The statute of limitation for net operating losses

The statute of limitation defines the time within which the IRS may initiate an audit of a tax return. According to Sec. 6501(a), the statute of limitation for income tax returns is three years from the filing date of the return or the due date if the return is filed early.

While most of the income and deduction amounts reported on a return are generated in the current tax year, some amounts that are created in a prior year and carried over to the current year’s return can be included in the calculation of taxable income. For example, a net operating loss (NOL) from a business activity can be carried back two years and carried forward 20 years (Sec. 172(b)(1)(A)). As this carryover period extends beyond the three-year statute of limitation, the use of an NOL deduction can create circumstances where amounts generated in closed years affect the calculation of taxable income in an open year. If a taxpayer’s return is selected for audit and it includes an NOL deduction from a closed year, can the IRS challenge the calculation of the prior-period carryover amount and, in effect, reopen a closed return?

The tension between the statute-of-limitation provision that can close a tax year for future audits and carryover amounts that are created in closed years but reported and subject to audit in an open year is resolved in Sec. 7602(a), which states, “For the purpose of ascertaining the correctness of any return . . . the Secretary is authorized—(1) to examine any books, papers, records, or any other data which may be relevant or material to such inquiry.”

With respect to audits including NOL amounts created in years that are closed under the statute of limitation, the IRS applies the rules of Sec. 7602(a) in the following ways in the Internal Revenue Manual (IRM). IRM Section 4.11.11.13(2) instructs revenue agents that they may redetermine the correct taxable income for a closed year to determine either the amount of the carryforward deduction reported in the open year or the amount of an NOL deduction that is absorbed in a closed year and supports the determination of the available NOL deduction for the open year under examination.

IRM Sections 4.11.11.13(5) and (6) provide two examples that may prompt a revenue agent to identify a problem in an NOL deduction under examination. In the first example, a 2011 tax return that included a substantial NOL deduction that was created in 2007 is under audit. In the course of the investigation, the revenue agent finds evidence that the NOL created in the closed year may have been incorrectly calculated. Specifically, part of the loss deduction may have been created from a related-party loan that was forgiven. The revenue agent uncovers evidence in 2011 that undermines the legitimacy of the loan arrangement, and the taxpayer is asked to provide the supporting documentation from 2007 to substantiate the existence of the loan, evidence of the forgiveness, and the determination of the loss. When the taxpayer fails to provide sufficient evidence, the loss deduction is reduced to the amount that could be substantiated.

In this scenario, the IRS compares the request for documentation from the closed year to a routine request for receipts to support any deduction on the return. That is, the IRS does not regard the request as opening a closed year but rather as the normal audit procedure that requires taxpayers to meet the legal burden of proof for substantiating all amounts reported on the return. For this example, the IRM states that “[t]he consideration of the 2007 issue is not an audit of 2007 and a 2007 revenue agent report (RAR) is not required . . . the examiner simply requested verification of the NOL carryforward.”

In the second example, the IRS describes an audit of a 2012 corporate tax return that includes a material amount of nondeductible personal expenses and an NOL carryforward. When the agent disallows the personal expenses on the 2012 return, the tax loss on the originally filed return becomes taxable income that can be offset by an NOL carryforward that has accumulated since 2007. The agent picks up 2010 and 2011 and discovers the same problem with the same expense accounts. Inspection of the 2007 through 2010 returns reveals the same types of expense accounts; however, the years 2007, 2008, and 2009 are closed by the statute of limitation. The agent requests supporting documentation from 2007 through 2009 to substantiate the NOL carryforward for those years that would be brought into the open years. When the taxpayer fails to provide sufficient evidence that the NOL deduction generated in the closed years represents legally defensible business expenses and not nondeductible personal expenses, the agent disallows the entire NOL carryforward.

The rules in Sec. 7602(a) that permit the IRS to examine any records deemed relevant for confirming the correctness of a return and the application of these rules in the IRM with respect to NOLs create two potential pitfalls for taxpayers. First, if taxpayers are familiar with the three-year statute of limitation and believe this period applies to all returns and in all circumstances, then they may discard the records that support the NOLs too soon.

The examples above demonstrate that taxpayers will bear the burden of proof to substantiate all amounts reported on their returns even if the amounts are carried over from closed years. If they fail to keep the supporting documentation for an NOL carryforward created more than three years earlier, they risk losing NOL deductions in audits.

The second pitfall is assuming that a closed statute-of-limitation period implies that the IRS has accepted returns from closed years as correctly filed. IRM Section 4.11.11.13(4) explicitly refutes this inaccurate assumption by stating “copies of tax returns are not proof” of an NOL deduction. This directive from the IRM means that taxpayers cannot use tax returns from prior years as supporting documentation to substantiate an NOL deduction on an audit. When this provision has been challenged in court, the Tax Court has ruled in favor of the IRS and supported the directive.

In Owens, T.C. Memo. 2001-143, the court responded to the taxpayers’ presentation of prior-year returns as evidence to support an NOL deduction by stating “[t]he returns . . . constitute nothing more than the position of petitioners that they had the respective losses claimed in those returns.” Thus, taxpayers must keep the underlying records that confirm the NOL amount, even for closed years. To avoid these pitfalls, taxpayers should be made aware that when they file a return showing the creation of an NOL, the records supporting the loss carryforward should be kept until the NOL is fully utilized and the return including the final NOL deduction expires under the three-year statute of limitation.