Editor: John L. Miller, CPA
Recent legislation has amended Sec. 172(b)(1)(H), which gives taxpayers an ability to carry back a net operating loss (NOL) for a period of three, four, or five years to offset taxable income in those preceding years and obtain refunds of taxes paid. The IRS’s ability to make adjustments to the affected returns is an important consideration for taxpayers when deciding whether to make the carryback election and how many years to include. This item focuses on the procedures for filing returns, the IRS examination policy and procedures, and implications to be aware of.
Seeking a Refund Based on an NOL Carryback
Taxpayers can apply for a refund based on a loss carryback by either filing an amended return or filing an application for tentative refund on the appropriate forms. Generally, a taxpayer must file an application for a tentative refund no later than 12 months after the close of the tax year in which the NOL was incurred. For example, the taxpayer must file the application for a tentative refund for a NOL incurred during a calendar year by December 31 of the following year. The IRS has issued guidance in the form of two revenue procedures that provide rules for filing the appropriate forms under the legislation. Taxpayers filing as an eligible small business (ESB) should review Rev. Proc. 200919 (as modified by Rev. Proc. 200926), and taxpayers with NOLs arising in tax years ending after December 31, 2007, and beginning before January 1, 2010, should consult Rev. Proc. 200952 for rules related to making the election and when to file the application.
The obvious advantage of filing an application for tentative refund, as compared with filing an amended return, is that the IRS must process a tentative refund within 90 days of receipt, provided the application is prepared correctly and contains no material errors. The amount requested in a tentative refund claim is paid prior to an examination, even if the amount of the requested refund is in excess of $2 million (the statutory amount subject to review by the Joint Committee on Taxation (JCT)). However, amended returns are claims for refund and are therefore subject to IRS scrutiny before payment of the refund. These returns can be examined or accepted as filed but may require JCT review prior to the payment of any refund. The examination process can last for more than a year, depending on the span and scope of examination activity.
Examination of NOL and Carryback Years
Depending on the taxpayer’s filing method, the IRS can recoup the prior tentative refund by assessment, or it can reduce the amount of refund requested either by disallowing a taxpayer’s claim for refund through the examination of the loss year or by making adjustments to the carryback year(s).
The NOL Year
The IRS can examine and adjust the loss year return to determine the correct amount of NOL available for carryback. Assuming a reduced NOL, if the taxpayer filed an application for tentative refund, the IRS can recover the tax refunded and make an assessment to the carryback year(s) even if the normal statute of limitation on assessment has expired. If the taxpayer filed amended returns, the IRS would be able to reduce the amount of the claimed refund to the extent that the NOL carryback is reduced. If the IRS does not make a change to the NOL year, it will then look to the carryback year(s).
The Carryback Year
If the carryback year was previously examined, the IRS will not reexamine it except in specific circumstances. (To reopen a prior examination year, IRS Policy Statement P43 requires evidence of fraud, malfeasance, collusion, concealment, or misrepresentation of a material fact; a clearly defined substantial error based on an established IRS position existing at the time of the previous examination; or other circumstances indicating that failure to reopen would be a serious administrative omission (Internal Revenue Manual §22.214.171.124.1 (12/21/84).) Assuming that reopening criteria are not present, the IRS would further process the case.
If the IRS did not previously examine the carryback year, it is free to examine the issues on the return to determine the correct taxable income of the year before allowance of the carryback. Once determined, the NOL carryback is applied to offset the corrected taxable income, and any excess NOL will be available for carryover to the next carryback year. That year will be subject to the same examination procedures.
For any carryback year in which the statute of limitation on assessment has expired, any resulting tax increases would be limited to the amount of the refund; however, the NOL carryback could be reduced or eliminated by the tax increases, precluding any further carryover to other tax years.
Other implications of the NOL carryback to consider include the suspension of the 90% limitation for computation of the alternative minimum tax, a 50% limitation on the deductibility of the NOL in the fifth preceding year, the effect on allowable and deficiency interest computations, the use or loss of tax credits, and, for some corporate taxpayers, the potential impact on their financial statements.
The change to the NOL carryback rules has given taxpayers the opportunity to obtain refunds of taxes paid in earlier years. However, to maximize the overall position, taxpayers must be wary of the rules relating to NOLs and the interaction between the various sections of the law and IRS policy. A taxpayer should make the decision to elect to carry back a NOL to a closed tax year only after a complete analysis and risk assessment.
The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP.
John Miller is a faculty instructor at Metropolitan Community College in Omaha, NE. William O’Meara is with Ernst & Young LLP in Philadelphia, PA, and is a member of the AICPA Tax Division’s IRS Practice and Procedures Committee. For further information about this column, contact Mr. Miller at firstname.lastname@example.org.