Perhaps the most talked-about subject of the Tax Code right now is the allowance of net operating losses (NOLs). This is no doubt due in large part to the October 1 New York Times article that claims Donald Trump recognized roughly $915 million in losses on his 1995 tax returns, giving rise to his ability to use NOLs to offset taxable income in other years.
Like many stories we hear from the media, the truth about NOLs is much more complex than most pundits have suggested. It is interesting that in all the chatter surrounding NOLs, I have yet to hear a single commentator cite Tax Code Section 172, which does have the heading “Net Operating Loss Deduction.”
Section 172 defines NOLs as the excess of deductions over gross income. Because a deduction by definition reduces taxable income, when a taxpayer’s deductions are greater than his income in a given year, he needs to apply the deductions against income in other tax years. Otherwise, the taxpayer would completely lose a deduction to which he is entitled solely because he did not receive enough income.
Currently, NOLs allow a taxpayer to carryback losses to two prior years and carryover to twenty future years to offset income according to Section 172(b)(1)(A)(i)-(ii). By utilizing the deductions NOLs permit, a taxpayer is able to reduce his tax liability for the years that NOLs apply.
Carrybacks are generally more favorable than carryforwards because they allow a taxpayer to recognize a loss immediately and receive a refund for taxes he paid in prior years. However, for a taxpayer to carryback his losses, he would need to amend his prior tax returns for the applicable years.
In some cases, a taxpayer may carryback his NOLs for three years instead of the normal two. However, that treatment is reserved for “eligible losses” which are defined as:
- Losses of property arising from fire, storm, shipwreck, other casualty, or theft;
- Losses attributable to federally declared disasters suffered by small businesses; and
- Losses attributable to federally declared disasters suffered by farmers.
It is important to keep in mind that NOLs are not some fiction that can be merely cooked up and artificially generated. Instead, the Tax Code only allows for NOLs when a taxpayer recognizes specific losses. NOLs for individuals are generally limited to deductions and/or losses that are attributable to:
- Operating a trade or business;
- Suffering damage to business property;
- Recognizing bad business debts (meaning the taxpayer will not be repaid by his debtor);
- Paying business debts and obligations;
- Receiving relevant attributes from passthrough entities;
- Covering employee business expenses; and
- Expensing for casualty or theft losses.
In addition to only applying to these limited circumstances, NOLs require a taxpayer to satisfy a significant burden to prove that he is entitled to the NOLs. Taxpayers claiming NOLs typically include with their tax returns financial records and/or detailed and reasoned explanations from accountants, bookkeepers and parties to the transactions that created the losses. In the example with Trump, we have no idea what evidence he used to support his NOLs because all the New York Times obtained was page 1 of his state tax returns for New York, New Jersey and Connecticut. Supporting NOLs in the high nine figures would likely require hundreds if not thousands of pages of schedules.
NOLs are “personal” tax attributes that cannot be transferred from one individual to another. They cannot be passed around via various business entities, through trusts, or even to family members at death.
These limitations show that NOLs do serve a legitimate purpose in the Tax Code. Note that nowhere in these provisions is a taxpayer required to make a substantial amount of money (or satisfy any income threshold) in order to utilize NOLs, they are available to anyone whose qualifying losses exceed his taxable income. In my experience as an attorney, NOLs have been relevant in dire situations when business owners were the target of a scam or some unexpected event that was outside their control and caused them to lose a significant amount of money or property in a single year.
I certainly do not know all the facts surrounding Trump’s situation nor do I vouch for him, his tax planning strategies, or his or anyone else’s political platforms. However, it is fair to say that the use of NOLs is usually less nefarious than the mainstream media has suggested, and a little more research probably could have led to a discussion that was more conducive to understanding the actual function of the Tax Code.
Posted by Attorney Daniel C. Willingham. Willingham, a tax attorney, advises clients on federal and state tax statutes and regulations that affect their objectives. He assists with complex commercial transactions and corporate reorganizations, compliance issues, entity formation, and is also involved in historic and new market tax credit investments.