The Mechanics of the NOL

DANGER — NOL UNDER CONSTRUCTION! Since its inception, the number of years allowable for carryback or carryover purposes has depended on Congressional winds in response to economic upheavals.

June 9, 2011
Sponsored by Drake Software

by Merry Broughton, EA

The basic rule for net operating losses (NOLs) is this: Expenses exceed taxable revenue for the year, creating negative taxable income. The idea is to provide tax relief to taxpayers and reduce the need to make tax payments in future periods. The benefit to taxpayers is to be able to reduce the tax bill in years when a loss is not incurred.

The difficulty arises when you try to apply tax law to the carryback or carryforward of NOLs. It seems, from the inception of NOL rules in 1918 as a temporary post-WWI relief measure that the number of years allowable for carryback or carryover purposes depended on Congressional winds, generally in response to economic upheavals.

In 1950, the two-year carryback and carryover periods were replaced by a one-year carryback period and a five-year carryover period. In 1976, Congress extended the five-year carryover to seven years and included the election to relinquish carryback periods and to carry the loss forward only. In 1997, the carryover period was extended to 20 years. By 2002, NOL rules changed again to allow carryback of five years, mostly to alleviate the adverse affects of September 11, 2001. In 2009, we saw the increase of the carryback period to three, four or five years.

Form 1045, Application for Tentative Refund, completed to carry back net operating losses at the individual level, can be confusing at best and terrifying at its worst.

As a preparer, you have to pay attention to changes in the tax law to know whether you can carry the loss back two, three or five years. You also have to know what qualifies as a net operating loss and whether or not the taxpayer actually has an NOL. For example, the fact that the taxpayer, as an individual, has more itemized deductions than income to take them against does not mean he or she has an NOL.

Unfortunately, calculating the net operating loss is not as simple as plugging figures into a form. Things to consider (for individual filers):

  • Personal and dependency exemptions cannot be used;
  • Net operating losses from a different year cannot be used;
  • Nonbusiness capital losses, those arising outside the taxpayer’s trade or business, can be used only against nonbusiness capital gains;
  • Nonbusiness deductions, such as charitable donations, deductible medical expenses, mortgage interest, alimony, can be used only against nonbusiness income.

Once it is decided that the taxpayer does, indeed, have a net operating loss, a decision has to be made whether to carry the NOL back to prior years or to carry it forward. If the taxpayer elects to waive the carryback period, however, once the election is made it is irrevocable.

The application of an NOL to prior years is a complicated, multi-step calculation that requires the adjustment and refiguring of a number of things, such as taxes owed and the taxable income in the carryback year, not to mention many of the deductions taken in that year.

For those new to the 1045, the first quandary faced is deciding which year goes in what column. 1045 instructions state that you should begin with the earliest year. Thus if this is 2010 and you want to carry the NOL back three years, you would begin with 2007.

The mechanics of carrying an NOL to a prior year become involved. The tax for the prior year must be refigured by re-computing the adjusted gross income for that year. Then, any items limited by the AGI must be recomputed, such as allowances for passive activities, taxable SSB, IRA deductions and excludable savings bond interest. Next, the taxable income is refigured to reflect changes in itemized deductions for medical expenses, casualty losses and miscellaneous itemized deductions. If AMT applied to the taxpayer, it will also come into play.

One other note: Tax preparers will also have to determine whether Form 1045 should be filed or if an amended return for the years in question should be filed.

Estates, trusts and corporations may also make use of net operating losses. Corporations wishing to carry back NOLs against prior years file Form 1139, Corporation Application for Tentative Refund. Preparers should be aware that rules for carrybacks may differ.

For more information about NOLs, search such tax research websites as RIA Checkpoint or the Tax Library. Other resources include:

  • IRS Publication 536, Net Operating Losses (NOLs) for Individuals, Estates and Trusts;
  • IRS Instructions for Form 1045, Application for Tentative Refund;

  • IRS Instructions for Form 1139, Corporation Application for Tentative Refund;
  • IRS Publication 334, Tax Guide for Small Businesses.
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