PORTFOLIO

Net Operating Losses — Concepts and Computations (Portfolio 539)

Tax Management Portfolio, Net Operating Losses — Concepts and Computations, No. 539-3rd, describes and illustrates the tax principles for using a net operating loss sustained by a taxpayer as 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.

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DESCRIPTION

Tax Management Portfolio, Net Operating Losses — Concepts and Computations, No. 539-3rd, describes and illustrates the tax principles for using a net operating loss sustained by a taxpayer as 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. The Portfolio then furnishes a step-by-step explanation of the computations required in applying §172, including: (1) the computation of a net operating loss; (2) the determination of the carryback and carryover periods, including the temporary carryback periods applicable to disaster losses; (3) the computation of the amount of net operating loss carrybacks and carryovers; and (4) the computation of the net operating loss deduction. Procedural aspects of claiming the deduction are also examined. The Portfolio describes the alternative minimum tax net operating loss deduction, which replaces the deduction under §172 for alternative minimum tax purposes.


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AUTHORS

CARLA NEELEY FREITAG
Carla Neeley Freitag, B.A., Duke University (magna cum laude, 1974); J.D., University of Florida College of Law (with high honors, 1976); LL.M. (in Taxation), University of Miami School of Law (1988); admitted to practice in Florida, Texas, and Georgia; member, American Bar Association; author, The Funding of Living Trusts; contributor to Tax Practice Series; author of 462 T.M., Unrelated Business Income Tax, 875 T.M., Debt-Financed Income (Section 514), 607 T.M., Farm and Ranch Expenses and Credits, 744 T.M., Taxation of Cooperatives and Their Patrons; co-author of 863 and 521 T.M., Charitable Contributions: Income Tax Aspects, and 517 T.M., Scholarships and Educational Expenses; Tax Management Distinguished Author.

TABLE OF CONTENTS

Portfolio Description

Authors

Technical Advisors

Description

Detailed Analysis

I. Introduction

A. Background of the Deduction

B. Overview of the Deduction

C. Judicial Construction of §172

D. State Laws

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

a. Treatment at Partnership Level

b. Deduction by Partners

2. S Corporations

a. Losses Pass Through to Shareholders

b. Deduction of Losses Limited to Shareholder's Basis

(1) In General

(2) Economic Outlay Required for Debt Basis

(3) Treatment of Open Account Debt

c. Carryover of Disallowed Losses

(1) In General

(2) Transfers Involving Spouses

(3) Last Taxable Year of S Corporation

d. Conversion of C Corporation to S Corporation

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

a. Carryover in Liquidations of Subsidiaries and Certain Reorganizations

b. Section 382 Limitation

c. Acquisitions to Evade Taxation

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

(1) Deducting Unused Loss Carryovers

(2) Deducting Excess of Deductions over Income

(3) Section 642(h)(1) vs. Section 642(h)(2)

(4) Beneficiaries Succeeding to the Property of the Estate or Trust

3. Corporations

a. Net Operating Losses of Corporations Generally

b. Net Operating Losses of Corporations That Dissolve

c. Changes in Form of Business

4. Termination of Disputed Ownership Funds

III. Calculation of Net Operating Loss

A. Introduction

1. Net Operating Loss Defined

2. What Constitutes a Loss

3. Substantiation of Loss

4. 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, Former §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. 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 Under §199

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 Former §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. Carryover Period

2. Carryback Periods

a. Net Operating Losses for Taxable Years Other Than 2001, 2002, 2008, or 2009

b. Extended Carryback Period for 2001 and 2002 Net Operating Losses

(1) Five-Year Carryback Period

c. Extended Carryback Period for Applicable 2008 Net Operating Losses

(1) Applicable 2008 Net Operating Loss

(2) Eligible Small Businesses

(3) Election

d. Extended Carryback Periods for Net Operating Losses Incurred in a Taxable Year Ending After December 31, 2007 and Beginning Before January 1, 2010

