A Primer on Trump Tax Tool: Carrying Over Net Operating Loss

The Bloomberg BNA Tax Management Weekly State Tax Report filters through current state developments and analyzes those critical to multistate tax planning.

By Jennifer McLoughlin

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.

What Are Net Operating Losses?

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.

Do States Conform With Federal NOL Deductions?

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.

  • Carryforward Conformity.
Based on information gathered by Bloomberg BNA, 30 states and the District of Columbia conform to the federal carryforward period of 20 years for corporate income tax purposes ( see chart below).

States that don't track the 20-year time frame stretch as far as 15 years and as little as five years.

  • Carryback Conformity.
The federal-state discrepancy is more stark with the treatment of NOL carrybacks. Twenty-eight states and the District of Columbia don't permit NOL carrybacks for corporate income taxes. And of those states that recognize NOL deductions for prior taxable years, 13 conform to the federal standard of two years ( see chart below).

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.

Why Do Taxpayers Utilize NOLs?

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 ).

What Is the Criticism of NOLs?

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.”

Are Taxpayers Challenging NOLs?

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.”

Did Trump Trigger a Fight Over NOLs?

Probably not.

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.

To contact the reporter on this story: Jennifer McLoughlin in Washington at jmcloughlin@bna.com

To contact the editor responsible for this story: Ryan Tuck at rtuck@bna.com

For More Information

The Tax Foundation post on Trump's tax returns is at http://src.bna.com/i8h.

Corporate NOL Deductions - Carryforwards STATE CARRYFORWARD YEARS CAP 1 Alabama Yes 15 2 Alaska Yes 20 3 Arizona Yes 20 4 Arkansas Yes 5 5 California Yes 20 6 Colorado Yes 20 7 Connecticut Yes 20 8 Delaware Yes 20 9 District of Columbia Yes 20 10 Florida Yes 20 11 Georgia Yes 20 12 Hawaii Yes 20 13 Idaho Yes 20 14 Illinois Yes 12 15 Indiana Yes 20 16 Iowa Yes 20 17 Kansas Yes 10 18 Kentucky Yes 20 19 Louisiana Yes 20 20 Maine Yes 20 21 Maryland Yes 20 22 Massachusetts Yes 20 23 Michigan Yes 10 24 Minnesota Yes 15 25 Mississippi Yes 20 26 Missouri Yes 20 27 Montana Yes 7 28 Nebraska Yes 20 29 Nevada No Corp. Income Tax N/A 30 New Hampshire Yes 10 Yes 31 New Jersey Yes 20 32 New Mexico Yes 20 33 New York Yes 20 34 North Carolina Yes 15 35 North Dakota Yes 20 36 Ohio No Corp. Income Tax N/A 37 Oklahoma Yes 20 38 Oregon Yes 15 39 Pennsylvania Yes 20 Yes 40 Rhode Island Yes 5 41 South Carolina Yes 20 42 South Dakota No Corp. Income Tax N/A 43 Tennessee Yes 15 44 Texas No Corp. Income Tax N/A 45 Utah Yes 15 46 Vermont Yes 10 47 Virginia Yes 20 48 Washington No Corp. Income Tax N/A 49 West Virginia Yes 20 50 Wisconsin Yes 20 51 Wyoming No Corp. Income Tax N/A Corporate NOL Deductions - Carrybacks STATE CARRYBACK YEARS CAP 1 Alabama No 2 Alaska Yes 2 3 Arizona No 4 Arkansas No 5 California Yes 2 6 Colorado No 7 Connecticut No 8 Delaware Yes 2 Yes 9 District of Columbia No 10 Florida No 11 Georgia Yes 2 12 Hawaii Yes 2 13 Idaho Yes 2 Yes 14 Illinois No 15 Indiana No 16 Iowa No 17 Kansas Yes 2 18 Kentucky No 19 Louisiana No 20 Maine No 21 Maryland Yes 2 22 Massachusetts No 23 Michigan No 24 Minnesota No 25 Mississippi Yes 2 26 Missouri Yes 2 27 Montana Yes 3 28 Nebraska No 29 Nevada No Corp. Income Tax N/A 30 New Hampshire No 31 New Jersey No 32 New Mexico No 33 New York Yes 3 34 North Carolina No 35 North Dakota No 36 Ohio No Corp. Income Tax N/A 37 Oklahoma Yes 2 38 Oregon No 39 Pennsylvania No 40 Rhode Island No 41 South Carolina No 42 South Dakota No Corp. Income Tax N/A 43 Tennessee No 44 Texas No Corp. Income Tax N/A 45 Utah Yes 3 Yes 46 Vermont No 47 Virginia Yes 2 48 Washington No Corp. Income Tax N/A 49 West Virginia Yes 2 Yes 50 Wisconsin No 51 Wyoming No Corp. Income Tax N/A

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