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

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

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

3 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. If individual might have NOL, consider moving items that don’t go into an NOL into another year if possible. Carryback or only forward Carryback or only forward State income tax treatment State income tax treatment What is approaching end of c/f period and still have large NOL/ What is approaching end of c/f period and still have large NOL/

4 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 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. 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 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 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 8 History - 2 Revenue Act of 1918 –first time NOL c/o allowed c/b 1 year and then forward 1 year. c/b 1 year and then forward 1 year. Ending of WWI = expectation of business losses (The Yale Law Journal, April 1932, p. 900). 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 year carryforward enacted 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 ; 8/5/97) periods were 3 and 15, respectively).

9 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 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 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 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 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) Treat personal casualty losses are business (so can generate an NOL) Charitable contributions considered non-business. Charitable contributions considered non-business. Alimony paid = non-business (Monfore, TCM ) Alimony paid = non-business (Monfore, TCM ) §404 deductions (deferred comp plans) of an EE = nonbusiness §404 deductions (deferred comp plans) of an EE = nonbusiness State income taxes attributable to Schedule C business = business State income taxes attributable to Schedule C business = business Deductible moving expenses = business (Rev Rul ) Deductible moving expenses = business (Rev Rul ) Employee business expenses = business Employee business expenses = business Employee wages = business ( ) Employee wages = business ( ) Rental of a residence = business (Lagreide, 23 TC 508 (1954)) Rental of a residence = business (Lagreide, 23 TC 508 (1954)) Standard deduction = nonbusiness Standard deduction = nonbusiness Manufacturing deduction of §199 [§172(d), and various court cases, IRS rulings, Schedule A of Form 1045, nice summary in IRS Pub 536] [§172(d), and various court cases, IRS rulings, Schedule A of Form 1045, nice summary in IRS Pub 536]

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

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

15 15 What to do with NOL 1.Attach statement to timely filed return (including extensions) electing to forego c/b period (§172(b)(3)) 1. Generally no revocable 2. Also applies to AMT NOL (Rev Rul 87-44) 2.File amended returns for prior years (carryback to earliest year first) 1. Must file within 3 years of the filing date (incl extension) for the NOL return) 2. 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)) 3.File Form 1045, Application for Tentative Refund 1. IRC §6411 must file within 1 year after end of NOL year 2. Complete the worksheets to figure refund 3. IRS to process form within 90 days

16 16 Questions 1.Will a passive activity loss increase an NOL? 2.Bob had NOL in 2009 and wants to carry it back using Form What is deadline to file that form? 3.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)? 4.If it looks like the Smiths will have an NOL for current year, what planning advice should you give them?

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

18 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 19 Policy perspectives Loophole? Sometimes c/o referred to such by lawmakers and others 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 Some recognition wrt carrybacks, but not carryfowards Should c/f amounts be increased for an interest factor? Should c/f amounts be increased for an interest factor? Flat tax promoted by Drs. Hall and Rabushka allows: 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 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.


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