Net Operating Losses—Concepts and Computations, written by Carla Neeley Freitag, Esq., describes and illustrates the applicable tax principles for converting a net operating loss sustained by a taxpayer into a net operating loss deduction under §172.  

The net operating loss deduction allows a taxpayer with a loss in one taxable year to carry the loss back or forward to offset taxable income of earlier or later taxable years. By permitting taxpayers to offset profitable years with loss years, the deduction minimizes the disparity that would otherwise result between businesses with stable incomes and businesses with fluctuating incomes due to use of an annual accounting period. 

After briefly examining the background and rationale of §172 and providing an overview of the deduction, this Portfolio points out that most taxpayers are eligible to deduct net operating losses and examines the eligibility restrictions.  

This Portfolio then furnishes a step-by-step explanation of the computations required in applying §172, including: 

• the computation of a net operating loss
• the determination of the carryback and carryover periods
• the computation of the amount of net operating loss carrybacks and carryovers
• the computation of the net operating loss deduction 

Net Operating Losses—Concepts and Computations also examines the procedural aspects of claiming the deduction. It describes the alternative minimum tax net operating loss deduction, which replaces the deduction under §172 for alternative minimum tax purposes. 

Net Operating Losses—Concepts and Computations allows you to benefit from:

• Hundreds of hours of original research on specific tax planning topics from leading practitioners in this area
• Invaluable practice documents
• Plain-English guidance from world-class experts
• Real-world and in-depth analysis that lets you explore various options
• Time-saving access to relevant sections of tax laws, regulations, court cases, IRS documents and more
• Alternative approaches to both common and unique tax scenarios

This Portfolio is part of the U.S. Income Portfolios Library, a comprehensive series that includes more than 200 Portfolios, which covers every federal tax topic with expert, in-depth analysis, and offers commentary on a wide range of federal taxation topics, including Compensation Planning, Deductions and Credits, Partnerships and Corporations, Special Pass-Through Entities, Corporate Reorganizations, Real Estate, Procedure and Administration, and more.

Detailed Analysis

I. Introduction

A. Background of the Deduction

B. Overview of the Deduction

C. Judicial Construction of § 172

II. Eligible Taxpayers

A. Taxpayers Eligible to Deduct Net Operating Losses

1. Individuals

2. C Corporations

3. Estates and Trusts

4. Exempt Organizations

5. Non-Life Insurance Companies

B. Restrictions on the Deduction of Net Operating Losses

1. Partnerships

2. S Corporations

3. Life Insurance Companies

4. Regulated Investment Companies

5. Corporations Subject to Accumulated Earnings Tax

6. Personal Holding Companies

7. Cooperative Organizations

8. Membership Organizations

9. Reorganizations Involving Loss Corporations

C. Deduction Allowed to Taxpayer Who Sustained the Loss

1. General Rule

2. Estates and Trusts

a. Net Operating Losses of Decedents

b. Net Operating Losses of Ongoing Estates and Trusts

c. Net Operating Losses of Terminating Estates and Trusts

3. Corporations

a. Net Operating Losses of Corporations Generally

b. Net Operating Losses of Corporations that Dissolve

c. Changes in Form of Business

III. Calculation of Net Operating Loss

A. Introduction

1. Net Operating Loss Defined

2. What Constitutes a Loss

3. Role of the Modifications

B. Corporations

1. General Rule

2. Modifications

a. Net Operating Loss Deduction

b. Dividends Received Deductions

(1) Dividends Received Deductions Under § § 243, 244, and 245

(2) Modification Under § 172(d)(5)

(3) Coordination of Net Operating Loss Rules, the Dividends Received Deduction, and the Percentage Depletion Deduction

(4) Planning Considerations

c. Disallowance of Domestic Production Activities Deduction

C. Taxpayers Other Than Corporations

1. General Rule

2. Modifications

a. Net Operating Loss Deduction

b. Personal Exemption Deduction

c. Limitations on Deduction of Nonbusiness and Business Capital Losses and Ordinary Nonbusiness Deductions

(1) Threshold Issues

(a) Attributable to or Derived from a Trade or Business

(i) ‘‘Trade or Business’’ Defined

(A) In General

(B) Employment as a Trade or Business

(C) Embezzlement Not a Trade or Business

(ii) “Attributable to” or “Derived from”

