the NOL she would have on a MFS return by the sum of the NOL she would have on a MFS return and the NOL her husband would have on a MFS return. If only one spouse has an individual NOL, all of the joint NOL is allocated to that spouse. Example.10 Allocation of Joint NOL Darrell and Sidney s joint NOL is $10,000; Darrell s individual NOL is $9,000, and Sidney s individual NOL is $3,000. The separate NOLs total $1,000 ($9,000 + $3,000), and a portion of the $10,000 joint NOL is allocated to each spouse as follows: Darrell: ($9,000 $1,000) $10,000 = $7,500 Sidney: ($3,000 $1,000) $10,000 = $,500 Example.11 One Spouse Has an NOL Sandy and Cindy s joint NOL is $4,000; Sandy s individual NOL is $7,000, and Cindy has no individual NOL. Sandy s share of the joint NOL is the entire $4,000. Allocation of Income and Deductions Income and deductions must be allocated between spouses if an NOL that arose in a year they were not married is carried to a year they file a MFJ return [Rev. Rul , C.B. 17]. For example, a married couple filed MFJ returns each year until one spouse died. If the surviving spouse has an NOL in a later year, and that NOL is carried back to a MFJ return year, the income and deductions for the carryback year must be allocated between the spouses because the NOL can be used to offset only the surviving spouse s income in the carryback year [Zeeman v. United States, 395 F.d 861 (d Cir. 1968)]. NOL Carryback after Spouse s Death See pages of the 006 National Income Tax Workbook for a comprehensive illustration of carrying an NOL from a year after the death of the taxpayer s spouse to a MFJ return year. If an NOL is carried from a year a married couple filed a MFJ return to a year after one spouse died and the surviving spouse files a single return, the NOL must be allocated between the two spouses. The surviving spouse can deduct only the NOL allocated to him or her on his or her single return. The NOL allocated to the deceased spouse that remains at his or her death cannot be deducted. If the taxpayers are divorced and one exspouse carries an NOL from a year after the divorce back to a MFJ return year, the income, deductions, and tax payments on the MFJ tax return must be allocated between the ex-spouses. Each may be eligible for a share of the income tax refund that results from the carryback even though the NOL is allocable to only one spouse. Each spouse s percentage of the recomputed joint liability is calculated by dividing his or her recomputed separate liability by the total of their recomputed separate liabilities. Each spouse s refund is limited to his or her share of the tax payments (including withholding) made for the carryback year, reduced by his or her share of the recomputed tax [Rev. Rul , C.B. 36]. Two allocations may be required if a taxpayer is divorced and remarried. If an NOL occurs in a year when a MFJ return is filed with the second spouse, and it is to be carried back to a year when a MFJ return was filed with the first spouse, the NOL must first be allocated between the taxpayer and the second spouse. The carryback then Allocation of Income and Deductions 51

14 can be used to offset only the taxpayer s share of the taxable income on the MFJ return with the first spouse [Rev. Rul , C.B. 16]. Summary of Allocation Rules The rules for allocating NOLs and income and deductions are summarized in Figure.7. FIGURE.7 Allocation Requirements for Spousal NOLs NOL Year Carryback/Carryforward Year Filing Status Single MFJ MFS Single No allocations Income and deductions allocated No allocations MFJ NOL allocated No allocations NOL allocated MFS No allocations No allocations No allocations Separate Returns May Reduce Tax Liability If one spouse has an NOL and the spouses joint income without the loss is lower than their average annual income, it may be advantageous to file MFS returns in the NOL year. By filing MFS, the NOL can be carried to another tax year to reduce income in a tax bracket higher than the MFJ income tax bracket of the NOL year. Example.1 Separate Returns Tom and Mary Katt have no children, have no investment income, do not itemize deductions, and are both under age 65. Figure.8 shows their AGI for 015 and 013 (the first carryback year). FIGURE.8 Tom and Mary s AGI 015 AGI 013 AGI Tom ($19,000) $30,000 Mary 1,500 40,000 Total $,500 $70,000 If Tom files a MFS 015 return, his NOL is $19,000. If Tom and Mary file a MFJ return for 015, their income tax is zero, but they have no NOL to carry back. Therefore, their AGI for 013 (the carryback year) is still $70,000. After deducting the $0,000 total of their $1,00 standard deduction and $7,800 personal exemptions deduction, their taxable income for 013 is $50,000, and their tax is $6,611. If Tom and Mary file MFS returns for the loss year (015), Mary s taxable income is $11,00 ($1,500 AGI $6,300 standard deduction $4,000 personal exemption deduction), her federal income tax is $1,3, and Tom has a $19,000 NOL to carry back. The NOL deduction reduces their 013 joint AGI to $51,000 ($70,000 $19,000), their joint taxable income to $31,000 ($51,000 $1,00 $7,800), and their income tax liability to $3,761. Therefore, the total tax due for the years if they file MFS returns in 015 is $4,984 ($1,3 + $3,761) a savings of $1,67 ($6,611 $4,984). MFS Filing May Limit Deductions and Tax Credits See the Tax Benefits Limited by Income chapter in this book for a discussion of deductions and tax credits limitations for MFS filers. 5 NOL CARRIED BETWEEN JOINT AND SEPARATE RETURNS

