Small Business Taxes & Management

Special Report

Deducting Net Operating Losses


Small Business Taxes & ManagementTM--Copyright 2012, A/N Group, Inc.



Your sole proprietorship lost $87.000 for 2012. Your adjusted gross income on your Form 1040 was negative $22,000 and your taxable income was negative $36,000. You may have a net operating loss or NOL.

Most taxpayers associate an NOL with large corporations. But if you do business as a sole proprietorship, LLC, partnership, or S corporation, the losses are passed through and reported on your personal tax return. And that's also where you'd report and get the benefit of an NOL. As with much of tax law, the basics are pretty simple, the devil is in the details. Before worrying about the details, you should find out if there's even a chance you have an NOL. Fortunately, that's easy to do. After you've completed your tax return for the year, determine if the figure on Form 1040, line 41 (AGI less standard or itemized deductions) (line 22 on Form 1041, Estates and Trusts) is negative. If so, you may have an NOL. That NOL can be carried back to a prior year to reduce your taxes and generate a refund for that year, and/or carried forward to reduce your taxes in a future year.


Computing the NOL

If think you may have an NOL, the next step is to actually compute the amount of the NOL. How involved this is depends on the sources of your income and deductions. Eventually you'll have to complete Form 1045, Schedule A. But, without some background information and explanation, it's easy to make a mistake.

Before going further, a brief discussion of business and nonbusiness income is in order. The idea behind the NOL it's a loss from business activities. And what's reported on Form 1040 is income and deductions from both business and personal sources. For example, you made $15,000 from your job as a bookkeeper at Madison Inc. That's business income. You paid $16,000 in real estate taxes on your residence. While that results in a negative number on line 41 of your 1040, you don't have an NOL because the real estate taxes are a nonbusiness deduction. The point is you have to categorize your income and expenses as business and nonbusiness. For the most part it's easy. Business income includes salaries, income and losses from sole proprietorships, S corporations, etc., (but only if you materially participate) rental income, unemployment compensation, etc. Nonbusiness income is interest and dividend income, pensions, social security benefits, etc. Capital gains and losses can fall into either category. A capital gain on the sale of investment securities would be a nonbusiness capital gain; the gain on the sale of some business equipment would be a business capital gain.

Deductions are also categorized as business and nonbusiness. Medical expenses, home mortgage interest, contributions, etc. are nonbusiness deductions; moving expenses and the self-employed tax and health insurance deductions are business expenses.

Some income and expenses need to be allocated. For example, state income taxes on Schedule A that are attributable to business income are business deductions; those attributable to nonbusiness income are nonbusiness deductions. Likewise, state tax refunds have to be allocated between business and nonbusiness income. Fortunately, there are only a few such items that have to be allocated. The best way to see what's going on is with an example. We'll include a number of common items, but still try to keep it simple.

Example--Fred and Sue file a joint return. Fred has salary income of $26,000 from a part-time job with a former employer. He also has a 50% interest in an LLC that generated $6,900 in income. Sue is putting together a single-member start-up LLC that had $50,865 in losses. They had $3,203 in interest income, $1,812 in dividend income and $662 in taxable refunds of state taxes. Of that amount $251 was attributable to business income. They deducted $11,251 for self-employed health insurance. Their itemized deductions included $17,017 in real estate taxes (principal residence and vacation home), $12,404 in mortgage interest and $800 in charitable contributions.

There are two ways to compute the NOL. At some point you'll have to complete Schedule A for Form 1045 so we'll go through that approach first. (We'll skip lines that are not used in the example.)

               Line 1, Income or loss after itemized or standard deduction        -52,960
               Line 6, Nonbusiness deductions                              29,421
               Line 7, Nonbusiness income                           5,426
               Line 8, Line 5 plus Line 7                                   5,426
               Line 9, Difference of line 6 and 32                                 23,995       
               Line 25, NOL                                                       -28,965
Here's the explanation of lines 6 and 7. Nonbusiness deductions include $17,017 in real estate taxes and $12,404 in mortgage interest. The $800 in contributions aren't included in either Line 1 or Line 6. They're not deductible because of the income limitation (unrelated to the NOL). Line 7 includes $3,203 in interest income, $1,812 in dividends, and $411 representing the nonbusiness portion of the state tax refund.

The second approach is to just compute the net business income (loss). That's would be:

             Fred's salary                                                        $26,000
             Sue's LLC loss                                                       -50,865
             Fred's LLC income                                                      6,900
             Business portion of taxable refund                                       251
             Self-employed health insurance deduction                             -11,251
                             NOL                                                  -28,965
At the end of this article we'll include a list of the business and nonbusiness income and deduction items.

While the mechanics can be complicated by marital status, changes in credits, etc., computing the NOL is always the first step. If you come down to the bottom line and your NOL is $500 you may decide to skip going through the effort of actually claiming the NOL or paying a professional to do it for you. But you won't be able to make that decision without computing the NOL.

Fortunately, most tax software programs can handle most of the details. This is definitely one time when the software will more than pay for itself.


Deducting the NOL

There are several variations on deducting the NOL. Generally, the NOL must first be carried back two years to reduce the income in that year. For example, in 2010 you had $120,000 of adjusted gross income. For 2012 you've got an NOL of $28,965. That amount can be used to reduce the $120,000 of income in 2010. If your NOL is large or your income in 2010 was small any NOL that's not used in 2010 can be carried to 2011. If not fully used in 2011, any remaining amount can be carried forward to 2013 and 19 additional years.

