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Part 4. Examining Process

Chapter 11. Examining Officers Guide (EOG)

Section 11. Net Operating Loss Cases

4.11.11  Net Operating Loss Cases

4.11.11.1  (05-13-2005)
Net Operating Loss References

  1. The references for Net Operating Loss cases are:

    • IRC section 172 - Net Operating Loss Deduction

    • IRC section 6501 - Limitations on Assessment and Collection

    • IRC section 6511 - Limitations on Credit or Refund

    • IRC section 6411 - Tentative Carryback and Refund Adjustments

    • Treas. Reg. 301.6501(m)-1 - Tentative Carryback Adjustment Assessment Period

    • Treas. Reg. 301.9100-2(b) - Automatic 6-Month Extension

    • Temp. Treas. Reg. 301.9100-12T - Various Elections Under the Tax Reform Act of 1976

    • IRM Exhibit 4.10.4-6 - Auditing Net Operating Loss Deductions (NOLD)

    • IRM 4.10.8.12.2 - Adjustments to Net Operating Loss

    • IRM 4.4.4.5.2 - Carryback Claim

    • IRM 4.4.12.4.56-57 and Exhibit 4.4.12-6 - Item 44 and Item 45 of Form 5344

    • IRM 4.10.5 - Required Filing Checks

    • IRM 4.27.1 - Bankruptcy - Petitions Filed after 9/30/79

    • IRM 20.2.9 - Interest on Carryback of Net Operating Loss

    • IRM 20.1.5.2.2 - Penalty Handbook - Carrybacks and Carryovers

    • IRM 21.5.9 - Carrybacks

    • Rev. Rul. 81-88, 1981-1 C.B. 585 - Sec. 6511 Limitations on Credit or Refund

    • Rev. Rul. 77-225, 1977-2 C.B. 73 - Charitable contribution; carryover of improper deduction; limitation period

    • Rev. Rul. 56-285, 1956-1 C.B. 134 - Sec. 172 - Net Operating Loss Deduction; excess depreciation deduction in carryover

    • PL 107-147, Job Creation and Worker Assistance Act of 2002

    • Training Pub. No. 3147-125 (Cat. No. 83027P) - Net Operating Loss for Individuals

    • Publication 536 - Net Operating Losses (NOLs) for Individuals, Estates and Trusts

    • Publication 542 - Corporations

    • http://rgs.msr.irs.gov/RGS_Workstation/download.htm

    • http://lmsb.irs.gov/hq/pqi/quality/jcreview.htm

    • Practitioners Publishing Company - 1040 or 1120 Deskbook

    • Tax Management Portfolios No. 539 - Net Operating Losses

    • SAIN 601- Net Operating Loss Deduction Leadsheet

4.11.11.2  (05-13-2005)
Overview for Net Operating Loss Cases

  1. Due to the possibility of fluctuations in income and expenses, a taxpayer can have substantial profits in one year, but losses in another. With this in mind, the relief provisions of IRC section 172 were enacted for business income and loss. IRC 172 provides that net operating losses may be carried back to prior years or carried forward to future years as deductions, thereby preserving the economic impact of the loss.

    1. Losses arising in 2001 and 2002:
      The Job Creation and Worker Assistance Act of 2002 retroactively changed the two year carryback period to a five year carryback period for losses arising in 2001 and 2002.

    2. Taxable years beginning after 8/5/97:
      NOLs are carried back two years and then forward 20 years. See IRM 21.5.9.5.2 and IRM 21.5.9.5.14(6) for rules and exceptions.

    3. Taxable years prior to 8/5/97:
      A net operating loss (NOL), a capital loss (corporation only), and certain non-refundable unused tax credits can be carried back to the three years preceding the loss year and carried over to the 15 succeeding tax years. See IRM 21.5.9.5.6 and IRM 21.5.9.5.14 for additional information.

  2. After a reorganization or other change in corporate ownership, the use of certain carryforwards may be limited or prohibited under IRC section 382.

  3. It is important to ensure that net operating losses receive the proper tax treatment, because of the potential impact that NOLs may have on multiple year returns. A key element of that process is the correct determination of the loss year's net operating loss and computation of the net operating loss deduction. Form 3621, Net Operating Loss Computation, and Form 3621-A, Computation of Net Operating Loss Deduction, may be used by examiners to assist in that process. Schedules A and B of Form 1045, Application for Tentative Refund, can also be used to compute the individual NOL and NOL carryovers. These forms may be included as supporting schedules in the examiner's workpapers.

