Using the Tax Code’s Net Operating Loss Carryover
By John Alan Cohan, Attorney at Law
Since 1918, the Tax Code has provided for the net operating loss carryover (NOL). It is a fundamental feature of U.S. tax law. According to IRS statistics, in 2014 over 1.2 million taxpayers filed for an NOL deduction, with the average amount being $163,292, for a total amount of $196.2 billion.
Originally, the NOL was allowed to be carried back one year and then forward one year. Presently, section 172 of the IRS Code allows the NOL to be carried back two years and then forward 20 years.
The NOL provision is not a “loophole,” but is justified on the basis of fundamental fairness in light of the exigencies of business. The House Report to the 1939 Revenue Bill stated that “the allowance of a net operating business loss carry-over will greatly aid business and stimulate new enterprises.” The Supreme Court has stated that NOL carryovers “ameliorate the unduly drastic consequences of taxing income strictly on an annual basis. They were designed to permit a taxpayer to set off its lean years against its lush years, and to strike something like an average taxable income computed over a period longer than one year.” (Libson Shops, 353 U.S. 382, 386 (1957)).
The NOL carryover is especially important for owners of horse, cattle and other livestock businesses. As with other businesses, people in the livestock industries often experience cycles of achievement and financial success, and their income may fluctuate over the course of months or years. Unusual events or setbacks can occur that may unexpectedly cause losses in a given year. Periods of recession ordinarily yield an increase in loss deductions.
According to Terence D. Miller of Miller & Miller CPAs in Fresno, California, “All businesses are subject to a swing in the business cycle, and it’s my experience that farmers are even more prone towards swings. We all know that in the horse business you could have a horse one year that sells for $100,000 and no sales in another year, but you’ve still got your expenses. It’s the same with the cattle business. Sometimes people won’t sell one cow because of the prices, and other years they realize hundreds of thousands in sales. If ranchers didn’t have the benefit of the NOL to average the gains and losses, they couldn’t afford to be in business.”
The NOL has received a lot of attention since it was revealed that Donald Trump incurred a $916 million loss in 1995 that yielded a NOL on future and preceding years.
The NOL is available to any small or large business. Individual taxpayers can use their NOL deductions for up to 20 years.
Most cases that end up in IRS audits or in Tax Court have a sizable NOL at issue. Expenses are incurred whether or not profitable sales or prizes are realized: advertising, commissions, depreciation, insurance, repairs and maintenance, supplies, board, breeding, farrier, hay, memberships, show or racing expenses, training, transportation, veterinarians – and for many taxpayers these costs are often in the six figure range annually.
It is important to plan ahead. In IRS audits, taxpayers are usually asked to produce annual written business plans and profit-and-loss statements. Business plans should include goals, job descriptions, policies and procedures, an itemization of horses or other livestock sold, proposed advertising and promotional activities for the upcoming year, and detailed information on methods to decrease costs or increase revenues. The IRS tends to audit activities that have generated a long history of losses, and will want to find out how these losses can be explained, and also how the taxpayer can expect to generate an overall profit in the future.
John Alan Cohan is an attorney representing people in federal and state tax disputes, IRS appeals, and Tax Court litigation, and is a long-standing of a legal advice column published in numerous sporting magazines. In addition, he advises organizations on compliance with newly enacted laws and regulations. John is also author of the book, Turn Your Hobby Into a Business – Tax and Legal Tips. He can be reached at: (310) 278-0203, or email at firstname.lastname@example.org. His website is JohnAlanCohan.com.