You have two ways to carry back the loss. Form 1045 will result in a quicker refund, but you must file the form on or after the due date of filing the return for the NOL year, but no later than one year after the NOL year. For example, for a 2012 loss, Form 1045 must be filed by December 31, 2013. Another advantage to Form 1045 is that if the NOL is not absorbed in the first carryback year, the claim for the second year is filed at the same time. The second option is to file Form 1040X for each year of the claim (e.g., 2010 and 2012 in our example). In this case you have three years from the filing of the tax return with the loss. For example, an NOL claim for 2012 must be filed by April 15, 2016 (if the loss return was filed on April 15, 2013).

Either way, there's a good chance you'll have to refigure some of your deductions because of the now reduced income for the carryback year. For example, in 2010 you couldn't deduct passive activity rental losses because your income was too high. The carryback loss may drop your income far enough so that you're able to deduct at least some of those losses. Other potential items to adjust include your medical deductions, casualty losses, miscellaneous itemized deductions (2% threshold). The adjustments can benefit or hurt you. You may also have to refigure your alternative minimum tax and certain credits, but don't refigure your self-employment tax.

You have the option of waiving the carryback and just carry the loss forward. While you forgo the immediate tax refund, the process is far easier (just put the NOL on Line 21 of the following year's tax return) and it could produce a larger tax benefit. For example you have an NOL of $65,000 for 2012. In 2010 you had taxable income of only $35,000; for 2011 it was $40,000. Using the NOL in those two years will only save taxes at 10% and 15%. But in 2013 you expect the business to turnaround and you anticipate taxable income of $200,000. That puts you in the 28% bracket, so deferring the NOL to 2013 will produce far bigger tax savings. There are other factors to consider. For example, lowering your income next year might allow you to take one of the education credits. There's no rule of thumb here. You've got to work through the numbers and try different options.

You waive the carryback period by attaching a statement to your original return filed by the due date (including extensions) for the NOL year. If you filed your return, but did not file the statement, you can file the statement with an amended return within six months of the due date of the original return (including extensions). Check Publication 536 for details. Waiving the carryback period is generally irrevocable.


Other Points

Exceptions to 2-year carryback rule. The carryback period for any part of an NOL that is from a casualty or theft or is attributable to a federally declared disaster for a qualified small business or certain qualified farming businesses is 3 years.

The carryback period for a farming loss is 5 years. Only the farming loss portion of the NOL can be carried back 5 years.

The carryback period for a qualified disaster loss is 5 years. See Publication 536 for details. The carryback period for a qualified GO Zone loses is 5 years.

Finally, the carryback period for a specified liability loss is 10 years. Product liability losses are the most common issue, but there are several others that qualify.

Marital status. Special rules apply if there's a change in marital status during the years involved in figuring the NOL and if you filed as married filing separate.

Gains and losses. Capital gains and losses can be complicated. See IRS Publication 536 and Schedule A of Form 1045.

State rules. You may have an NOL for state purposes. A number of states allow an NOL. The rules are often similar to federal tax law, but check the instructions for your state return.

Recordkeeping. You should keep records for any tax year that generates an NOL for 3 years after you have used the carryback or carryforward or 3 years after the carryforward expires. If you claim an NOL and are audited, you can expect the IRS to ask for documentation and deny the NOL if you can't substantiate the amount.


Business and Nonbusiness Income and Deductions

You tax software may or may not contain a similar worksheet. But classification of income is a critical starting point.

             Income (Loss)                    Total    Business    Nonbusiness
Wages, salaries, tips, etc.                   _____     _______         
Schedule C income                             _____     _______       
Other Gains                                   _____     _______  
Partnerships and S Corporations               _____     _______      _______
Schedule F income                             _____     _______ 
Rents                                         _____     _______
Estates and Trusts                            _____     _______      _______
Unemployment Compensation                     _____     _______
Interest Income                               _____                  _______
Dividend Income                               _____                  _______
Alimony                                       _____                  _______
Interest Income                               _____                  _______
IRA Distributions                             _____                  _______
Pensions                                      _____                  _______
Taxable Social Security                       _____                  _______
State Tax Refund                              _____     _______      _______
Other Income                                           

           Deductions                         Total    Business    Nonbusiness
Certain Business Expenses                     _____     _______         
Health Savings Account                        _____                  _______
Medical Savings Account (MSA)                 _____                  _______
Self-Employed Tax Deduction                   _____     _______
Moving Expenses                               _____     _______
Self-Employed Health Insurance                _____     _______
Keogh, SIMPLE, SEP                            _____     _______
IRA Deduction                                 _____                  _______
Student Loan Deduction                        _____                  _______
Alimony Paid                                  _____                  _______
Early Withdrawal Penalty                      _____                  _______
Tuition and Fees                              _____                  _______
Domestic Production Activities                _____     _______

           Capital Gains/Losses               Total    Business    Nonbusiness
Capital Gains                                 _____     _______      _______
Capital Losses                                _____     _______      _______
Capital Loss Carryover                        _____     _______      _______
Capital Gain Distributions                    _____                  _______

           Schedule A                         Total    Business    Nonbusiness
Medical                                       _____                  _______
Taxes                                         _____     _______      _______
Interest                                      _____                  _______
Contributions                                 _____                  _______
Casualty                                      _____                  _______
Unremibursed Business Expenses                _____     _______      _______
Tax Preparation Fees                          _____     _______      _______


Copyright 2012 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536

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--Last Update 11/16/12