    Note:

    Excel workbooks (Individual NOL Worksheet.xls and Corporate NOL Worksheet.xls) are available for downloading off the RGS Workstation website.

4.11.11.3  (05-13-2005)
Workpapers

  1. In addition to the above forms, examiners should include in their workpapers a spreadsheet analysis covering the loss year and any carryover/carryback year(s) to which the loss is carried. The spreadsheet should begin with taxable income per return or as previously adjusted, and conclude with the proposed deficiency or overassessment. The analysis will serve to ensure the proper accounting of all carryover and carryback items (NOL's, investment credits, foreign tax credits, etc.) as well as tentative allowances. A workpaper or schedule should be prepared for contribution carryovers and Alternative Minimum Tax Net Operating Loss Deduction. For preparation of examination reports see EOG - Examination of Returns Chapter 1, Amended Returns and Claims.

4.11.11.4  (05-13-2005)
Penalties

  1. See IRM 20.1.5.2.2 for the impact on penalties by a carryback or carryforward.

4.11.11.5  (05-13-2005)
Statute of Limitations

  1. SPECIAL STATUTE FOR A CARRYBACK YEAR. For the year of a NOL carryback, the Service may assess any deficiency attributable to that carryback as long as the period of limitations for assessment for the year in which the NOL arose remains open (e.g., under the general 3-year period, under the 6-year period for a substantial omission, by consent, or due to fraud). See IRC section 6501(h).

  2. INCREASED AMOUNT ASSESSABLE IF A TENTATIVE REFUND WAS PROVIDED FOR A REQUEST ON FORM 1139, CORPORATION APPLICATION FOR TENTATIVE REFUND, OR FORM 1045, APPLICATION FOR TENTATIVE REFUND - The amount that may be assessed for the carryback year does not have to be attributable to the carryback; instead, it is limited to the amount erroneously refunded. In other words, the tentative carryback adjustment under IRC section 6411 opens the door for items unrelated to the carryback. The limitation is applied to the adjustments remaining after applying IRC section 6501(h) to the "attributable" items. See IRC section 6501(k).

    Example:

    Taxpayer A and Taxpayer B file a 1997 tax return showing a $50,000 NOL, which is carried back to 1995 and generates a $20,000 refund. The ASED has passed for 1995, but 1997 remains open. The Service finds deficiencies as follows: $14,000 relating to the computation of the NOL in 1997; $1,000 relating to a 1995 deduction that was reduced due to the effect the reduction of the carryback amount had on a 1995 limitation (i.e., it's attributable); and $7,000 relating to a 1995 deduction not attributable to the NOL carryback.

  3. REGULAR STATUTE OPEN IN CARRYBACK YEAR - If the regular statute of limitations under IRC section 6501(a) has not yet expired for the carryback year, a decision should be made and Form 9984, Examiner's Activity Record, documented as to whether the normal statute will be protected or the carryback statute will be controlling. If the normal statute will not be protected, the statute should be updated to BB and the decision not to protect the normal statute documented on Form 895. See IRM Exhibit 25.6.23-3 paragraph 21.

  4. CARRYOVERS FROM A CARRYBACK YEAR WITH BARRED ITEMS:

    1. In general. Taxable income means the correct taxable income, which means, generally, errors in a closed year are corrected for purposes of determining the taxable income of an open year.
      (i) For the application of this rule to the year in which an NOL should have arisen except a now barred deduction was not claimed by the taxpayer, see Situation 2 of Rev. Rul. 81-88, 1981-1 C.B. 585 (a taxpayer who failed to take a deduction of $220x in a closed year in which it had $100x of taxable income could use the $220x to generate a NOL carryforward of $120x).
      (ii) For the application of this rule to the year in which an NOL arose, but a now barred deduction was overstated, see Rev. Rul. 56-285, 1956-1 C.B. 134 (a NOL carryover to an open year was reduced by the amount of erroneous excess depreciation a taxpayer had claimed in the closed loss year).