15 SPECIAL ISSUES IN NOL CALCULATIONS One of the most difficult issues in calculating an NOL is deciding whether a particular gain or loss is part of the NOL. The treatments of passive activity losses, gains and losses from sales of business assets, and passthrough gains and losses from partnerships and S corporations are three common issues in the NOL calculation. Passive Activity Losses The passive activity loss rules are applied before the NOL rules. Therefore, only losses that are currently deductible under the passive loss rules can become a part of an NOL. A loss that is suspended by the passive loss rules becomes part of an NOL computation in the year it comes out of suspension. In that year, it is characterized as a business or nonbusiness loss according to its origin. Example.13 Passive Loss Inclusion in NOL Bridgett Briley has a $30,000 loss from her rental real estate activity in 015. Under the passive loss rules, she can deduct $5,000 of that loss in 015, and the remaining $5,000 is carried to 016. The $5,000 deduction that is allowed under the passive loss rules is treated as a business loss in calculating Bridgett s NOL for 015 and is not included as a nonbusiness loss on line 9 of Schedule A (Form 1045). That means it will contribute to Bridgett s NOL for 015, if she has one. If the $5,000 loss that is carried to 016 is allowed as a deduction in 016 under the passive loss rules (i.e., Bridgett has passive income, she is permitted to deduct it under the active participation allowance for rental real estate losses, or she disposed of the entire passive activity that generated the $5,000 loss carryover), it is treated as a business loss in calculating Bridgett s 016 NOL. Sale of Assets Used in a Trade or Business Gain or loss from the sale of an asset used in a trade or business is a business gain or loss for the NOL calculation. Example.14 Sale of an Asset Used in a Trade or Business Calvin Hobbs realized a $5,000 loss when he sold a machine that he used in his shoe repair business. That loss is a business loss in calculating his NOL. S Corporations and Partnerships S corporations and partnerships cannot carry business losses to other tax years by deducting NOLs. Instead, the losses flow through to the shareholders or partners in the loss year and become a part of the shareholder s or partner s NOL calculation on their individual returns. These gains and losses are characterized as business or nonbusiness according to their status inside the S corporation or partnership. Example.15 S Corporation Gain Georgia Gentry operates her construction business as an S corporation and is the sole shareholder. The corporation realized a $7,000 gain on the sale of land used in the business. That gain flows through to Georgia and is treated as a business capital gain in calculating Georgia s NOL. Example.16 Partnership Loss Theodore Bare is a 5% partner in a partnership that leases cars under long-term leases. The partnership realized a $40,000 loss from its leasing activity in 015. Theodore has no other passive income or losses in 015. Theodore s $10,000 share of the loss is a passive loss. Because he has S Corporations and Partnerships 53

16 no passive income in 015, it is suspended under the passive loss rules and therefore is not a part of his 015 NOL calculation. It will become a part of his NOL calculation in the year it is allowed as a deduction under the passive loss rules. MAKING OPTIMAL USE OF AN NOL DEDUCTION The tax benefit of an NOL can be squandered if other tax benefits are used in the loss year or in a year the NOL deduction is claimed. Tax benefits may waste NOLs in two ways. 1. They may reduce an NOL in a loss year, even though they do not reduce taxable income in that or any other year.. In years that an NOL deduction is claimed (carryback and carryforward years), other tax benefits may reduce the NOL to be carried to subsequent years even though they do not reduce taxable income in that year or any other year. Because some of those tax benefits could be shifted to another tax year, it is useful to know which ones waste NOLs. NOL Planning: Case Study Barb and Guy Wire are married, have two children, and file a MFJ return. Figure.9 reports their income and deductions for 013, 014, and 015. The Wires $,500 NOL for 015 is calculated on Schedule A (Form 1045), as shown in Figure.10. The first entry on Schedule A (Form 1045) is the $38,000 negative amount from line 41 of Form This is AGI reduced by the standard deduction or itemized deduction. The personal exemptions deduction is not subtracted because it is not allowed in computing an NOL [I.R.C. 17(d)(3)]. Lines through of Schedule A (Form 1045) apply two of the NOL rules: 1. Nonbusiness deductions are allowed in computing an NOL only to the extent of nonbusiness income.. Capital losses are allowed only to the extent of capital gains. Because nonbusiness capital losses are included in both of the above rules, the rules interact in adding back losses and deductions that were used in calculating the negative income reported on line 1 of Schedule A (Form 1045) but that are not allowed in computing an NOL. Completing lines through of the schedule requires sorting the taxpayer s capital losses, capital gains, ordinary deductions, and ordinary income into business and nonbusiness portions. The first four worksheets in the appendix of this chapter help with that sorting process. They are completed for this case study. The Wires $900 short-term capital loss from Schedule D (Form 1040) is reported on line A of NOL Worksheet 1 and is treated as a nonbusiness capital loss for purposes of the NOL computation. Their $500 capital gain from Form 4797 is reported on line F of NOL Worksheet and is treated as a business capital gain for purposes of the NOL computation. The Wires ordinary deductions and income are sorted out on NOL Worksheet 3 and NOL Worksheet 4 respectively. On line P of NOL Worksheet 3, the state income tax is allocated pro rata between nonbusiness and business amounts based on the nonbusiness and business income in 014, the year for which the taxes were paid. Therefore, $3 [$500 ($,000 $43,000)] is allocated to nonbusiness and $477 [$500 ($41,000 $43,000)] is allocated to business. The $3,500 real estate tax is allocated to nonbusiness because it was paid for the Wires personal residence. The preceding information is all that is necessary to complete lines through of Schedule A (Form 1045), as shown in Figure SPECIAL ISSUES IN NOL CALCULATIONS

