Editor: Anthony S. Bakale, CPA, M. Tax.
Gains & Losses
Net operating loss (NOL) is a topic that clients and tax professionals often discuss. One of the biggest questions surrounding an NOL is when to use this potentially significant tax attribute. Once a taxpayer makes a decision about when to use an NOL, it is important that it be carried back and/or forward properly.
Under Sec. 172(b)(1), an NOL (in general) can be carried back 2 years and forward 20 years (certain special rules exist for NOLs for specified losses, resulting in NOLs that may be carried back more than 2 years). The general rule under Sec. 172(b)(2) is that an NOL is used in the following order until exhausted:
- Carried back to the second preceding tax year;
- Carried back to the first preceding tax year; and
- Carried forward to the following 20 tax years.
Carrying an NOL back to the two preceding tax years may not result in its best utilization, even if the taxpayer had significant income in those years, because the income could have been taxed at lower rates due to capital gain or qualified dividends. The taxpayer may benefit in these circumstances by making the election provided in Sec. 172(b)(3) to waive the carryback period. This is an all-or-nothing election, so the taxpayer is electing either affirmatively to waive the entire carryback period or by default to use the entire carryback period. In addition, this election must be “made by the due date (including extensions of time) for filing the taxpayer’s return” and “shall be irrevocable” (Sec. 172(b)(3)). Therefore, a taxpayer should make this election only after weighing the benefits of carrying the NOL back to the two preceding tax years versus the expected benefits of carrying the NOL forward.
Statute of Limitation for NOL Carryback Claims
A taxpayer that is an individual can carry an NOL back to the two preceding years in one of two ways. The first is by filing Form 1045, Application for Tentative Refund, within one year from the end of the year in which the NOL occurred. For example, an individual taxpayer whose tax year ends on December 31 has until the following December 31 to file Form 1045. The taxpayer could also file Form 1040X, Amended U.S. Individual Income Tax Return.
Sec. 6511 governs the period in which a taxpayer can file Form 1040X. A claim for credit or refund must generally be “filed by the taxpayer within 3 years from the time the return was filed or 2 years from the time the tax was paid, whichever of such periods expires later” (Sec. 6511(a)). The statute of limitation found in Sec. 6511(a) is modified in the case of a claim for credit or refund attributable to an NOL carryback. Sec. 6511(d)(2)(A) provides that
[i]f the claim for credit or refund relates to an overpayment attributable to a net operating loss carryback or a capital loss carryback, in lieu of the 3-year period of limitation prescribed in subsection (a), the period shall be that period which ends 3 years after the time prescribed by law for filing the return (including extensions thereof) for the taxable year of the net operating loss or net capital loss which results in such carryback, or the period prescribed in subsection (c) in respect of such taxable year, whichever expires later.
Therefore, taxpayers have at least three years from the date they filed the return that generated the NOL to file a claim for credit or refund to carry the NOL back to the two preceding tax years. The statute of limitation found in Secs. 6511(a) and (d)(2)(A) can be illustrated by the following examples:
Example 1 : X, an individual, calendar-year taxpayer, filed his 2009 Form 1040 on April 15, 2010. If X’s 2009 return fails to include a deduction for educator expenses, assuming that he otherwise qualifies for the deduction, X will have until April 15, 2013, to amend this return under Sec. 6511(a).
Example 2 : The facts are the same as in Example 1, except that X wishes to amend his 2009 return to carry back a 2011 NOL instead of claiming a deduction for educator expenses. X files his 2011 Form 1040 on April 15, 2012. Since his claim for credit or refund is attributable to an NOL, X has until April 15, 2015, to file an amended return for 2009 under Sec. 6511(d)(2)(A).
Mitigating the Results of Failing to Properly Carry Back an NOL
Making the election under Sec. 172(b)(3) to waive the carryback period on a timely filed return is critical. If the taxpayer does not make the election and does not file claims for credit or refund for the preceding two years within the statute of limitation discussed above, the taxpayer may lose its ability to use all or a portion of its NOL.
