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Oct. 5 — The ubiquitous chatter and commentary about the leak of Donald Trump's 1995 state tax returns has turned the spotlight on a standard tax tool that often flies under the radar: net operating loss deductions.
The New York Times on Oct. 1 released pages from Trump's Connecticut, New Jersey and New York 1995 tax returns, allegedly demonstrating that the Republican presidential nominee declared “other income” of negative $916 million and was equipped to cancel out federal income tax liability for up to 18 years.
As reported by the Tax Foundation, the loss and subsequent offset of taxable income “is almost certainly what is known as a net operating loss (NOL) carryforward.”
While conversation about Trump's tax strategy has largely been constricted to his federal income-tax bill—or lack thereof—it triggered questions about how NOL deductions operate and whether states have adopted a similar feature.
Bloomberg BNA details below the structure of NOL deductions, how state regimes vary and how they are viewed, and what lies ahead for them.Carryback
The use of a net operating loss deduction in earlier taxable years.
An NOL represents the excess of allowable deductions over gross income for a given tax year, which generates negative taxable income. Originating with the Revenue Act of 1918, an NOL provision permits the carryover of those losses to offset taxable income in preceding or subsequent reporting periods—either to claim a refund for prior taxable years or to reduce tax payments in future taxable years.
NOL deductions weren't always available under federal law, and the carryover periods have fluctuated through the years. Today, Section 172 of the Internal Revenue Code provides a carryback period of two years and a carryforward period of up to 20 years.
While often a feature in corporate tax planning, NOLs can also play into personal income taxes. For example, operating losses from partnerships, limited liability companies and S corporations can be used in personal tax returns to cancel out an equivalent amount of taxable income from other sources
There are two ways to use NOLs: carryback (using an NOL in earlier taxable years) and carryforward (using them in later tax years).Carryforward
The use of a net operating loss deduction in later taxable years.
State treatment of NOLs is far from uniform. States not only vary in their conformity to the federal NOL regime, but also deviate from one another's rules.
States that don't track the 20-year time frame stretch as far as 15 years and as little as five years.
For personal income tax purposes, states vary considerably in their approaches, and the rules are more difficult to pin down. Some conform with the federal regime, while others have curbed the scope of NOL deductions. Pennsylvania and Massachusetts don't permit NOL deductions at all. Similar to the corporate treatment, some have limited the carryforward periods.
The NOL deduction is a product of accounting for income tax on an annual basis, which can lead to disparities between the tax liability of businesses with steady income and those with fluctuating income.
Practitioners note that businesses with steady income exceeding expenses can consistently take the full benefit of deductions. However, corporate gains and losses don't always coincide with the calendar year.
For businesses with shifting income, the benefit of deductions is lost in taxable years when expenses exceed income—potentially leading to greater tax liability over a period of years than businesses with stable profits and equivalent average income. NOLs help with leveling out the corporate ups and downs.
Likewise, NOL deductions can encourage investment in new businesses, allowing losses in early years to offset income in later profitable years.
Dating back to 1957, the U.S. Supreme Court observed the balancing act underlying NOL rules, promoting taxation on long-term net income:
The net operating loss provisions “were enacted to ameliorate the unduly drastic consequences of taxing income strictly on an annual basis. They were designed to permit a taxpayer to set off its lean years against its lush years, and to strike something like an average taxable income computed over a period longer than one year ( Libson Shops, Inc. v. Koehler, 353 U.S. 382, 1957 ).
Revenue loss is often cited as the primary drawback of NOL deductions. Accordingly, states frequently reassess them during budget talks and economic downturns.
And some have characterized them as a tax break for a small contingent of wealthy individuals and businesses.
However, practitioners largely view NOL carryforwards and carrybacks as a core component of an income tax—not as a source of controversy.
Observing that 1.2 million taxpayers reported NOLs on their 2014 federal income tax forms, the Tax Foundation noted that the arbitrary system of taxing income on a calendar year basis is ripe for crafty accounting absent NOL deductions. Subject to a tax bill during a year with negative income, a taxpayer “would have an incentive to manipulate gains and losses to make them happen in the same year.”
Generally, NOL deductions don't incite notable political pushback at the state level.
“Many states have eliminated NOL carrybacks, because states have to balance their budgets and have challenges with the uncertainty carrybacks pose (resulting in a “call” on the state fisc likely at the same time revenues are performing poorly),” Joseph R. Crosby, a principal at MultiState Associates, told Bloomberg BNA in an Oct. 5 e-mail. “Similarly, when revenues underperform significantly, some states (e.g., California) have been known to temporarily suspend or reduce NOL carryforwards. But those NOLs are almost always fully restored once the revenue crisis passes.”
Pending litigation in Pennsylvania is contesting the state's statutory cap on net operating losses—not the availability of a NOL deduction. In Nextel Commc'ns of the Mid-Atlantic, Inc. v. Commonwealth, Pa., No. 6 EAP 2016, Pennsylvania's high court is reviewing the lower commonwealth court's Nov. 23, 2015, decision that the cap on NOL carryover deductions is unconstitutional (2016 Weekly State Tax Report 10, 8/26/16).
Since 2006, Pennsylvania has capped the amount of net operating losses that businesses may apply to their taxable income to either a flat dollar amount or a percentage of income. In 2007, Pennsylvania's law limited the amount of net losses a company could carry over to $3 million or 12.5 percent of income, whichever was larger. The current cap is the larger of $5 million or 30 percent of taxable income.
To the extent some have a fundamental opposition to NOL deductions, it can be founded on a misguided, apples-to-oranges comparison, Crosby explained.
“The challenge with the NOL deduction, and with the corporate income tax generally, is that voters, to the extent they think about the corporate income tax at all, analogize it to the personal income tax,” he said. “But that's a bad analogy—workers can't show up at their jobs every day and at the end of the year owe their employers money (i.e., take a loss on their labor). But businesses can and do lose money. Until we figure out a way for companies to always make profits, or we eliminate profits based taxes, the NOL deduction will remain.”
Crosby expects that some states will introduce legislation and a handful of policymakers will push out press releases. But, beyond that knee-jerk reaction, it appears the NOL deduction is here to stay.
“If Donald Trump's tax return represents a real flaw in our tax system, and it's not at all clear that it does, eliminating the state level NOL deduction won't solve that problem,” Crosby said. “In fact, it would simply create a much larger problem that would punish businesses that are in cyclical industries or economic sectors.”
State tax watchers have noted that the public scrutiny over Trump's tax returns disregards the unknown—particularly avoidance strategies that potentially played into his tax planning, including “debt parking.” Also missing from most discourse is the broader discussion of revamping the federal tax code, which further suggests no changes are coming.
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The Tax Foundation post on Trump's tax returns is at http://src.bna.com/i8h.
Copyright © 2016 Tax Management Inc. All Rights Reserved.
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