17 FIGURE.9 Income and Deductions for Barb and Guy Wire (Line references are to the 015 forms.) 013 (nd Prior Year) 014 (1st Prior Year) 015 (Loss Year) Income Wages (line 7, Form 1040) $ 9,000 $ 10,000 $ 6,477 Taxable interest (line 8a, Form 1040),000,000,000 Business income or loss (line 1, Form 1040) 1,000 31,000 (3,000) Capital gains and losses (line 13, Form 1040): Short-term [line 7 Schedule D (Form 1040)] 0 0 (900) Long-term [line 8a, Schedule D (Form 1040)] (1,000) 0 0 Gain from Form 4797 [line 11, Schedule D (Form 1040)] Ordinary gain (loss) from Form 4797 (line 14, Form 1040) 0 0 3,000 Jury duty pay (line 1, Form 1040) Total Income (line, Form 1040) $31,000 $ 43,000 $(0,83) Adjustments Deductible part of self-employment tax (line 7, Form 1040) $ 1,484 $,190 $ 0 Domestic production activities deduction (line 35, Form 1040) 1,000 1,000 1,000 Jury duty pay turned over to employer (line 36, Form 1040) Total adjustments (line 36, Form 1040),484 3,190 1,100 Adjusted gross income (line 37, Form 1040) $8,516 $ 39,810 $(1,93) Itemized Deductions Medical expenses [line 1, Schedule A (Form 1040)] $ 5,000 $ 5,000 $ 5,477 Minus 10% of AGI (line 3, Schedule A (Form 1040)] (,85) ( 3,981) 0 Medical deduction [line 4, Schedule A (Form 1040)],148 1,019 5,477 State income taxes [line 5, Schedule A (Form 1040)] Real estate taxes [line 6, Schedule A (Form 1040)] 3,500 3,500 3,500 Home mortgage interest [line 10, Schedule A (Form 1040)] 6,000 6,000 6,000 Misc. itemized deductions (line 4, Schedule A (Form 1040)] Minus % of AGI [line 6, Schedule A (Form 1040)] ( 570) (796) 0 Net misc. itemized deductions [line 7, Schedule A (Form 1040)] Total itemized deductions [line 9, Schedule A (Form 1040)] $ 1,178 $ 11,019 $ 16,077 Line 41, Form 1040 (AGI minus itemized deductions) $ 16,338 $8,791 $(38,000) Personal exemptions deduction (line 4, Form 1040) 15,600 15,800 16,000 Taxable Income (line 43, Form 1040) $ 738 $ 1,991 $ (54,000) Income tax (line 44, Form 1040) $ 74 $ 1,98 $ 0 Self-employment tax (line 57, Form 1040),967 4,380 0 Total Tax Liability (line 63, Form 1040) $ 3,041 $ 5,678 $ 0 NOL Planning: Case Study 55

18 FIGURE.10 Wires NOL for MAKING OPTIMAL USE OF AN NOL DEDUCTION

19 Schedule A NOL in Figure.10 is completed as follows: Line : Enter the $900 nonbusiness capital loss from NOL Worksheet 1. Line 3: Enter zero because the Wires have no nonbusiness capital gains from NOL Worksheet. Line 4: Enter the $900 excess of line over line 3. The purpose of line 4 is to prevent a taxpayer from using nonbusiness capital losses in excess of nonbusiness capital gains as part of an NOL that will be carried to another tax year. In this example the $900 is included on line 15, reduced by the zero on line 0, and entered on line. Line 5: Enter zero because line 3 does not exceed line. If line 3 did exceed line, the excess could be used to qualify nonbusiness ordinary deductions for purposes of the NOL computation. See line 8 of Schedule A (Form 1045). Line 6: Enter $15,600, the nonbusiness itemized deductions from NOL Worksheet 3 (in the appendix of this chapter). Line 7: Enter the $,000 of interest, which is treated as nonbusiness income. Line 8: Enter $,000, the sum of lines 5 and 7. Line 9: Enter $13,600, the excess of line 6 over line 8. The purpose of line 9 is to add back ordinary nonbusiness deductions that exceed nonbusiness income. That amount is not allowed as part of the NOL because the NOL rules allow only business losses to be carried to another tax year. Line 10: Enter zero because line 8 is less than line 6. Line 11: Enter zero because there are no business capital losses from NOL Worksheet 1. Line 1: Enter $500, the business capital gains from NOL Worksheet. Line 13: Enter $500, the sum of lines 10 and 1. Line 14: Enter zero because line 11 is not more than line 13. Line 14 is designed to calculate the business capital losses that must be added back to the taxable income (loss) on line 3. In this example the amount is zero because the business capital gains exceed the business capital losses. Line 15: Enter $900, the sum of 1. $900 from line 4: the nonbusiness capital losses that must be added back because they exceed nonbusiness capital gains; and. $0 from line 14: the business capital losses that must be added back because they exceed the sum of a. the business capital gains, plus b. the excess nonbusiness capital gains. Line 16: Enter the $400 net capital loss from line 16 of Schedule D (Form 1040) ($500 long-term gain and $900 short-term loss). Line 17: Enter zero because there is no I.R.C. 10 exclusion in this example. Line 18: Subtract zero from the $400 entered on line 16 and enter $400. Line 19: Enter as a positive number the $400 loss from line 1 of Schedule D (Form 1040). Line 0: Enter zero because line 18 is not more than line 19. Line 1: Enter zero because line 19 is not more than line 18. Line : Subtract zero from $900 and enter $900. Line 3: Enter the $1,000 domestic production activity deduction. Line 4: There is nothing to enter in this example because the Wires had no previous NOLs. Line 5: Combine the negative $38,000 on line 1 with the positive $13,600 on line 9, the positive $900 on line, and the positive $1,000 on line 3. Enter the negative $,500 result as a negative number. Planning to Avoid Wasting Deductions The Wires came to your office in November 015 and asked for tax-planning advice. Figure.11 reports a projection of their 016 income and deductions. NOL Planning: Case Study 57

