Net Operating Losses of Individuals

1. Net Operating Losses of Individuals BUS 225K Professor Nellen

2. Agenda • Relevance • Basic definitions • Rationale • History • §172 Overview • Mechanics – calculation and c/o • State tax considerations • Policy perspectives

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

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

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

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

7. History - 1 • Originally, calculation of NOL took an economic income approach, changing to a taxable income approach with IRC of 1939 (Callanan Road Improvement, 404 F2d 1119 (2nd Cir. 1968)).

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

9. §172 Overview • Need to calculate the NOL • Carry it back 2 years (generally) unless timely elect to forego c/b period (§172(b)(3)) • In any year, could have both a c/b and a c/f to that year. The total of these amounts is the NOLD. • Need recordkeeping to track NOL – for both regular tax and AMT purposes. • Many special rules included in §172 for certain entities or types of losses

10. §172 Mechanics • “(a)Deduction allowed. There shall be allowed as a deduction for the taxable year an amount equal to the aggregate of (1) the net operating loss carryovers to such year, plus (2) the net operating loss carrybacks to such year. For purposes of this subtitle, the term “net operating loss deduction” means the deduction allowed by this subsection.”

11. NOL Defined “§172(c) Net operating loss defined.For purposes of this section, the term “net operating loss” means the excess of the deductions allowed by this chapter over the gross income. Such excess shall be computed with the modifications specified in subsection (d).”

12. Modifications for Individuals Add back to negative taxable income: • Any NOLD • Excess of capital losses over capital gains • QSBS gain exclusion of §1202 allowed • Personal exemptions • Excess of nonbusiness deductions over nonbusiness income • G/L from disposition of business property subject to depreciation and real property used in trade or business are considered business income and deductions • Treat personal casualty losses are business (so can generate an NOL) • Charitable contributions considered non-business. • Alimony paid = non-business (Monfore, TCM 1988-197) • §404 deductions (deferred comp plans) of an EE = nonbusiness • State income taxes attributable to Schedule C business = business • Deductible moving expenses = business (Rev Rul. 72-195) • Employee business expenses = business • Employee wages = business (1.172-3) • Rental of a residence = business (Lagreide, 23 TC 508 (1954)) • Standard deduction = nonbusiness • Manufacturing deduction of §199 [§172(d), 1.172-3 and various court cases, IRS rulings, Schedule A of Form 1045, nice summary in IRS Pub 536]

13. Excess of deductions over income = $11,300 To determine NOL that can be c/b, need to apply 172(d) modifications to $11,300 Example from Pub 536

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

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

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

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

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

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

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