FINAL COPYRIGHT 2015 LGUTEF NET OPERATING …

1 2015 Land Grant University Tax Education Foundation, Inc. 39 NET OPERATING LOSSES2 Steps for NOL Deduction 40 NOL Carried between Joint and Separate Returns 50 Special Issues in NOL Calculations 53 Making Optimal Use of an NOL Deduction 54 Appendix 65 Learning ObjectivesAfter 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 carrybackIntroductionA net OPERATING loss (NOL) deduction can offset the sometimes harsh consequences of the annual accounting period used for income taxes.

2 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 2, 3, 5, or 10 years, and forward up to 20 years, to offset tax-able income in those years. The principle of NOLs is simple, but actual computation of NOL deductions can be com-plex. Complexity arises because the provisions of 172 remove several other tax benefits before an NOL deduction is calculated. Those benefits are removed by modifying income and deductions in all affected years: FINAL COPYRIGHT 2015 LGUTEF40 INTRODUCTION their own NOLs. Partnerships and S corpora-tions, 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 part-nership, LLC, or S corporation business income and deductions to figure their individual 2: Compute the NOLN egative taxable income for the NOL year is modified by removing deductions that are not allowed in computing the Taxable income Must Be NegativeIf 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 NOLS everal items that are included in the calculation of taxable income are not included in the NOL calculation.

3 These usually are excluded from the NOL computation for one of two reasons. Generally, only business losses can be car-ried from one year to another; therefore, with a few exceptions, nonbusiness deduc-tions in excess of nonbusiness income are not included in the NOL. STEPS FOR NOL DEDUCTION Computing an NOL and claiming the NOL deduction requires four successive steps The process of computing an NOL for an indi-vidual taxpayer and claiming the NOL deduction must be carried out in the following four Determine eligibility2. Compute the NOL3. Distribute the NOL to carryback and carry-forward years4. Recalculate taxes in the carryback years and calculate taxes in the carryforward yearsEstate and Trusts The NOL rules for individuals also apply to estates and trusts If an estate or trust has an NOL car-ryover 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 642(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 1 642(h)-2(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 deduc-tions) exceeds the beneficiary s gross income , the excess cannot be carried over to subsequent years [Treas Reg 1 642(h)-2(a)] Step 1.

4 Determine EligibilityGenerally, taxpayers are allowed to reduce their own income with their own losses from other years. Individuals and C corporations may claim 1. Deductions for the NOL year are modified to determine the NOL that can be carried to other Taxable income is modified in the years to which the loss is carried to determine how much of the NOL is 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 21 of Form 1040. The deadlines for filing these forms are discussed under the heading Step 4: Calculate Taxes in Carryback and Carryforward Years later in this COPYRIGHT 2015 LGUTEFStep 2: Compute the NOL 412 Items that carry to another tax year under another carryover rule such as capital loss carryovers are excluded from the NOL cal-culation to avoid following items are excluded from the NOL by adding them back to the taxpayer s neg-ative taxable income [ 172(d)]:1.

5 Dependent and personal exemption deductions Schedule A (Form 1045) CalculationForm 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 2. Nonbusiness deductions in excess of non-business income 3. Capital losses in excess of capital gains 4. The exclusion of 50% of the gain from 1202 stock (qualified small business stock) 5. An NOL deduction carried from another year 6. The 199 domestic production activi-ties deductionIf the sum of the items that are added back is greater than the negative taxable income , there is no NOL for the Adding Back Nonbusiness DeductionsPaige Turner s taxable income for 2015 before deducting exemptions is a negative $10,000 due to both business losses and nonbusiness deduc-tions.

6 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, 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 DeductionsIncome 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 [ 172(d)(4)(A)]. Employment is treated as a trade or business, which means wages are busi-ness income and deductible employee expenses are business 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 busi-ness losses for the NOL calculation even though they are not connected with a trade or business [ 172(d)(4)(C)].

7 Effect of Business or Nonbusiness ClassificationClassifying 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 DeductionsNeil Down, who is not married and does not itemize deductions, realized a $10,000 loss from his sole-proprietor auto parts business in 2015. However, due to other income and deductions, as shown in Figure , his taxable income for 2015 was negative $13, Neil Down s 2015 Taxable IncomeIncome or DeductionAmountBusiness loss($10,000)Wage income6,000 Investment income 500 Adjusted gross income ($3,500)Personal exemption deduction(4,000)Standard deduction (6,300)Taxable income ($13,800) FINAL COPYRIGHT 2015 LGUTEF42 STEPS FOR NOL DEDUCTIONIn calculating his NOL, Neil is not allowed to deduct his personal exemption deduction.

8 He can deduct $500 of his standard deduction because he has $500 of nonbusiness (investment) income . Consequently, Neil adds back his $4,000 per-sonal 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) Ways to Look at the NOLNote 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 AveragingAn NOL that is carried to a base year under the 1301 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 ben-efit in another tax year must be added back to calculate base year taxable income [Treas.]

9 Reg. (d)(2)(i)(A)] for any subsequent years income averaging calculations. This prevents taxpayers from getting a double benefit from an income Averaging Election ExampleSee pages 371 375 of the 2009 National income Tax Workbook for an example of the interaction of the NOL rules and the farm income averaging rules Suspended DeductionsDeductions 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 sus-pended. 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 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 aid in the completion of Schedule A NOL (Form 1045), a set of four worksheets is included in the appendix of this chapter.

10 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 2 and 11 of Schedule A (Form 1045) respectively. NOL Worksheet 2 computes the nonbusiness and business capital gains that are reported on lines 3 and 12 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 NOLThe NOL calculated in Step 2 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. 2. The amount of the NOL that is absorbed in a carryback or carryforward year is the modi-fied taxable income for that carryback or car-ryforward year not the taxable income of the carryback or carryforward year.