20 FIGURE.11 Projection of 016 Income and Deductions Income Wages $10,000 Interest 9,000 Business income or (loss) 30,000 Business capital gain 6,000 Nonbusiness capital gain,000 Business capital loss 0 Total $57,000 Adjustments to income FINAL COPYRIGHT 015 LGUTEF Domestic production activity deduction ( $ 1,000) Adjusted gross income $56,000 Itemized deductions Taxes: State income (withholding) $ 3,000 Real estate 4,000 Mortgage interest expense 6,000 Total $ 13,000 Personal exemptions deduction* $16,000 Taxable income (loss) $7,000 * The $4,000 deduction for personal and dependent exemptions for 015 is used to estimate the 016 deduction for personal and dependent exemptions. Excess Nonbusiness Deductions If nonbusiness deductions exceed nonbusiness ordinary income plus excess nonbusiness capital gains in an NOL year, the excess nonbusiness deductions will never provide a tax benefit. Therefore, those deductions should be shifted to another tax year if possible. If those deductions are shifted to a year that has no NOL, they will offset taxable income in that year. If they are shifted to a year when there is an NOL but nonbusiness ordinary income plus net nonbusiness capital gains exceed nonbusiness deductions, they will increase the NOL. Shifting excess nonbusiness deductions involves the same kind of planning as bunching itemized deductions every other year and claiming the standard deduction in the alternate years. Therefore, medical expenses, taxes, interest expenses, charitable contributions, and miscellaneous deductions should be shifted as much as 58 MAKING OPTIMAL USE OF AN NOL DEDUCTION possible. Above-the-line nonbusiness deductions such as alimony payments should also be shifted whenever possible. If the taxpayers are making less than the maximum retirement plan contributions, they could bunch contributions in the years where they would offset taxable income or add to the NOL. If Barb and Guy do nothing to change the income and deductions estimated in Figure.11, they will not benefit from $13,600 of their nonbusiness deductions in 015 [the difference between lines 6 and 7 on Schedule A (Form 1045)]. If they wait until 016 to pay the $3,500 of real estate taxes that they planned to pay in 015, they will preserve the benefit of that deduction. The Schedule A (Form 1045) in Figure.1 shows that their 015 NOL remains the same ($,500) even though the $3,500 real estate taxes are moved to 016. That is because real estate taxes are part of the excess nonbusiness deductions that must be added back to calculate an NOL. The extra $3,500 of real estate taxes in 016 will reduce the 016 taxable income by $3,500. Therefore, shifting the real estate taxes from 015 to 016 preserves the value of the deduction. 015 NOL Remains the Same Even though the $3,500 real estate tax deduction is shifted to 016, the 015 NOL remains the same. Lines 1 and 9 each change by $3,500, but they change in opposite directions and cancel each other out. Barb and Guy could further reduce their 016 taxable income without decreasing their 015 NOL by shifting up to $10,100 of other nonbusiness deductions to 016. Shifting Nonbusiness Income to Loss Year The problem of nonbusiness deductions in excess of nonbusiness ordinary income plus excess nonbusiness capital gains can also be alleviated by increasing the total amount of nonbusiness ordinary income and nonbusiness capital gains in the loss year. Such an increase will be effectively tax-free until the sum of nonbusiness ordinary income and excess nonbusiness capital gains equals nonbusiness deductions.