(A) Nature of Relationship Required

(B) Interest on Tax Deficiencies

(C) Treatment of Related Activities

(D) Embezzlement Not Attributable to Employment

(iii) Timing Considerations

(A) Preparatory Activities

(B) Events Following Business Termination

(iv) Trade or Business Distinguished from Investment

(A) Transactions Between Corporations and Shareholders

(B) Real Estate Transactions

(C) Securities Transactions

(D) Oil and Gas Transactions

(v) Multiple Trades or Businesses

(b) Business and Nonbusiness Income and Deductions

(i) Business Income

(ii) Nonbusiness Income

(iii) Business Deductions

(iv) Nonbusiness Deductions

(c) Business and Nonbusiness Capital Gains and Losses

(i) Deduction of Capital Losses Generally

(ii) Distinction Between Business and Nonbusiness Capital Gains and Losses

(iii) Required Allocation for Capital Loss Carryovers

(2) Limitations

(a) Nonbusiness Capital Losses

(b) Nonbusiness Deductions

(c) Business Capital Losses

d. Disallowance of Exclusion for Certain Capital Gains Under § 1202

e. Disallowance of Domestic Production Activities Deduction

3. Comprehensive Examples

D. Special Rules

1. Real Estate Investment Trusts

a. Modification for § 857(b)(2) Adjustments

b. Treatment of Capital Gain Dividends

2. Exempt Organizations

3. Public Utilities

a. Dividends Paid Deduction Under § 247

b. Modification Under § 172(d)(5)

4. Estates and Trusts

E. Applicable Law

IV. Carryback and Carryover Periods

Introductory Material

A. General Rule

1. Carryback and Carryover Periods

a. Net Operating Losses for Taxable Years Beginning after August 5, 1997, Except for Certain Periods

b. Net Operating Losses for Taxable Years Ending During 2001 and 2002

(1) Five-Year Carryback Period

(2) Waiver of Five-Year Carryback Period

(3) IRS Guidance for Taking Advantage of Five-Year Carryback Period if Taxpayer Acts On or Before October 31, 2002

c. Net Operating Losses Incurred by Electing Eligible Small Businesses in Taxable Years Beginning or Ending in 2008

2. No Extensions Granted

3. Treatment of Short Taxable Years

4. Special Applications

a. Effect of Conversion by C Corporation to S Corporation

b. Exempt Organizations

B. Exceptions

1. Real Estate Investment Trusts

a. Net Operating Losses for REIT Years

b. Net Operating Losses for Non-REIT Years

2. Specified Liability Losses

a. 10-Year Carryback Period

b. Product Liability Losses

c. Deferred Statutory or Tort Liability Losses

(1) Deferred Statutory or Tort Liability Losses - Taxable Years Ending Before October 22, 1998

(2) Deferred Statutory Losses - Taxable Years Ending After October 21, 1998

d. Decommissioning Nuclear Power Plants

e. Election to Waive Carryback Period

3. Corporate Equity Reduction Interest Losses

a. Carryback Restriction

b. Criteria for Application of Exception

(1) Corporate Equity Reduction Transactions

(a) Major Stock Acquisitions

(b) Excess Distributions

(2) Applicable Corporations

(3) Corporate Equity Reduction Interest Losses

(4) Loss Limitation Year

c. Examples

4. Losses from Casualty, Theft, and Presidentially Declared Disasters

a. Net Operating Losses for Taxable Years Beginning after August 5, 1997, Except for Certain Periods

b. Taxable Years Subject to Special Rules

5. Farming Losses

a. Net Operating Losses for Taxable Years Beginning after 1997, Except for Certain Periods

