With the pandemic (finally!) starting to ebb, many people are getting out more and restarting fun activities. On the list of fun things to do, getting audited by the IRS is probably somewhere around 10,456, if not even lower. If you suffered economic losses before or during the pandemic, you may now have a net operating loss (NOL) that has impacted your taxes. Getting audited by the IRS is never a pleasant experience but it can be complicated even more by the IRS choosing to audit an issue that could affect more than one tax year, such as NOLs. How do you defend yourself against an audit of your net operating loss carryover from a prior year?
Before we answer that question, let's review some of the basic knowledge and rules of net operating losses. Net operating losses can only be generated by business activities or activities engaged in for profit. In rarer cases, suffering a major casualty can also generate an NOL. Most taxpayers who have NOLs will have them because of an interest ownership in a partnership, S corporation, or sole proprietorship. They can also be generated by the deductible portion of activities, such as rental real estate and investments, but those activities may have other rules on them that limit the amount of losses that can be claimed each year. The rule of thumb here is that the loss has to be generated by a business or investment activity - taxpayers who do not have business interests or investment activities cannot have a net operating loss. A net operating loss occurs when the expenses or losses from a business or investment exceed the income or gains from the same activity. These losses must be higher than your income from other sources, such as wages, pensions, or investment income like dividends and interest. If your other income is sufficiently high enough to cover your losses, you probably don’t have an NOL.
The rules for calculating an NOL are complicated and can be found in the form instructions for Form 1045, but we aren’t going to go over them here as that would probably take another blog or two. And like the rules for calculating the NOL, the rules for carrying forward net operating losses are also a mixed bag that have varied over the years. Prior to the Tax Cuts and Jobs Act of 2017 (TCJA), most net operating losses had a required carryback period of two years and a carryforward of 20 years. However, like everything in tax law, there are exceptions: certain farming activities had a longer carryback period, and some years had different carryback periods as well due to economic conditions (such as 2008 and 2009). When TCJA was enacted, it originally eliminated the required carryback period and allowed an unlimited carryforward period, but the amount of the loss that could be carried forward was limited to 80% of a taxpayer’s pre-NOL modified taxable income. However, due to the COVID-19 pandemic, the CARES Act of 2020 changed this rule again so for tax years beginning in 2018, 2019, or 2020, there is a required five-year carryback period with an unlimited carryforward. If you were carrying forward pre-2018 NOLs, the 80% income limitation on using the loss was also temporarily eliminated.
What happens if the IRS decides to audit your NOL carryforward? If the NOL is being questioned, the IRS will audit the year the activity gave rise to the losses to verify the amount of the loss being claimed is accurate. They will want to see the tax return of the original NOL year, plus the Form 1045 or amended returns filed to claim the carryback of the NOL for the mandatory carryback period. If you elected to opt-out of the carryback period, your return for the NOL origination year must have the opt-out election attached. If there are other years where the carryforward has been used, the IRS will want to see schedules to prove that the NOL amount has been adjusted in those other years for the mandatory adjustments (such as adjusting itemized deductions that may be AGI limited) and that the amount of the NOL has been properly reduced for the following year. Given the backlog at the IRS, it’s quite possible that an NOL carryover will not be questioned until several years after the NOL originated. And unlike most tax audits where the statute of limitations restricts what the IRS can audit and assess taxes on, NOLs can be questioned any time they impact a tax return.
The normal statute of limitations on assessments is three years from the original due date or the date the return is filed, whichever is later. It’s not uncommon for returns with an NOL to be filed later than April 15, due to the complexity of calculating the loss. While the IRS cannot assess taxes on expired years where the NOL may have been inaccurate, they can adjust any open tax years if the NOL carryover is determined to be incorrect. For example, we recently handled an audit of a 2020 return where the taxpayer’s NOL was generated by a casualty loss due to Hurricane Sandy in 2012. While they cannot assess taxes on that year, they can review and audit the year to verify that the casualty loss which generated the NOL was computed accurately. The IRS can also review any intervening years where the NOL was used to verify the amount of the NOL used and also to verify that there are no other additional income sources that were not reported which may have used more of the net operating loss than that reported on the return.
Because of these complicated carryback and carryover rules, taxpayers with NOLs will be expected to maintain records relating to their operating losses far beyond the normal time frame to retain other tax records. Most tax professionals agree that the majority of taxpayers only need to maintain tax records for about five years, although if something impacts your return for a longer period of time (such as net operating losses, capital improvements on your home, or capital loss carryovers) you should maintain the records for that item much longer. Because net operating losses can be carried forward for many years without being challenged by the IRS, it's important to maintain the tax information that supports the original NOL computation and its usage in other years until you either use the NOL completely, or the carryforward period has expired.
You may be asking yourself, “My NOL originated 10 years ago, are you saying that I need to maintain my tax records for ten years or more?” Yes, exactly! And it’s important for anyone carrying back their NOL to know that the statute of limitations for an NOL carryback is the expiration date of the NOL year, not the carryback year. If I incur an NOL on my 2020 tax return and carry it back for 5 years to my 2015 return (which is mandatory under the CARES Act unless I opt out of the carryback), the statute of limitations on that carryback expires on April 15, 2024, assuming I file my 2020 return by April 15, 2021.
Another complicating factor is the carryback period. Most taxpayers are unaware that the carryback is mandatory under the law, not optional. The taxpayer can elect to forgo the carryback for a net operating loss, but this needs to be done for every year that a net operating loss is generated. If the taxpayer forgets to make the election, then the IRS, in an audit situation, can carry back the NOLs to the appropriate years to determine whether the carryforward is correct. If the IRS does this, the taxpayer does not get a refund for any year that the NOLs were required to be carried back, but were not carried back to, because the statute of limitations for the refund has expired. This means you could be leaving money on the table. Since the carrybacks have existed for any years prior to 2020, this is something important to know if you have a net operating loss that you are currently using and forgot to carry back or forgot to file the election to forgo the carryback.
You may want to refer to our other blog on what creates a net operating loss. But, as you can see, the rules for an NOL can be more involved than simply adding the loss to your tax return every year. A common mistake that we frequently see in defending audits where net operating losses are present is that the taxpayer is not adjusting the net operating loss correctly from year to year. The net operating loss is not simply your negative income. There are adjustments that must be performed on Form 1045 to calculate the amount of the net operating loss, and how much can be carried over from year to year. Most tax software does not support these calculations. As such, it's incumbent upon the taxpayer or their return preparer to make these computations manually and to enter them into their tax software when preparing their tax returns.