21 FIGURE NOL after Shifting $3,500 of Real Estate Taxes to 016 NOL Planning: Case Study 59

22 If nonbusiness ordinary income is shifted from a year without an NOL to an NOL year in which nonbusiness deductions exceed the total of nonbusiness ordinary income and net nonbusiness capital gains, the shifted income is tax-free. The same result occurs if nonbusiness ordinary income is shifted from an NOL year with an excess of nonbusiness ordinary income and net nonbusiness capital gains over nonbusiness deductions. If Barb and Guy could shift $900 of interest income from 016 to 015, their 016 taxable income would be reduced by $900 without reducing their 015 NOL. The Schedule A (Form 1045) in Figure.13 shows that the extra $900 of interest income reduces their loss on line 1 but also reduces the amount of nonbusiness deductions that must be added back on line 9 by increasing the nonbusiness income on line 7. Therefore, their 015 NOL is unchanged. 015 NOL Is Unchanged Even though $900 of interest income is shifted from 016 to 015, the 015 NOL shown above remains the same. Lines 1 and 7 each increase by $900 and therefore wash each other out. Excess Nonbusiness Capital Losses Nonbusiness capital losses in excess of nonbusiness capital gains provide no tax benefit in an NOL year because they are not allowed as part of the NOL computation. If those capital losses are shifted to a year when there is no NOL, or to an NOL year that has excess nonbusiness capital gains, the losses will provide a tax benefit. If Barb and Guy shift their $900 nonbusiness capital loss from 015 to 016, they will not reduce their 015 NOL (as shown in Figure.14), and they will reduce their 016 taxable income by $ MAKING OPTIMAL USE OF AN NOL DEDUCTION NOL Unchanged Even though the $900 business capital loss is shifted from 015 to 016, the 015 NOL remains the same. Lines 1 and each change by $900, but they change in opposite directions and wash each other out. Waiving Carryback May Reduce Tax Liability In some cases an NOL deduction is more useful to the taxpayer in the years following the NOL year than in the carryback years because of the higher tax rates imposed in high-income years. If the carryback years have low income compared to carryforward years, forgoing the carryback is advantageous as long as the 0 carryforward years will use most or all of the NOL. Capital losses in carryback or carryforward years may keep the taxpayer from realizing the full benefit of the NOL deduction in those years. Similarly, the NOL deduction may cause the loss of a tax credit that cannot be carried beyond the carryback or carryforward year. (For example, an investment tax credit is wasted if an NOL is carried to the final year the credit can be claimed and the NOL reduces taxable income to zero for that year.) In these cases the election can be used to minimize the loss of the NOL deduction or credit. Finally, there may not be enough taxable income in the carryforward years to absorb the NOL. In those cases the NOL should be carried back to the low-income years to reduce lowbracket income rather than be completely wasted. Present Value of Carryforward Because the timing of the tax savings differs between carrying an NOL back and carrying it forward, the present value of the tax savings must be computed to properly compare them. If the NOL is carried back, the tax savings will be received shortly after the refund claim is filed. The following discussion assumes that the request for refund is filed early in the year following the

23 FIGURE NOL after Shifting $900 of Interest Income to 015 Present Value for Carryforward 61

24 FIGURE NOL after Shifting $900 of Capital Loss to MAKING OPTIMAL USE OF AN NOL DEDUCTION

25 NOL year and the refund is received by April 15 of that year. If the NOL is carried forward, the tax savings are realized when taxes would otherwise be paid in the carryforward years. The NOL deduction can be used to reduce quarterly estimated tax payments, or it can be used to reduce the tax paid or increase the refund received when the carryforward-year return is filed. In either case the present value is less than the face amount of the tax savings. To compare the value of future tax savings with the value of refunds from previous years, the present value of future tax savings as of April 15 can be calculated. The tables in Figures.15 and.16 give discount factors for taxes saved in the 5 years following the NOL year. Figure.15 should be used if the tax savings are used to reduce estimated tax payments. Figure.16 should be used if the tax savings are used to reduce the tax paid with the return or increase the refund claimed on the return. The tax savings that result from carrying the NOL forward must be estimated for each year following the NOL year. Those tax savings are then multiplied by the appropriate factor from the applicable table. The interest rate is the opportunity cost of the taxpayer s capital that is, the after-tax rate the taxpayer is paying or would pay to borrow money. (If the taxpayer is not borrowing money, the appropriate rate is the after-tax rate the taxpayer is earning on investments.) FIGURE.15 Factors for Calculating Present Value of Taxes Saved in Years Following NOL Year, Assuming Savings Are Used to Reduce Quarterly Estimated Tax Payments Interest Rate Year 1* Year ** Year 3** Year 4** Year 5** 1% % % % % % % % *These factors were calculated using the following formula: Factor = [1 + {1 + (i 1)} - + {1 + (i 1)} -5 + {1+ (i 1)}-9] 4, where i = interest rate divided by 100. **These factors were calculated using the following formula: Factor = F (1 + i) -(n-1), where F = the Year 1 factor, i = interest rate divided by 100, and n = year. FIGURE.16 Factors for Calculating Present Value of Taxes Saved in Years Following NOL Year, Assuming Savings Are Used to Reduce Payment or Increase Refund with Tax Return Interest Rate Year 1* Year * Year 3* Year 4* Year 5* 1% % % % % % % % * These factors were calculated using the following formula: Factor = (1 + i) -n, where i = interest rate divided by 100 and n = year. Present Value of Carryforward 63