    2. Exceptions.
      (i) In general. Do not use the correct taxable income when the IRC or regulations specifically requires a timely act as a condition to allowing a particular tax treatment in a closed year.
      (ii) Carryback to an otherwise closed year in which the taxpayer failed to claim a deduction. A barred deduction is not taken into account in determining the amount of the carryback used in the closed year, and, therefore, more of the NOL must be applied than would be the case if the correct taxable income was taken into account. This result is based on Treas. Reg. 301.6511(d)-2(a)(3). Consequently, the barred deduction does not reduce the amount carried over to the year after that closed year (i.e., the correct taxable income is not applied for this purpose either). See Rev. Rul. 81-88, 1981-1 C.B. 585 at Situation 1 and the following example.

    Example:

    XYZ Corporation filed its 9212 return timely, reporting taxable income of $100,000 and tax of $40,000. No extensions were filed and the IRC section 6501(a) statute for 9212 expired on March 15, 1996. XYZ Corp. filed its 9512 return timely, in which a net operating loss of $165,000 was reported. On June 1, 1996, an 1120X was filed by XYZ to carry back the 9512 loss to 9212. On September 8, 1996, an audit of XYZ for taxable years 9212 through 9512 revealed that XYZ had failed to claim $20,000 in deductions on its 9212 return. No other adjustments were discovered during the audit. XYZ will receive a refund of the $40,000 in tax for 9212. The net operating loss carryover to 9312 will be $65,000 ($165,000 - $100,000). The $20,000 unclaimed deduction cannot increase the amount of the refund in 9212 nor will it impact the amount of the NOL carryover to taxable year 9312.

4.11.11.6  (05-13-2005)
Form 5344 Procedures

  1. Carefully input the proper amounts and transaction codes in Item 12 if any of the adjustment is due to a carryback.

    Example:

    The transcript shows a TC 295 code for $20,000 (abatement resulting from a tentative allowance). The RAR shows $15,000 of the tentative is disallowed. The RAR also shows an adjustment of $5,000 that is not attributable to the carryback. Item 12 should reflect a TC 308 (deficiency assessment generating an assessment of interest from the computation included with the entry) of $15,000 and a TC 300 (deficiency assessment) of $5,000 and a restricted interest RAR should tie to the $5,000, for a total of $20,000.

  2. NOL Carryforward Disallowed Amount (Item 44) - This item is used if all or part of a NOL carryforward is disallowed and the carryforward year return is not picked up for examination (return not due). See IRM 4.4.12.4.56, Item 44: NOL C/F Disallowed Amount and IRM Exhibit 4.4.12-6 for examples.

  3. NOL Indicator (Item 45) - This item is entered whenever an NOL return (taxable income line is less than zero) was audited. See IRM 4.4.12.4.57, Item 45: NOL Indicator and IRM Exhibit 4.4.12-6 for examples.

4.11.11.7  (05-13-2005)
Form 5346 Procedures

  1. When examination adjustments are made which reduce or eliminate the amount of NOL being carried over to subsequent years not yet filed, Form 5346, Examination Information Report, should be completed by the examiner and submitted to PSP. This is important since it safeguards against the possibility of taxpayers claiming unallowable losses in future unfiled years.

4.11.11.8  (05-13-2005)
Effects on Other Areas

  1. A NOL carryback may necessitate a recomputation of tax liability for the carryback year. Typical deductions that may require recomputation include the deductions for charitable contributions and itemized deductions based on adjusted gross income. Any credits that are based on or limited by the amount of tax must also be refigured.

4.11.11.8.1  (05-13-2005)
Business Credits

  1. Investment credits are limited to the tax liability (with certain adjustments), and any credits in excess of the tax liability are subject to the carryback and carryforward provisions of IRC section 39. Since the carryback of an NOL usually reduces the tax liability for the prior year, allowable credits will be affected. In such situations, the NOL takes precedence over the business credits. Thus, if the carryback of a net operating loss creates unused business credits in the carryback year, the business credits may be carried back three additional years.

  2. For taxable years beginning after 12/31/97, the General Business Credit is carried back one year per IRC section 39(a)(1). The statute of limitations will be governed by the year in which the NOL arose [IRC section 6511(d)(4)].

