Net Operating Losses

If deductions and losses from your business exceed your business income, you may be able to use the losses to offset income in other years. Net losses from the conduct of your business are net operating losses (NOLs). In 2009 (the last year for which statistics are available), NOLs claimed on individual returns exceeded $124 billion.

Net operating losses are not an additional loss deduction. Rather, they are the result of your deductions exceeding the income from your business. The excess deductions are not lost; they are simply used in certain other years.

You have an NOL if you have deductions from a trade or business, deductions from your work as an employee, or deductions from casualty and theft losses.

Only individuals and C corporations can claim NOLs. Partnerships, limited liability companies (LLCs), and S corporations cannot have NOLs, since their income and losses pass through to owners. However, partners, LLC members, and S corporation shareholders can have NOLs on their individual returns. These NOLs are created by their share of the business’s operating losses.

Calculating NOLs

After you have completed your tax return for the year, you may find that you have an NOL. If you are an individual, you may have an NOL if your adjusted gross income, reduced by itemized deductions or the standard deduction (but before personal exemptions), is a negative figure. C corporations may have an NOL if taxable income is a negative figure. This negative figure merely indicates a possibility of an NOL; then you must determine whether, in fact, there actually is one. This is due to the fact that certain adjustments must be made to that negative figure in arriving at an NOL. Individuals and corporations calculate NOLs in a slightly different manner.

INDIVIDUALS

An NOL does not include personal exemptions, net capital losses, nonbusiness losses, or nonbusiness deductions. The NOL can be computed on Schedule A of Form 1045. This form adds back to taxable income any of these items claimed on the return and makes other adjustments required to compute the NOL. For example, individuals must add back to taxable income any deductions for Individual Retirement Account (IRA) contributions, alimony, the standard deduction, and charitable contributions. More specifically, nonbusiness deductions in excess of nonbusiness income get added back. Do not add back business-related deductions for:

• One-half of self-employment tax
• Moving expenses
• State income tax on business profits
• Interest and litigation expenses on state or federal income taxes related to business
• Payments by a federal employee to buy sick leave
• Loss on rental property
• Loss on the sale or exchange of business real estate or depreciable business property
• Loss on the sale of accounts receivable if you are on the accrual method
• Loss on the sale or exchange of stock in a small business company or small business investment company if the loss is treated as an ordinary loss (such as loss on Section 1244)

CORPORATIONS

The NOL for corporations generally is calculated by reducing gross income by deductions. Special rules then apply to adjust the NOL. They are:

• A full dividends-received deduction is taken into account in calculating the NOL. For example, the 70% or 80% limit is ignored.
• NOLs from other years are not taken into account in calculating a current NOL.
• Losses that fall under the passive activity rules cannot be used to calculate an NOL.

If a corporation’s ownership changes hands, limits apply on the use of NOL carryforwards. The tax law does not want 1 corporation to acquire another for the purpose of using NOLs of the target corporation to offset the income of the acquiring corporation. These rules are highly complex.

S corporations do not have net operating losses. Instead, losses are passed through to owners who figure their NOLs on their individual returns. NOL carryovers of a C corporation cannot be claimed after the conversion to S corporation status (they remain in limbo and can be used by the corporation if it terminates its S status and returns to being a C corporation). However, the S corporation can use the C corporation’s NOL carryover as a deduction to offset any net recognized built-in gain (built-in gain is explained earlier in this chapter).

Carrybacks and Carryovers

Net operating losses may be carried back and, if not used up, carried forward for a certain number of years. The carryback and carryforward periods depend on the year in which the NOL arose.

For NOLs arising in tax years beginning before August 6, 1997, the carryback period was 3 years and the carryforward period continues to be 15 years.

For NOLs arising in tax years beginning after August 5, 1997, generally there is a 2-year carryback and a 20-year carryforward period. However, for small businesses (those with average annual gross receipts of $5 million or less during a 3-year period), a 3-year carryback applies to NOLs arising from government-declared disasters, and for farmers and ranchers and certain specified disaster victims, there is a 5-year carryback for all NOLs. There is a 10-year carryback for NOLs arising from product liability.

If you had an NOL arising in a tax year beginning or ending in 2008, you were permitted to choose a 3-, 4-, or 5-year carryback, provided your business had average annual gross receipts under $15 million for the 3 years ending with the year of the loss. For such losses arising in 2009, small business taxpayers were also able to opt for a longer carryback period of 3, 4, or 5 years (for the fifth carryback year, only half of the income could be used to offset in that year). The 90% NOL limitation that usually applies for alternative minimum tax purposes is waived for any carrybacks. Businesses with average gross receipts of $15 million or less that used a 5-year NOL carryback in 2008 were able to do so again in 2009 if they so elected (and had any remaining income to offset in carryback years).