26 Example.17 Present Value Calculations Scott and Erin Jackson had a $55,000 NOL in 015. Their income and deductions from 013 and their expected income and deductions for 016 are shown in Figure.17. FIGURE.17 Jacksons 013 and 016 Income and Deductions 013 (First Carryback Year) 016 (First Carryforward Year)* Income Wages (line 7, Form 1040) 4,195 0 Taxable interest (line 8a, Form 1040) $ 7,000 $ 7,000 Business income (line 1, Form 1040) 41,005 69,00 Total income (line, Form 1040) $7,00 $ 76,00 Adjustments Deductible part of SE Tax (line 7, Form 1040),897 4,889 Adjusted gross income (line 37, Form 1040) $69,303 $71,311 Standard deduction (line 40, Form 1040) 1,00 1,600 Personal exemptions deduction (line 4, Form 1040) 7,800 8,000 Taxable income (line 43, Form 1040) $49,303 $ 50,711 Income tax (line 44, Form 1040) $ 6,506 $ 6,686 * The 015 deductions and tax rates were used to estimate the 016 deductions and tax rates. If Scott and Erin carry their $55,000 NOL from 015 back to 013, they will reduce their 013 income taxes to zero, and they can claim a $6,506 refund. The NOL would be fully absorbed in 013, so there would be no carryforward to 014. If Scott and Erin forgo the carryback, the $55,000 NOL from 015 will reduce their 016 income taxes from $6,686 to zero. The NOL would be fully absorbed in 016, so there would be no carryforward to 017. If the tax savings will be realized by reducing the estimated payments for 016, the tax savings 64 MAKING OPTIMAL USE OF AN NOL DEDUCTION must be discounted by a factor from Figure.15. If their after-tax opportunity cost of capital is 4%, the appropriate factor is , and the present value of the $6,686 tax savings is $6,598. Consequently, Scott and Erin should forgo the NOL carryback because the $6,598 ($6, ) present value of the future tax savings from the carryforward option is greater than the $6,506 refund received by using the carryback option. To forgo the NOL carryback, Scott and Erin must attach the statement shown in Figure.18 to their timely filed (including extensions) 015 income tax return. FIGURE.18 Election to Forgo NOL Carryback Scott and Erin Jackson SSN Taxpayers elect to forgo the net operating loss carryback period under I.R.C. 17(b)(3)(C) for the net operating loss shown on this return. If the 016 tax savings will not be realized until their tax return is filed in 017, the tax savings must be discounted by a factor from Figure.16. If their after-tax opportunity cost of capital is 4%, the appropriate factor is , and the present value of the $6,686 tax savings is $6,49 ($6, ). Consequently, Scott and Erin should carry the NOL back and claim a refund for taxes paid because the $6,508 refund is greater than the $6,49 present value of the future tax savings. Wasted NOL Deduction Carrying the NOL to a year in which the taxable income it reduces is less than the amount of the NOL that is absorbed wastes part of the NOL. That waste is a bigger factor in making optimal use of the NOL than the discounting of tax savings realized by carrying the NOL forward. In Example.17, the $55,000 NOL was fully absorbed by the $57,103 ($49,303 taxable income plus $7,800 personal exemptions deduction) of modified taxable income in the 013 carryback year even though it offset only $49,303 of taxable income. If the 013 taxable income had been $55,000, the tax without the NOL carryback would

27 have been $7,361. Carrying the $55,000 NOL back to 013 would have still reduced the 013 taxes to zero, saving $7,361 of taxes, compared to only $6,686 (before discounting) saved by waiving the carryback and carrying the $55,000 NOL forward to 016. Also in Example.17, if Scott and Erin elected to forgo carryback, the $55,000 NOL would be fully absorbed by the $58,711 ($50,711 taxable income plus $8,000 personal exemptions deduction) of modified taxable income in 016 even though it offset only $50,711 of taxable income. If the 016 taxable income had been $55,000, the tax without the NOL carryforward would have been $7,331. Carrying the $55,000 NOL forward to 016 would have still reduced the 016 taxes to zero, saving $7,331 of taxes, compared to only $6,508 saved by carrying the $55,000 NOL back to 013. The discounted value of the 016 tax reduction would have been $7,34 ($7, ) of estimated taxes or $7,049 ($7, ) of tax paid with the 016 tax return. Control Timing of NOL If the taxpayer has some discretion in determining the tax year when an NOL is realized, it should be placed in the year where it will generate the greatest tax benefit. The years in which the NOL generates the greatest benefit are those that have the highest taxable income (and are therefore in the highest marginal bracket) and those with little long-term capital gain or tax credits that will waste the NOL. For example, if a taxpayer s marginal tax rate is higher in 013 than in 014, accelerating an NOL into 015 instead of delaying it to 016 will cause the NOL to be carried back to 013 where it will offset the higherbracket 013 income instead being carried back to 014 to offset the lower-bracket 014 income. Use Up NOL Before It Expires If the time for using an NOL is about to expire, accelerating income to absorb the full loss will reduce total taxes. Shifting income to make use of an NOL that would otherwise expire makes the shifted income effectively tax-free. APPENDIX The first four worksheets in this appendix guide tax practitioners when calculating (1) business and nonbusiness capital gains and losses and () nonbusiness deductions and income, which are required to complete Schedule A (Form 1045). These worksheets are filled in for the case study presented earlier in this chapter. The fifth worksheet computes itemized deductions for an intervening year. It is not illustrated in this chapter. Appendix 65

