Undoubtedly, you have some clients whose businesses were battered by the recession and lost money in 2008. Or perhaps they started a new venture that ran in the red. Either way, the Internal Revenue Code allows business owners to carry NOLs to other years and deduct them. For 2008 only, these businesses are not bound by the normal two-year carryback. In fact, some red-ink businesses may be able to get refunds of all or part of the income taxes they paid for past years or find that they may be able to trim their taxes in future years.
The revised Code Section 172 specifies two choices--elections, in IRS-speak: One allows businesses that experience NOLs to carry losses back and offset them against previous years' profits, and then to carry them forward and offset against future years' profits. The second choice allows businesses that forego the carryback route to use their NOLs as offsets against future years' profits only, for as many as 20 years.
The year in which NOLs occur determines the number of years they can be carried back--a maximum of two years for losses incurred in 2007 and earlier and as far back as five years for losses incurred in 2008.
The Recovery Act retroactively liberalized the carryback rules for NOLs in 2008 and authorized an enhanced option. Businesses that enjoyed profitable years before 2008 can elect to carry back their 2008 losses for two, three, four or five years--whichever proves most advantageous. Such carrybacks are limited to operations that meet the criteria for "small businesses," meaning those with average annual gross receipts below $15,000,000 for the years 2006 to 2008. The Act helps all kinds of ventures--anything from full-time and long-established to part-time and newly launched--and they can be conducted through sole proprietorships, partnerships or corporations.
The Recovery Act left unchanged the two-year carryback cap on losses for years prior to 2008. And the two-year cap is slated to return for post-2008 years.
What happens after 2008?
Will our lawmakers decide that a "temporary" carryback for as many as five years should be kept on the books? Congress almost always renews temporary provisions--particularly when they benefit beleaguered businesses with negative earnings that might be unable to survive without infusions of cash. And it is clear that operating loans from banks and other conventional sources have become increasingly unavailable.
Businesses must select a carryback of two, three, four or five years or waive any carryback and proceed with a carryforward.
The IRS has its own precise method for calculating NOLs; some write-offs permitted under regular tax rules are prohibited when figuring NOLs. For example, there are no deductions for personal exemptions or for contributions to IRAs, Keoghs or other tax-deferred accounts. But it is permissible for NOLs to include such deductions as casualty and theft losses--even when the property was used for personal purposes--as well as expenses of job-related moves.
Once made, however, the decisions are irrevocable. The IRS does not allow businesses to undo their elections, nor can they make late elections, an IRS edict with which the courts agree.
Backward or forward?
Section 172 allows small business owners with NOLs for 2008 to use them first to offset business profits or other kinds of income listed on their returns for the two, three, four or five previous years, thereby generating immediate refunds for those years. Note that carrybacks to those years do not decrease self-employment taxes for individuals.
There is another route for business owners who are unable to apply part of their NOL as an offset because it exceeds income for the earlier years. What they then are allowed to do is apply the unused part--until used up--to offset business profits or other kinds of income listed on returns for the following 20 years. After 20 years, however, unused carryforwards become forfeit. They cannot be passed down to heirs.
Section 172 also allows business owners to dispense with carrying back NOLs to any of the earlier years. Instead, they simply carry forward their entire NOL for 20 years. This can be an appropriate tactic for business operators who were in low brackets in earlier years and anticipate rising into loftier brackets in subsequent years. But it is not a worthwhile tactic for those who anticipate skimpy future profits because years could go by before they become able to reap the full benefit of the write-offs.
An example: Sole proprietor Elijah Vennebush has a NOL for 2008; 2003 to 2007 were low-income years. But Eli expects to go gangbusters for 2009 and future years. In such a scena-rio, Eli elects to relinquish any carryback. To do so, he attaches a statement to that effect to his return. The deadline for the election is the due date, plus extensions, for the return for the year of the loss. For a 2008 Form 1040 that would have been by April 15, 2009, or Oct. 15, 2009 if he submits Form 4868 for an automatic six-month extension.
On the other hand, Eli is free to go the carryback route and select the period that results in the largest tax savings. However, he does not have an unlimited time to elect a carryback period of two, three, four or five years. As is true of a carryforward, he must decide on a carryback by the filing due date for his 2008 Form 1040.
The law mandates a strict chronological sequence. Assume Eli decides to carry back and deduct his 2008 NOL on his 2005 return to obtain a refund of 2005's taxes. Only if his NOL surpasses his income in 2005 can he then carry the unused portion of the NOL to returns for 2006 and 2007. And if there is still a portion of the 2008 NOL left? He then carries it over to his 2009 return and so forth.
Does it pay for small businesses to build up the current year's NOL and thereby increase the amount of the carryback? If it does, whenever possible they should delay the receipt of income until a later year and accelerate payments of deductions into the current year. Taxpayers who decide to claim NOLs should first check to see whether returns for prior years contain any items that might be challenged by the IRS.
Help from IRS
Sole proprietors and owners of pass-through entities should use Form 1045 (Application for Tentative Refund) to obtain "quick refunds." The IRS usually accepts or rejects refund claims within 90 days from the time the forms are filed. The agency tells taxpayers not to attach Form 1045 to Form 1040. Instead, Form 1045 should be filed separately, together with a copy of Form 1040. But before you spend that refund money, keep in mind that the IRS may later determine that the refund was excessive and assess additional tax, plus interest and penalties.
Information on the complex carryback/carryforward rules is available on the IRS Web site: irs.gov.
Julian Block, an attorney based in Larchmont, N.Y., conducts continuing education courses for financial planners. Information about his books can be found at www.julianblocktaxexpert.com.