Loss Relief: When the bottom line is not black
Operate a business that lost money this year? Or start a new venture that ran in the red? Either way, an often overlooked relief provision allows you to use a loss from the active conduct of a business to recover taxes paid in previous and/or future years.
The key to this opportunity is Internal Revenue Code Section 172. It authorizes two choices for businesses that suffer what are known as NOLs, short for net operating losses, the situation in which expenses exceed income. The first option is to carry back NOLs for two years. The second is to carry forward NOLs for as much as 20 years.
Backward or Forward?
Ailing businesses can use their current year's NOL to first offset business profits (there need not be any) or other kinds of income listed on returns for the two previous years and thereby generate immediate refunds for those years. This strategy is particularly advantageous for outfits with negative earnings that urgently need infusions of cash.
What happens when part of a NOL is not applied as an offset because it exceeds income for the two earlier years? The unused part then gets applied under the carryforward rules, until it is used up, to offset business profits (here, too, there need not be any) or other kinds of income listed on returns for the following 20 years.
An alternative is not to carry back a NOL for two years. Instead, simply carry forward the entire NOL for 20 years—an appropriate tactic when, for instance, you were in low brackets in earlier years and anticipate falling into loftier brackets in subsequent years. For example: Your NOL is for 2005, and 2003 and 2004 were low-income years. But you expect to go gangbusters for 2006 and later years. With this scenario, you elect to forgo any carryback. This assumes using up the NOL during the carryforward years that begin in 2006.
The IRS allows you ample time to assess your situation and decide whether to carry forward all of 2005's NOL. The deadline until the due date, including any extensions, for filing 2005's return.
Once made, that decision usually is irrevocable.
The Carryback Route.
The law mandates a strict chronological sequence. First, carry back and deduct 2005's NOL on 2003's return to obtain a refund of 2003’s taxes. Only if the NOL surpasses 2003’s income can the unused part then be carried to 2004’s return.
Still a part of 2005’s NOL left? It can then be carried over to 2006’s return, and so forth. Does it pay to build up the current year’s NOL and thereby increase the amount of the carryback? In that event, where possible, delay the receipt of income until a later year and accelerate payments of deductions into the current year.
The carryback increases from two years to three years for individuals who suffer casualty losses caused by natural disasters. This category includes Gulf Coast residents whose property was damaged or destroyed by hurricanes in 2004 and 2005.
Before deciding to claim a NOL, check to see whether returns for prior years contain any items that might be challenged by the IRS. Filing for a carryback refund doesn’t mean that the loss year’s return will be bounced automatically for an examination. Nevertheless, a refund claim might also cause the IRS to scrutinize earlier returns.
Note that the IRS has its own precise method to calculate NOLs. For additional information on these complex carryback/carryforward rules, consult Publication 536, “Net Operating Losses.” To obtain a free copy, telephone 1-800-TAX-FORM or download it from the IRS’s Web site (http://www.irs.gov).