28 NOL Worksheet 1 for NOL Planning Case Study Allocation of capital losses between nonbusiness capital losses and business capital losses [Use this worksheet to complete lines and 11 of the 015 Schedule A (Form 1045)] Where Loss Is Reported on Tax Return 015 Sch. D (Form 1040) 1 Amount Reported on Tax Return Disposition Nonbusiness Business A. Lines 1a, 1b,, and 3 column h 900 Allocate 900 B. Line 4, column h Allocate C. Line 5, column h Allocate 3 D. Line 6, column h Allocate 4 E. Lines 8a 10, column h Allocate F. Line 11, column h Allocate G. Line 1, column h Allocate 3 H. Line 14, column h Allocate 4 I. TOTALS Enter the amount from the designated lines on Schedule D (Form 1040) only if they are losses. Enter the amounts as positive numbers.. In most cases losses reported on lines 1 4, 8 10, and 13 of Schedule D (Form 1040) are nonbusiness capital losses for purposes of the NOL calculation. Losses from property used in a trade or business are reported on Form 4797, and if there is a net I.R.C. 131 loss for the year, the net loss is treated as an ordinary deduction. However, in rare cases losses reported on those lines can be business capital losses if the asset on which the loss was realized was an I.R.C. 11 asset rather than an I.R.C. 131 asset but was purchased for a trade or business reason rather than for investment. For example, loss realized on stock in another company that was purchased to enhance the taxpayer s business is reported on one of those lines but is treated as a business capital loss for the NOL calculation. See Crow v. Commissioner, 79 T.C. 541 (198). 3. The character of the loss reported on line 5 or 1 of Schedule D (Form 1040) is determined by the character of the loss to the partnership, S corporation, or fiduciary. In most cases losses reported on lines 5 and 1 of Schedule D (Form 1040) are nonbusiness capital losses, but see footnote for a discussion of the rare cases in which losses from an I.R.C. 11 asset may be treated as a business capital loss for the NOL calculation. 4. Capital loss carryovers must be allocated between business and nonbusiness capital losses according to the proportionate contribution of business and nonbusiness capital losses to the capital loss carryover. 5. Enter the total nonbusiness capital losses and total business capital losses on lines and 11 of the 015 Schedule A (Form 1045) respectively. 66 APPENDIX

29 NOL Worksheet for NOL Planning Case Study Allocation of capital gains between nonbusiness capital gains and business capital gains [Use this worksheet to complete lines and 11 of the 015 Schedule A (Form 1045)] Where Gain Is Reported on Tax Return 015 Sch. D (Form 1040) 1 A. Lines 1 &, column h Allocate B. Line 4, column h Allocate C. Line 5, column h Allocate 3 D. Line 8a, column h Allocate E. Lines 8b 10, column h Allocate Amount Reported on Tax Return Disposition Nonbusiness Business F. Line 11, column h 500 Allocate G. Line 1, column h Allocate 3 H. Line 13, column h Allocate I. TOTALS Enter the amounts from the designated lines only if they are gains.. In most cases gains reported on lines 1 4, 8 10, and 13 of Schedule D (Form 1040) are nonbusiness capital gains for purposes of the NOL calculation because gains from property used in a trade business are reported on Form 4797 and are carried to line 11 of Schedule D (Form 1040) if they are treated as long-term capital gain. However, in rare cases gains reported on lines 1 4, 8 10, and 13 of Schedule D (Form 1040) can be business capital gains if the asset on which the gain was realized was an I.R.C. 11 asset rather than an I.R.C. 131 asset but was purchased for a trade or business reason rather than for investment. For example, gain realized on stock in another company that is purchased to enhance the taxpayer s business is reported on one of those lines but is treated as a business capital gain for the NOL calculation. See Crow v. Commissioner, 79 T.C. 541 (198). 3. The character of the gain reported on line 5 or 1 of Schedule D (Form 1040) is determined by the character of the gain to the partnership, S corporation, or fiduciary. In most cases gains reported on lines 5 and 1 of Schedule D (Form 1040) are nonbusiness capital gains, but see footnote for a discussion of the rare cases in which gains from an I.R.C. 11 asset may be treated as a business capital gain for the NOL calculation. 4. Gain from Form 4797, Part I, is business gain. Gain from Form 439, Form 4684, Form 65, Form 6781, or Form 884 is nonbusiness gain in most cases. See footnote for a discussion of the rare cases in which gains from an I.R.C. 11 asset may be treated as a business capital gain for the NOL calculation. 5. Enter the total nonbusiness capital gains and total business capital gains on lines 3 and 1 respectively of the 015 Schedule A (Form 1045). Appendix 67