A classic example of this result can be found in Newton, 57 T.C. 245 (1971). In that case, the taxpayer reported income and paid the applicable tax for the years 1960–1962. In 1963, the taxpayer sustained an NOL in the amount of $15,895. The taxpayer also sustained losses for the tax years 1964–1967. The taxpayer failed to carry back the 1963 NOL to the three preceding years (the applicable carryback period at that time was three years) and instead carried the NOL forward and attempted to claim a deduction on the 1968 return. In disallowing the deduction on the taxpayer’s 1968 return, the court held that
Section 172(b)(1) and (2), I.R.C. of 1954, provides that a net operating loss sustained in a taxable year . . . must be carried back to the 3 immediately preceding taxable years, and, if not entirely absorbed by the income of those years, can be carried over . . . . When the $15,000 loss claimed by petitioners on the sale of the insurance agency in 1963 is carried back to 1960, 1961, and 1962 and offset against the income for those 3 years, no loss remains to be carried over to 1968. Unfortunately for the petitioners any claim for refund of the overpayment of tax for the years 1960, 1961 and 1962 is now barred by the statute of limitations.
As the Newton case illustrates, it is important for taxpayers to timely make the election to waive the carryback period or to file claims for refunds within the statute of limitation. However, the mitigation provisions of Secs. 1311–1314 may provide some relief for taxpayers, depending on their particular circumstances.
Advisers must understand when the mitigation provisions of Secs. 1311–1314 are applicable before they can analyze whether they can help a taxpayer when the taxpayer did not make an election to waive the carryback period for an NOL and has since carried the NOL forward. Sec. 1311(a) provides that
[i]f a determination (as defined in section 1313) is described in one or more of the paragraphs of section 1312 and, on the date of the determination, correction of the effect of the error referred to in the applicable paragraph of section 1312 is prevented by the operation of any law or rule of law, other than this part and other than section 7122 (relating to compromises), then the effect of the error shall be corrected by an adjustment made in the amount and in the manner specified in section 1314.
A determination is defined in Sec. 1313(a) as:
- a decision by the Tax Court or a judgment, decree, or other order by any court of competent jurisdiction, which has become final;
- a closing agreement made under section 7121;
- a final disposition by the Secretary of a claim for refund . . . ; or
- under regulations prescribed by the Secretary, an agreement for purposes of this part, signed by the Secretary and by any person, relating to the liability of such person (or the person for whom he acts) in respect of a tax under this subtitle for any taxable period.
Sec. 1311 requires a determination in one of the circumstances described in Sec. 1312. Sec. 1312(4), regarding double disallowance of a deduction or credit, is applicable when “[t]he determination disallows a deduction or credit which should have been allowed to, but was not allowed to, the taxpayer for another taxable year, or to a related taxpayer.” The legislative rationale for adding the double disallowance of a deduction or credit provision to the Code in 1953 is outlined in Letter Ruling 9249006:
The Senate Report to the 1953 Act gives the following reasons for the change: “Section 3801 of the code allows either the taxpayer or the Commissioner to correct an improper tax result in certain cases where such action would otherwise be prevented by the running of the statute of limitations. . . .
“The statute operates effectively in cases to which it is directed, but tax inequities, the correction of which is prevented by the running of the period of limitations, may exist without regard to whether or not the position maintained by either party is inconsistent. A taxpayer may be disallowed a deduction or credit to which he is entitled in another taxable year. . . .
