Increasing Your Tax Savings by Waiving the Net Operating Loss Carryback
Many readers are familiar with the term Net Operating Loss (NOL). However, you may not be as familiar with the procedures available for claiming them. As a general rule, once taxable income is reduced below zero in the year of a loss, NOLs are “carried” to another tax year where they are used to reduce taxable income in that year. There are, of course, rules that determine which years the loss can be claimed. Generally, an NOL must first be carried back to the second year preceding the loss year, and then forward, year by year, up to a maximum of twenty years following the loss year. Taxpayers have the ability, though, through election, to waive the two year carryback period and instead use only the twenty year carryforward period. Knowing when and how to do so can be very beneficial.
The procedure for waiving an NOL carryback is relatively straight forward but requires action. A one time, irrevocable election is made by attaching a statement to the tax return in the year of the loss. Per IRS Code Section 173(b)(3), the election must be made by the due date (including extensions) of the return. This time restriction is important, because it limits the opportunity for planning. For a taxable year in which an NOL occurs, the taxpayer has, at the latest, until October 15th of the year following the loss to evaluate the best utilization of the NOL. If the election is not made by the due date of the return, the NOL must first be carried back two years and then can be carried forward twenty.
The primary question to ask yourself as a taxpayer with an NOL is “when would I want to make the election to waive the carryback period?” There are several situations in which this election is appropriate. The first, and most obvious, is if income was taxed during one or both of the carryback years at a lower effective tax rate than that expected in future years. While we can’t say for certain what the tax rates will be in carryforward years, there are some instances when we can be fairly sure the taxpayer will be in a higher bracket. Assume, for example, that in the first two years of operation for a business, a small profit is shown. In the third year, a large net operating loss occurs. These results, however, are mostly caused by start-up costs. In future years, the business expects to be very profitable. The assumption of higher income for the foreseeable future leads us to determine that it may be best to waive the carryback period, conserving the NOL for future years. Also note that in 2012 the top federal individual tax rate was 35%, but for 2013 and forward it was increased to 39.6% and accompanied by some additional taxes and deduction phase-outs that for many taxpayers drove the current effective rate even higher. So for losses generated in 2014, forgoing the carryback to 2012 may make sense, simply to take advantage of the difference in top tax rates.
Similarly, an NOL could be carried back to a year where most or all of the income was from capital gains or qualified dividends, which are taxed at lower rates. In this situation, the taxpayer would want to determine whether or not they expect to be taxed at capital gain rates in future years. The difference between effective tax rates expected in the future and effective tax rates in the carryback years should be high enough that the additional savings are worthwhile. For example, if the expected savings are not large enough to offset the benefit of short-term cash flow from refunds of tax in carryback years, the taxpayer may not want to waive the carryback period even if higher rates are expected in future years.
Another slightly more complicated situation occurs when considering the alternative minimum tax (AMT). It is important to point out that because the AMT is calculated on its own, separate taxable income, referred to as Alternative Minimum Taxable Income (AMTI), a separate NOL exists for AMT purposes. The election to waive an NOL carryback must be applied to both the regular NOL and the Alternative Tax NOL. To properly evaluate the benefit of an NOL carryback, the taxpayer must examine the impact of both the regular NOL and the Alternative Tax NOL. Because AMT imposes restrictions and modifications to certain deductions taken for regular tax purposes, the NOL for regular tax purposes must be reduced by any tax preference and adjustment items which increased the NOL for regular tax purposes. This adjusted NOL is referred to as the Alternative Tax NOL (ATNOL). If a taxpayer has a lot of tax preference items, the ATNOL could be much smaller than NOL for regular tax purposes. Additionally, the ATNOL generally may not reduce AMTI by more than 90% of the AMTI computed without the ATNOL. As a result, while regular taxable income may be negative in a carryback year, AMTI could be positive. In this case, an AMT tax liability would be present, thus reducing the benefit in the carryback year.
Generally, the decision to waive the carryback period is a cost-benefit analysis conducted by the taxpayer and his or her tax advisor. Unless the taxpayer is in an unusual situation, an NOL carryback will result in a refund for one or both of the two preceding years. The forfeit of cash flow from these refunds is a cost of waiving the carryback period. This is weighed against the benefit of receiving a larger NOL deduction in the carryforward period, and the future tax savings that would occur as a result.
As a taxpayer, it is important to know the option to waive the carryback period is available. It is also important to ask your tax advisor to examine the impact of doing so. By examining your tax situation in each year in which an NOL occurs, you can be sure that your losses are being applied to the years in which you receive the highest benefit.
If you have any questions or would like to discuss these proposed changes further, please contact Stan Rose or your BNN tax advisor at 1.800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.