4.11.11.8.2  (05-13-2005)
Capital Loss Carrybacks

  1. A corporation may carry back a capital loss to each of the three years preceding the loss year. Any excess may be carried forward for five years following the loss year. However, the amount that can be carried back is limited to an amount which does not cause or increase a net operating loss in the carryback year [IRC section 1212(a)(1)]. See IRM 21.5.9.5.26.

4.11.11.8.3  (05-13-2005)
Alternative Minimum Tax

  1. The alternative minimum tax net operating loss is the regular tax net operating loss as modified by the adjustments required under IRC section 56 and IRC section 58, and tax preference items under IRC section 57. Use of an alternative minimum tax NOL is limited to 90% of alternative minimum taxable income in the carryover or carryback years. See IRM 21.5.9.5.17 regarding 100% offset.

4.11.11.8.4  (05-13-2005)
Restricted Interest

  1. IRC section 6611(f) provides that interest on NOL carrybacks is computed using different interest accrual periods than those used for " general" adjustments, which are subject to the regular interest provisions of the Code. The special carryback adjustments are referred to as " restricted interest" adjustments. Cases involving NOL carrybacks must be identified on Form 3198, Special Handling Notice, as restricted interest cases. A restricted interest RAR is required for multiple source years if carrybacks or both general adjustments and carryback adjustments are present. General adjustments (including carryforwards) are current year adjustments in which the interest is computed from the due date of the return. See IRM 4.11.35, Restricted Interest.

4.11.11.8.5  (05-13-2005)
Self-Employment Tax Cases

  1. NOL carryovers and/or carrybacks have no affect on the self-employment tax liability of the year to which they are carried see IRC section 1402(a)(4).

4.11.11.9  (05-13-2005)
Requesting a Refund

  1. If a taxpayer's tax liability is reduced due to an NOL carryback, the taxpayer may request a refund or credit or a tentative refund. Upon receipt of any claim or tentative carryback, the examiner should verify and update the statute of limitations. Also, the examiners should request a transcript of account before preparing the examination report to verify the correct statute and determine if the refund has already been made.

  2. A request for refund or credit can be accomplished:

    1. By a taxpayer filing Form 1040X, 1120X, etc. The claim must be filed within 3 years after the time prescribed by law for filing the loss year return. A processed claim can generally be identified on a transcript by the posting of a TC 291.

    2. A request for a refund under the provisions of IRC section 6411(a). A quick refund is accomplished by filing Form 1045 for individuals or Form 1139 for corporations. An application for tentative refund must be filed within 12 months following the end of the loss year. Action must be taken by the Service on the application within 90 days of the filing. The filing of Form 1045 or 1139 does not constitute a claim for credit or refund upon which the taxpayer may file suit in court, if it is rejected by the Commissioner. A tentative allowance can generally be identified on a transcript by the posting of a TC 295.

4.11.11.10  (05-13-2005)
Election to Forgo Carryback

  1. A taxpayer can elect to forgo the carryback period see IRC section 172(b)(3). The election must be made by the due date (including extensions) for filing the return for the loss year; if the return is filed by its original due date, an automatic six-month extension period for making the election is allowed under Treas. Reg. 301.9100-2(b). The election cannot be made on an amended return filed after the return due date even if the original return did not show a loss.

  2. Once the election is made, it is generally irrevocable. However, according to Temp. Treas. Reg. 301.9100-12T, the permanent regulations relating to this election (which have not yet been issued) will provide for revocation with the Commissioner’s consent. No application for consent to revoke will be accepted until the permanent regulations are issued.

  3. An election to forgo the carryback period applies to both the regular tax NOL and the AMT NOL (Rev. Rul. 87-44, 1987-1 C.B. 3, Plumb, Ray, 97 T.C. 632 (1991).

4.11.11.11  (05-13-2005)
Filing Status Changes

  1. NOLs incurred in years the taxpayers were not married to each other can only be applied against the separate income of the spouse who generated the loss. In other words, an NOL sustained by one spouse before marriage cannot be carried over to offset the other spouse’s income on a joint return; it can be applied only against the income of the spouse who incurred the loss, Calvin, Asa E., 354 F2d 202, 66-1 USTC 9108, 16 AFTR 2d 6025 (10th Cir. 1965). Losses incurred and carried back by a spouse after a divorce or the death of a spouse can only be applied against the separate income of the spouse who incurred the loss even if the taxpayers filed joint returns in the year to which the loss is carried, Zeeman, Audrey L., 395 F2d 861, 68-1 USTC 9406, 21 AFTR 2d 1380 (2nd Cir. 1968).