“Under present law, the errors described may not be corrected if discovered after the expiration of the period of limitation in respect to the correct year of the taxpayer or of the proper taxpayer. The bill includes provisions amending section 3801 in order to open the statute of limitations in such cases.” [Letter Ruling 9249006, quoting S. Rep’t No. 685, 83d Cong., 1st Sess. 10–11 (1953)]
When would Secs. 1311–1314 help a taxpayer mitigate the error of not properly carrying back an NOL? The Newton case presented the worst-case scenario, in which the taxpayer failed to carry back an NOL; by the time the error was discovered, the taxpayer had lost any ability to utilize it. However, given the right set of facts, a taxpayer may be able to file a claim for credit or refund to carry back an NOL after the statute of limitation discussed above has expired. The IRS analyzes Secs. 1311–1314 as follows:
Several statutory tests must be satisfied for the mitigation provisions to apply. First there must be a determination. . . . Second, the determination must involve one of the circumstances of adjustment as defined in section 1312 of the Code. . . . Third, on the date of the determination, correction of the effect of the error must be prevented by the operation of law or any rule of law, other than the mitigation provisions themselves or section 7122 of the Code (relating to compromises). However, if there is a double disallowance of a credit, the mitigation provisions only open the year of the error if an additional requirement is met. The credit or refund of an overpayment for the taxable year in which the credit should have been allowed to the taxpayer must not have been barred by any law or rule of law when the taxpayer first maintained before the Secretary or before the Tax Court, in writing, that the taxpayer was entitled to the credit for the taxable year to which the determination relates. [Letter Ruling 9249006, citing Secs. 1311(a) and (b)(2)(B)]
Assuming that a taxpayer is able to meet the first three requirements of the mitigation provisions—that there was a determination, that the determination involved one of the circumstances defined in Sec. 1312, and that the correction is prevented by the operation of law or a rule of law—the key question then becomes when the taxpayer first maintained “before the Secretary or before the Tax Court, in writing, that he was entitled to such deduction or credit for the taxable year to which the determination relates” (Sec. 1311(b)(2)(B)).
The taxpayer will be considered to have first maintained in writing before the Commissioner or the Tax Court that he was entitled to such deduction or credit when he first formally asserts his right to such deduction or credit as, for example, in a return, in a claim for refund, or in a petition (or an amended petition) before the Tax Court. [Regs. Sec. 1.1311(b)-2(b)]
As cases and letter rulings point out, taxpayers do not need to maintain in writing that they are entitled to the credit or deduction for the correct tax year within the statute of limitation but only that they are entitled to the credit or deduction within the statute of limitation. This point is illustrated in TLI, Inc., 100 F.3d 424 (5th Cir. 1996), and Letter Ruling 9249006.
Section 1312(4) applies in the select circumstances in which the taxpayer, while the correct taxable year is still open, picks the wrong year to take a deduction or credit and finds, when disallowance for the wrong year is determined, that the correct year is no longer open. [TLI, Inc., 100 F.3d 424, slip op. at 11–12]
Thus, under the 1953 Act amendments, if the correct taxable year is open when a taxpayer claims a credit, and the taxpayer is entitled to the credit but makes a mistake as to the proper taxable year, the taxpayer is protected if the Service disallows the credit because it was claimed in the wrong taxable year. [Letter Ruling 9249006]
If this were not the case, Sec. 1312(4) would not help the taxpayer in any meaningful way. Changing the facts of the Newton case slightly illustrates how this works.
Example 3: Taxpayer T has an NOL for 1965 that it is required to carry back to 1962, 1963, and 1964 before carrying it forward. T fails to carry the NOL back but instead carries it forward and deducts it on her 1967 return. The IRS audits T’s 1967 return, and in 1969 the IRS disallows the NOL deduction on her 1967 return, at a date more than three years after T’s 1965 return was filed.
These were the facts in Plauche-Locke Securities, Inc., No. 15,629 (W.D. La. 1972). In allowing the taxpayer to carry back the portion of the 1965 NOL on her 1967 return that the IRS disallowed, the court stated:
The types of events which qualify as determinations are those that lend finality to positions of both taxpayer and Government. Under Section 1313(a)(4), the term “determination” includes a binding agreement between the Internal Revenue Service and the taxpayer, entered into for the express purpose of providing a final determination to which the mitigation provisions would apply. . . . At that time, however, that plaintiff filed its 1967 return, upon which it claimed a deduction for one-eighth of the 1965 loss, the statutory period within which plaintiff could have claimed a refund of its 1962 tax as a result of the 1965 loss had not expired. . . . If plaintiff had never claimed any portion of the 1965 loss as a deduction, prior to the expiration of the statute of limitations, the mitigation provisions clearly would not apply, since there would be no double disallowance of a deduction. The mitigation provisions do not authorize the recovery of all the tax erroneously paid without more.