Note: For partnerships, limited liability companies, and S corporations, the election of the longer carryback period was made at the entity level even though the carryback was claimed by owners on their personal returns.

If you have an NOL in 2012, the basic 2-year carryback period again applies. You first carry the loss back to a year that is 2 years before the year in which the NOL arose (the NOL year), which is 2010. If it is not used up in that year, carry it to the year before the NOL year, which is 2011. If the NOL is still not used up, you can begin to carry it forward (with modifications explained below). However, if it is not used up after carrying it forward for 20 years, it is lost forever.

Be sure to keep track of each category of NOL. For example, do not lump your pre-August 6, 1997, carryforwards together with your post-August 5, 1997, carryforwards.

Personal service corporations (PSCs) are not allowed to carry back an NOL to any year in which there is a Section 444 election in effect to use a tax year other than a required tax year.

If your marital status in the carryback or carryover years differs from your status in the NOL year, only the spouse who has the NOL can claim it. If you file a joint return, the NOL deduction is limited to the income of the spouse who had the NOL. Special rules apply for carrybacks to a year involving a different marital status than the status in the year the NOL arises.

If your NOL is greater than the taxable income for the year to which you carried it, you must make certain modifications to taxable income to see how much of the NOL is used up in that carryback/carryover year and how much is still available as a carryover. The carryover is the excess of the NOL deduction over modified taxable income for the carryback/carryforward year. Modified taxable income is taxable income without regard to the NOL and with no deduction for net capital losses or personal exemptions. Also, you must recalculate items affected by a change in adjusted gross income. Your modified taxable income cannot be less than zero. You can determine your modified taxable income using Schedule B of Form 1045 for any carryback years and for carryovers from those years. If you have carryovers from more than 1 year, you use the carryovers in the order in which they were incurred.

While the NOL carryforward reduces income in the carryforward years for income tax purposes, it does not affect income for self-employment tax purposes in the carryforward years.

ELECTION TO FORGO CARRYBACK

Instead of carrying a 2012 NOL back 2 years and then forward, you can elect to forgo the carryback and just carry forward the loss for 20 years. You make this election in the NOL year by attaching a statement to your return if you are an individual, or by checking the appropriate box on the corporate return for C corporations. Once the election is made, it cannot be changed. If you incur another NOL in a subsequent year, you must make a separate election if you also want to forgo the carryback.

Some taxpayers prefer to forgo the carryback because they are afraid of calling attention to prior tax years and risking an audit. While this is certainly a possibility, claiming a carryback will not necessarily result in an audit of a prior year.

The election to forgo the NOL carryback applies not only to regular income tax purposes but also to alternative minimum tax purposes.

QUICK REFUNDS FROM CARRYBACKS

If your business is struggling, you can use an NOL carryback to generate quick cash flow. The carryback will offset income in the carryback years, and you will receive a refund of taxes paid in those years.

Individuals can file Form 1045, Application for Tentative Refund, to obtain a relatively quick refund. The IRS generally will act on the refund within 90 days of the filing of the form. When you carry back an NOL, you may have to recalculate certain deductions, credits, and other items in the carryback years. These are items figured with respect to adjusted gross income. For example, the NOL will lower your adjusted gross income in the carryback years and therefore allow for greater itemized deductions that have an adjusted-gross-income floor. You may also have to recalculate alternative minimum tax.

C corporations can expedite a refund from an NOL carryback by using a special form, Form 1139, Corporation Application for Tentative Refund, to obtain a quick refund. This form cannot be filed before the income tax return for the NOL year is filed and it must be filed no later than 1 year after the NOL year. What is more, if a corporation expects to have an NOL in the current year, it can delay filing the income tax return for the prior year with the knowledge that the tax on the prior year’s return will be fully or partially offset by the NOL.

A corporation that expects an NOL for the current year may extend the time for payment of tax for the immediately preceding tax year by filing Form 1138, Extension of Time for the Payment of Taxes by a Corporation Expecting a Net Operating Loss Carryback. This form is filed after the start of the year in which the NOL is expected but before the tax for the preceding year is required to be paid. Such corporations can also further extend the time for payment by filing Form 1139, explained earlier. Doing so extends the time for payment of tax for the immediately preceding tax year until the IRS has informed the corporation that it has allowed or disallowed its application in whole or in part.

You can also claim an NOL on an amended return, Form 1040X or Form 1120X. Individuals who carry back NOLs cannot recalculate self-employment tax and get a refund of this tax. The NOL applies for income tax purposes only.