30 NOL Worksheet 3 for NOL Planning Case Study Allocation of deductions between business deductions and nonbusiness deductions [Use this worksheet to complete line 6 of the 015 Schedule A (Form 1045)] Location on 015 Form 1040 Item FINAL COPYRIGHT 015 LGUTEF A. Line 3 Educator expenses Business Amount on Tax Return Disposition Business Nonbusiness AMT- Nonbusiness B. Line 4 Reservists, artists, etc. Business C. Line 5 HSA deduct. Nonbusiness D. Line 6 Moving expenses Business E. Line 7 Deductible part of SE tax Business F. Line 8 Keogh, SEP, SIMPLE, etc. Nonbusiness G. Line 9 SE health insurance Nonbusiness H. Line 30 Penalty, early withdrawal Nonbusiness I. Line 31a Alimony paid Nonbusiness J. Line 3 IRA deduction Nonbusiness K. Line 33 Student loan interest deduction Nonbusiness L. Line 34 Tuition & fees deduction Nonbusiness M. Line 36 Write-in expenses 100 Allocate N. Line 40 Std. ded. (if claimed) Nonbusiness Schedule A (Form 1040) (if claimed) O. Line 4 Medical 5,477 Nonbusiness 5,477 3 P. Line 9 Taxes 4,000 Allocate ,53 Q. Line 15 Interest 6,000 Nonbusiness 6,000 5 R. Line 19 Contributions Nonbusiness S. Line 0 Casualty and theft Business T. Line 7 Misc. (% floor) 600 Allocate U. Line 8 Other misc. deductions Allocate 7 V. TOTALS 16, , Most write-in adjustments on line 36 of Form 1040 are business deductions. However, Treas. Reg (a)(3)(i) defines nonbusiness deductions for purposes of computing an NOL as those that are not derived from or attributable to a taxpayer s trade or business, and it includes wages and salary in income attributable to the taxpayer s trade or business. Therefore, the following write-in adjustment items are likely to be treated as business deductions for computing a noncorporate NOL: a. Jury duty pay an employee turned over to the employer because the employer paid the employee s salary while the employee served on the jury b. Reforestation amortization and expenses. If the standard deduction is claimed for the regular tax, neither the standard deduction nor the itemized deductions can be claimed for the AMT. 3. The medical deduction floor is 10% of AGI for AMT purposes. 4. State and local income taxes paid are allocated between business and nonbusiness deductions according to the income of the year that created the taxes. For this allocation salaries and wages are treated as business income. Taxes are not allowed as a deduction when calculating AMT. 68 APPENDIX

31 5. The alternative minimum tax interest deduction is the same as the regular tax interest deduction except for the following adjustments: a. If debt on a personal residence has been refinanced, interest on debt in excess of the debt before refinancing cannot be deducted for AMT purposes. b. The investment interest deduction must be recalculated to include income from private activity bonds in investment income and the expenses on those bonds in investment expenses. 6. Because the amount on line 7, Schedule A (Form 1040), is reduced by % of AGI, the amounts allocated to business and nonbusiness deductions must be reduced on a pro rata basis. Therefore, the amount in the business column should be the amount from line 7, Schedule A (Form 1040), multiplied by the total business miscellaneous deductions subject to the % floor and divided by the total miscellaneous deductions subject to the % floor. The amount in the nonbusiness column should be the amount from line 7, Schedule A (Form 1040), multiplied by the total nonbusiness deductions subject to the % floor and divided by the total miscellaneous deductions subject to the % floor. These miscellaneous deductions are not allowed as a deduction when calculating AMT. 7. Deductions allowable for impairment-related work expenses are business deductions. Other deductions reported on line 8, Schedule A (Form 1040), are nonbusiness deductions. 8. Enter the total nonbusiness deductions on line 6 of the 015 Schedule A (Form 1045). NOL WORKSHEET 4 for NOL Planning Case Study Allocation of ordinary income between business and nonbusiness ordinary income [Use this worksheet to complete line 7 of the 015 Schedule A (Form 1045)] Location on 015 Form 1040 Item Amount on Tax Return Disposition Amount as Business Amount as Nonbusiness A. Line 7 Wages, salary, etc. 6,477 Business 6,477 B. Line 8a Taxable interest,000 Nonbusiness,000,000 C. Line 8b Tax-exempt interest Nonbusiness 1 D. Line 9a Ordinary dividends Nonbusiness E. Line 10 Taxable refunds Allocate F. Line 11 Alimony received Nonbusiness G. Line 1 Business income (loss) Sch. C (3,000) Business (3,000) H. Line 14 Form 4797 gains or losses 3,000 Business 3,000 I. Line 15b Taxable amount of IRA distributions Nonbusiness J. Line 16b Taxable amount of pensions Nonbusiness K. Line 17 Rents, royalties, and partnership income L. Line 18 Farm income (or loss) M. Line 19 Taxable unemployment N. Line 0b Taxable social security benefits Usually business Business Business AMT Nonbusiness Nonbusiness O. Line 1 Other income 100 Allocate 100 P. TOTALS (0,43) (,43),000 3, Nontaxable interest is nonbusiness income for AMT purposes only.. The state and local income tax refund is allocated between business and nonbusiness income according to the income of the year that created the refund. For this allocation salaries and wages are treated as business income. State and local income tax refunds are not included when calculating the AMT. 3. Enter the nonbusiness ordinary income on line 7 of the 015 Schedule A (Form 1045). Appendix 69

32 NOL Worksheet 5 (Use this worksheet to compute the itemized deduction to enter on line 1 of the After carryback columns of Form 1045 for a 014 tax year) Notes for entries on Schedule A (Form 1040): Line : Enter the AGI reported on line 11 of the After carryback column for the carryback year on Form Line 19: Figure the contribution deduction limit (50%, 30%, or 0% of modified AGI) using the AGI reported on line 11 of the After carryback column for the carryback year on Form Line 0: Calculate the casualty and theft loss deduction using the AGI reported on line 11 of the After carryback column for the carryback year on Form 1045 to determine the 10%-of-AGI floor. Line 5: Enter the AGI reported on line 11 of the After carryback column for the carryback year on Form Line 9: Replace Form 1040, line 38 with the AGI reported on line 11 of the After carryback column for the carryback year on Form 1045 in the line instructions. Enter the amount from line 9 on line 1 of the After carryback column of Form APPENDIX