It should be pointed out that the court in Plauche-Locke did not let the taxpayer carry the entire amount of the 1965 NOL back to 1962 but only the portion that the taxpayer attempted to deduct on her 1967 return. It is clear from the court’s comments above that had the taxpayer not claimed the NOL as a deduction within the statute of limitation, the mitigation provisions would not have applied, and the taxpayer would have been in the same situation as the taxpayer in the Newton case. Other cases have reached the same result in situations where the taxpayer has not claimed the NOL as a deduction, whether for the correct tax year or an incorrect tax year, within the statute of limitation (see Sanchez, T.C. Summ. 2003-63, where the court did not allow the taxpayer to carry back a 1990 NOL to 1987 when he failed to file an election to waive the carryback period and instead carried the NOL forward and claimed a deduction for the NOL on his 1995 return).
Therefore, in order to apply the mitigation provision in situations where the taxpayer has failed to carry back an NOL where no election to waive the carryback period was made, the NOL must be claimed as a deduction on a return the taxpayer files within the statute of limitation for filing a claim for credit or refund for the tax year of the loss. As mentioned earlier, generally the statute of limitation is three years from the time the return generating the NOL was filed. However, the statute could be longer “if an agreement under the provisions of section 6501(c)(4) extending the period for assessment . . . is made within the period prescribed in subsection (a) for the filing of a claim for credit or refund” (Sec. 6501(c)).
Sec. 6501(c)(4) governs agreements between the IRS and the taxpayer to extend the statute of limitation for assessment. This is done on IRS Form 872, Consent to Extend the Time to Assess Tax. If the period for assessment is extended under Sec. 6501(c)(4), “[t]he period for filing claim for credit or refund . . . shall not expire prior to 6 months after the expiration of the period within which an assessment may be made pursuant to the agreement or any extension thereof under section 6501(c)(4)” (Sec. 6511(c)(1)).
Example 4: Taxpayer Q’s 2008 Form 1040, which is filed on April 15, 2009, generates an NOL. On April 1, 2012, just prior to when the statute of limitation for assessment on Q’s 2008 return is going to expire, Q consents to extend the period of assessment until October 1, 2012, by signing Form 872. Q never carries back the 2008 NOL and fails to make an election waiving the carryback period for the 2008 NOL.
As a general rule, to use the mitigation provisions discussed above, Q would have been required to file the claim for credit or refund for the 2006 and 2007 tax years by April 15, 2012, or else claim the NOL as a deduction on her 2009, 2010, or 2011 Form 1040, as long as they were filed before April 15, 2012. However, because Q extended the period of assessment to October 1, 2012, she now has until April 1, 2013, to file a claim for credit or refund to carry back the 2008 NOL to the 2006 and 2007 tax years. In addition, under the court’s analysis in the Plauche-Locke case and the legislative intent of Secs. 1311–1314 discussed in TLI, Inc., and Letter Ruling 9249006, Q will be able to use the mitigation provisions if she claims the NOL on her 2012 return as long as the return is filed before April 1, 2013.
If an adviser encounters a similar situation, it will be important, regardless of whether it is the mistake of the taxpayer’s current tax professional or a prior tax adviser, to understand when and how the mitigation provisions may be able to alleviate some of the error caused by the failure to carry back an NOL when no election to waive the carryback period was made. Although the mitigation provisions will not allow a taxpayer to waive the carryback period if the election to waive it is not made timely, they can be useful in allowing the taxpayer to recover some benefit from an NOL that otherwise will be useless.
Anthony Bakale is with Cohen & Company, Ltd., Baker Tilly International, Cleveland, OH.
For additional information about these items, contact Mr. Bakale at (216) 579-1040 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly International.