(1) Carryback Amount Limitations

(2) Applicable Net Operating Loss

(3) Eligible Taxpayers

(4) Election

3. No Extensions Granted

4. Treatment of Short Taxable Years

a. Short Year in Carryback or Carryover Period

b. Loss Generated in Short Year

5. 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

(1) 10-Year Carryback Period Replaces 2-Year Carryback Period

(2) Coordination with Other Net Operating Losses

b. Product Liability Losses

(1) “Product Liability” Defined

(2) Services

(3) Insurance Expenses and Recoveries

c. Deferred Statutory Liability Losses

(1) Requirements

(2) Background

(3) Elements of a Specified Liability Loss

(a) Amount Allowable as a Deduction

(i) In General

(ii) Costs Allocated to Inventory

(b) Satisfaction of a Liability Under a Federal or State Law

(c) Five Types of Qualifying Liabilities

(i) Reclamation of Land

(A) Covered Expenses

(B) Effect of Election Under §468

(ii) Decommissioning of Nuclear Power Plant

(A) Covered Expenses

(B) Effect of Election Under §468A

(C) Alternative Carryback Period

(iii) Dismantlement of a Drilling Platform

(iv) Remediation of Environmental Contamination

(v) Payments Under Workers Compensation Acts

(d) Three-Year Requirement

(i) Case Law

(ii) Specific Contexts: Reclamation and Environmental Contamination

(iii) Depreciation Deductions

(e) Accrual Method of Accounting

d. 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. Farming Losses

a. Taxable Years Beginning After 1997, Except for Certain Periods

b. Taxable Years Ending During 2001 or 2002

c. Taxable Years Ending or Beginning During 2008 or 2009

d. Waiver of Carryback Periods

5. Electric Transmission Property and Pollution Control Facility Capital Expenditures

6. Losses from Disasters

a. Casualty, Theft, and Federally Declared Disasters

(1) Eligible Losses

(2) Exception Not Applicable

b. Losses in Targeted Areas

(1) Gulf Opportunity (GO) Zone

(a) In General

(b) Geographic Coverage

(c) Qualified GO Zone Losses

(i) Losses Before January 1, 2008

(A) Qualified GO Zone Casualty Losses

(B) Moving Expenses

(C) Temporary Housing Expenses

(D) Depreciation of GO Zone Property

(E) Repair Expenses

(ii) Losses After December 31, 2007

(d) Waiver of Carryback Period

(e) GO Zone Public Utility Casualty Losses

(2) Katrina, Rita, and Wilma GO Zones — Timber Losses

(a) Qualified Timber Property

(b) Eligible Taxpayers

(3) May 4, 2007, Kansas Storms and Tornadoes

(4) Midwestern Disaster Areas

c. Qualified Disaster Losses

C. Election to Waive Carryback Period

1. In General

2. Requirements for Election

a. Statement Requirement

(1) Use the Term “Elect” or “Election”

(2) Refer to §172(b)(3) and Avoid Erroneous Citations

(3) No Separate Election for Alternative Tax Net Operating Loss

(4) Taxpayer Signature Not Required

b. Timing Requirement

c. Substantial Compliance

3. Election by Corporations

4. Election Irrevocable

a. Irrevocable Election as a Calculated Risk

b. Bankruptcy

5. 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) Disallowance of Domestic Production Activities Deduction Under §199

(v) 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 Tax Year

(b) Zero Taxable Income in Earlier Tax 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

3. SECA

D. Applicable Law

VI. Deduction Allowed

A. Amount Deductible

B. Recomputation of Tax for Carryback Year

C. Self Employment Tax

D. Applicable Law

VII. Special Rules

A. Married Taxpayers

1. No Change in Marital or Filing Status

a. All Joint Returns

b. All Separate Returns

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

D. Averaging of Farm Income

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

4. Schedule UTP

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 Facts and Computation of Net Operating Loss of LJM Corporation

Worksheet 2 Carryback and Carryover of LJM Corporation's Net Operating Loss

Worksheet 3 Taxable Income (Loss) by Year After Net Operating Loss Carrybacks and Carryovers

Worksheet 4 Completed Form 1138 — Extension of Time for Payment of Taxes by a Corporation Expecting a Net Operating Loss Carryback

Worksheet 5 Completed Form 1139 — Corporation Application for Tentative Refund 2007-2008

Worksheet 6 Completed Form 1139 — Corporation Application for Tentative Refund 2008-2009

Worksheet 7 Completed Form 1120X Amended Return 2008

Worksheet 8 Case Study of NOL Carryback for an Individual: Data Per Original Return Filed

Worksheet 9 Computation of Net Operating Loss for 2011 (Regs. §1.172-3(a))

Worksheet 10 Completed Form 1045 — Application for Tentative Refund

Worksheet 11 Federal Income Tax Refunds — 2009–2010

Worksheet 12 Sample Election to Forgo Carryback Period Under §172(b)(3)

Worksheet 13 Sample Election to Forgo Carryback Period for Specified Liability Losses Under §172(f)(6)

Worksheet 14 Sample Election of Extended Carryback Period for Applicable 2008 NOLs of Eligible Small Businesses

Worksheet 15 Text of §1400N(k) for Midwestern Disaster Areas

Worksheet 16 IRS FAQs on Worker, Homeownership, Business Assistance Act of 2009, Section 13 Five-Year NOL Carryback

Bibliography

OFFICIAL

Statutes:

State Statutes:

Treasury Regulations:

Public Laws:

Legislative History:

Treasury Rulings:

Cases:

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