b. Taxable Years Subject to Special Rules

6. Electric Transmission Property and Pollution Control Facility Capital Expenditures

7. Gulf Opportunity Zone Net Operating Losses

a. In General

b. Qualified Gulf Opportunity Zone Casualty Losses

c. Moving Expenses

d. Temporary Housing Expenses

e. Depreciation of Gulf Zone Opportunity Property

f. Repair Expenses

8. Gulf Opportunity Zone Public Utility Casualty Losses

9. Losses Attributable to Federally Declared Disasters

C. Election to Waive Carryback Period

1. In General

2. Requirements for Election

a. Statement Requirement

b. Timing Requirement

c. Substantial Compliance

3. Election Irrevocable

4. Consolidated Returns

D. Applicable Law

V. Net Operating Loss Carrybacks and Carryovers

A. Introduction

B. Order of Carryback and Carryover

C. Amount of Carrybacks and Carryovers

1. First Carryback or Carryover Year

2. Additional Carryback or Carryover Years

a. Formula for Determining Amount of Carryback or Carryover

b. Modified Taxable Income

(1) Modified Taxable Income Defined

(2) Calculation of Modified Taxable Income

(a) Step 1: Modifications Used to Determine Modified Adjusted Gross Income

(i) Net Operating Loss Deduction

(ii) Limitation on Capital Losses

(iii) Disallowance of Exclusion for Certain Capital Gains Under § 1202

(iv) Recomputation of Certain Income and Deductions Based on or Limited by Adjusted Gross Income

(b) Step 2: Modification and Recomputation Used to Determine Modified Taxable Income

(i) Deduction for Personal Exemptions

(ii) Recomputation of Deductions Subject to Percentage Limitations

(3) Application of Modifications in Particular Contexts

(a) Loss Not Carried to Earlier Taxable Year

(b) Zero Taxable Income in Earlier Taxable Year

(c) Year in Carryback or Carryover Period Closed by Statute of Limitations

(4) Special Rule for Real Estate Investment Trusts

(a) Use of Real Estate Investment Trust Taxable Income

(b) Treatment of Capital Gain Dividends

c. Illustrations

D. Applicable Law

VI. Deduction Allowed

A. Amount Deductible

B. Recomputation of Tax for Carryback Year

C. Applicable Law

VII. Special Rules

A. Husband and Wife

1. No Change in Marital or Filing Status

2. Change in Filing Status

a. From Separate to Joint Returns

b. From Joint to Separate Returns

c. Recurrent Use of Joint Returns

3. Change in Marital Status

B. Consolidated Return

C. Discharge of Indebtedness

1. Income Inclusion and Exclusion

2. Reduction of Net Operating Losses and Loss Carryovers

3. Estates of Individuals in Chapter 7 or Chapter 11 Bankruptcy Proceedings

a. Bankruptcy Estate as Taxable Entity

b. Net Operating Loss Carryovers

c. Post-Bankruptcy Net Operating Loss Carrybacks

4. Other Bankruptcy Proceedings

VIII. Tax Returns and Compliance

A. Tax Returns

1. Carrybacks

a. Amended Return

b. Application for Tentative Carryback Adjustment

c. Special Rule for Corporations Expecting a Net Operating Loss

2. Carryovers

a. Individuals

b. Corporations

3. Required Statement

B. Interest

1. Interest on Overpayments

2. Interest on Underpayments

C. Assessment Period

D. Substantiation

IX. Alternative Minimum Tax Treatment

A. Introduction

B. Alternative Tax Net Operating Loss Deduction

1. Limitation on Amount of Deduction

2. Calculation of Net Operating Loss

3. Amount of Carrybacks and Carryovers

C. Carrybacks and Carryovers

1. In General

2. Waiver of Carryback

Working Papers

Table of Worksheets

Worksheet 1 IRS Publication 536 - Net Operating Losses

Worksheet 2 Facts and Computation of Net Operating Loss of LJM Corporation

Worksheet 3 Carryback and Carryover of LJM Corporation's Net Operating Loss

Worksheet 4 Taxable Income (Loss) by Year After Net Operating Loss Carrybacks and Carryovers

Worksheet 5 Completed Form 1138 - Extension of Time for Payment of Taxes by a Corporation Expecting a Net Operating Loss Carryback

Worksheet 6 Completed Form 1139 - Corporation Application for Tentative Refund

Worksheet 7 Completed Form 1139 - Corporation Application for Tentative Refund

Worksheet 8 Example of NOL Carryback for an Individual (Including Form 1045) Data Per Original Return Filed

Worksheet 9 Computation of Net Operating Loss for 2007 (Regs. § 1.172–3(a))

Worksheet 10 Completed Form 1045 - Application for Tentative Refund

Worksheet 11 Federal Income Tax Refunds - 2005–2006

Worksheet 12 [Reserved]

Worksheet 13 Sample Election for Life Insurance Company to Relinquish Operations Loss Carryback Period

Worksheet 14 Sample Elections to Waive Carryback Periods Certain for NOLs

Worksheet 15 Rev. Proc. 2002-40

Worksheet 16 Flow Chart-Determination of Carryback Period

Bibliography