4.11.11.12  (05-13-2005)
Carryforwards

  1. When the amount of a NOLD is material, it constitutes a Large, Unusual, or Questionable (LUQ) item under the auditing standards. This is especially true if the NOLD was generated from the same business that gave rise to an adjustment for unreported taxable income in the current year under examination.

  2. The Service may redetermine correct taxable income in a closed year in order to ascertain either the amount of a NOL, or the amount of a NOL that is absorbed in the closed year for purposes of determining the correct net operating loss deduction for an open year. The authority for doing so is IRC section 7602(a) which states, in part, that "For the purpose of ascertaining the correctness of any return, …the Secretary is authorized to examine any books, papers, records, or other data which may be relevant or material to such inquiry."

  3. The taxpayer is required to maintain such records as will allow the examiner to verify the accuracy of the deduction. If the taxpayer declines to produce the records, or the records are unavailable, the examiner may disallow the entire NOLD for lack of substantiation.

  4. Copies of tax returns are not proof, nor are accountant's workpapers.

  5. Example 1:

    The 1999 year is under examination. The return reflects a $320,000 NOL carryforward from 1995. The 1995 statute is closed but in reviewing the taxpayer’s financials and the 1995 return, it was determined the taxpayer took a large deduction for an ordinary loss. The loss appeared nondeductible based on facts uncovered in the 1999 examination and prior year financials. The NOL originated from a related party loan. The examiner requested evidence to support the following:

    1. Existence of a true debtor creditor relationship between the related parties,

    2. Substantiation of an actual economic outlay,

    3. Substantiation that the alleged loan was uncollectible,

    4. Substantiation that the alleged loan was not a capital investment.

    Since sufficient information was not submitted to support the NOL carryforward created from the business bad debt, the carryforward into the current year was reduced.

    The consideration of the 1995 issue is not an audit of 1995 and a 1995 RAR is not required. The agent requested verification of the NOL carryforward deduction on the 1999 return and examined the components of that deduction similar to other line items an agent would select for verification on a return. However, if the business bad debt issue had been examined in a prior year and accepted as filed, then the Service would not be able to raise this issue.

  6. Example 2:

    The 2000 Form 1120 is under examination. The 1995 through 1999 years have NOLs and a large NOL carryforward is reflected on the 2000 year. All returns were timely filed. The RA finds the taxpayer is claiming significant amounts of personal expenses in various corporate expense accounts. The disallowance of these expenses results in the 2000 NOL turning into positive taxable income. However, the NOL carryforward wipes out the 2000 current taxable income so no tax is due. The RA picks up 1999 and discovers the same problem with the same expense accounts. Inspection of the 1995 through 1998 returns reveal the same types of expense accounts, however, the statutes are closed for 1995, 1996, and 1997. In this instance, the RA received permission to pick up 1998. The RA disallowed the NOL carryforwards from 1995, 1996 and 1997 as no supporting documentation was provided, i.e. books and records for the source years. The request on the IDR was worded similar to:

    "The A, B, C expenses were adjusted by $XXXX in 2000, 1999 and 1998. Those adjustments exceeded the NOLs shown on the returns as filed. The 1995, 1996, and 1997 returns show the same expense categories in similar amounts with similar NOLs in each year. In order to substantiate that the carryover deduction from those years are allowable, please provide the appropriate 1995, 1996, and 1997 General Ledger pages for those expenses along with the supporting documentation for any allowable expenses" .

  7. Example 3: A 2001 tax year is under examination with carryforward deductions from 2000 and 1999. The 1999 statute is closed but the 2000 statute has eight months remaining on the statute. The examiner can work from copies of the 2000 and 1999 tax years properly identified in red "Information Only" on the face of the return. The activity record should be documented why the copies are in the file. The 2000 statute does not need to be protected to verify the carryforward. However, if the examiner and manager have agreed to propose a deficiency on the 2000 year, the case should be established on ERCS and a consent solicited.

4.11.11.13  (05-13-2005)
Joint Committee

  1. See IRM 4.11.50 and IRM 4.36 for Joint Committee procedures for refunds of $2 million or more.


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