Calculating Net Operating Loss on Individual 1040

Hello,
I am in the process of reviewing a potential client prospect. They gave me their last two years of tax returns for 2015 and 2016. Upon reviewing them, I feel they are incorrect and I would like some assistance before I bring this matter to them. I feel their previous tax preparer incorrectly calculated their NOL.

I will start will 2015.

Information from 2015 Federal 1040 - Filing Status = Married Joint

Line 1 Wages = $13,560
Line 12 Business income from Schedule C - Loss = ($3,919)
Line 17 Schedule E Rental income - loss = ($10,801)
Line 20a Social Security $28,214 but not taxable so Line 20b = 0
Line 21 Net Operating Loss carryforward from previous year = ($27,103)
Line 37 Total AGI ($28,263)

Line 40 Itemized deductions = $20,879 (consist of income tax from w2, real estate tax, mortgage int and contribution)
Line 41 = ($49,142)
Line 42 Exemptions 8,100
Line 64 Federal Income tax withheld $511
Line 66a Earned Income Tax = $503
Line 74 Total Payment = $1014
Line 75 Refund = $1014

The tax preparer than carried the loss on Line 41 to line 21 on their 2016.

2016 Federal 1040 - Filing Status = Married Joint

Line 1 Wages = $8,206
Line 12 Business Income from Schedule C - loss = (-18,566)
Line 14 Other gain = $26,550 (equipment sold from schedule C business)
Line 17 Schedule E Rental Income - loss = ($7,561)
Line 20a Social Security = $28,423 but not taxable so Line 20b = 0
Line 21 Net Operating Loss = (49,142) = carryforward from 2015
Line 37 Total AGI (40,513)
Line 40 Itemized Deductions = $24,490 (consist of income tax from w2, real estate tax, mortgage int and donations)
Line 41 = ($65,003)
Line 42 Exemptions 8,100
Line 64 Federal Income tax withheld $511
Line 74 Total Payment = $511
Line 75 Refund = $511

And the prior tax preparer has a worksheet showing ($65,003) being carryforward to their 2017 . I honestly do not believe that is correct.

Now honestly in all my years of tax preparation, I never had a client with a net operating loss, I guess I have been lucky, but I really do want to understand this. I have been reading Pub 536 and watching videos, however still bit confused on the business income vs non business income, what gets added back in and what does not. The publication also mentioned not to include line 21 NOL in the calculation as well. I know once I see how their figures get plugged in, I will be able to understand it a lot easier.

If someone can please look over these figures that were pulled directly their return 2015 and 2016 returns and please advise if these are indeed correct (which I feel they are not). They want me to possibly prepare their 2017, however, I need to figure out the correct NOL carryforward from 2016, and may need to advise them if they will have to amend their prior years before preparing their 2017.

Now I did try filling out NOL Business/Nonbusiness Allocation Worksheet from my Deluxe Edition The Taxbook. If there is a way to upload what I did, so one does not think I am not trying, I certainly will. Just not sure if for one, if I did it correctly and second how to interrupt the results.

Thank you in advance for taking the time to assist me. I greatly appreciate it.

Lisa

In calculating the NOL carryover from 2015 to 2016, I see that the prior preparer included nonbusiness deductions (itemized deductions) in excess of nonbusiness income (none). This excess must be added back to line 41, Form 1040, in determining the NOL.

If you use Schedule A of Form 1045 for the 2015 return, you’ll see that the NOL for 2015 is $1,460:

Line 1 = (49,142)
Line 6 = 20,879
Line 9 = 20,879
Line 19 = 27,103
Line 25 = 1,460

This must be carried back to 2013 unless the clients made a timely election under sec. 172(b)(3) to waive the carryback period.

The NOL carryforward from 2015 to 2016 can’t be determined from the data you provided. Since the prior preparer included nonbusiness itemized deductions in calculating the 2015 NOL carryover to 2016, then it’s likely that the preparer made the same error in calculating the NOL carryover from prior years to 2015. You’ll have to pull the prior years returns and re-calculate it. Use Form 1045, Schedule A to calculate the NOL for any particular year, and Schedule B to calculate how much of the NOL is absorbed when carried back to prior years.

Consider "passing" on the Engagement, too risky. Ask, "how do they afford the cost of living"?
They have W2 wages $8k SS $28 and yet lose $18k Sch C and lose $7k Rental.
Do they live on net income of $9 a Year?
IRC Sec 6701 looms large here, you don't want to be accused of "assisting in the preparation of a fraudulent return".
Easy win for the Prosecutors.
Why take the risk, don't be desperate for fees.

Welcome to the forum, Taxgal2018. I have one suggestion for next time: use round numbers. It makes the calculations easier to follow. Also, this is a publicly searchable forum, and you have posted what appears to be an exact AGI amount for this prospective client -- while perhaps unlikely, it would be at minimum embarrassing if this client or prior preparer were to stumble on this discussion. There is even a non-zero chance that that the prior preparer is a member here.

Hello and thank you for your response

The worksheet I filled out, I had the following results:
Line 1 (49,142)
Line 6 = 20,879
Line 9 = 20,879
Line 24 = 27,103
Line 25 = (1160)

Did you mean Line 24 instead of Line 19 on your example? Because they did not have a Schedule D line 21 for 2015.

Your Line 25 is what has me stumped. I came up with (1160) and you are showing a positive 1,460. Am I missing something? I took: (49,142)+20879+27103 = (1160)

And lets just say if the carryforward was correct on line 21 on 2015 from 2014 was indeed $27,103 I am showing a carryforward of ($28263) for 2016. Using the (1160) and (27103) = ($28263)


I will be contacting them about this situation. Seeing how 2015 and 2016 are currently incorrect, amending the previous years to get the correct NOL before continuing on would need to be done correct? I will also double check on the carryback, they may have forego that election. That I will have to ask about.

novacpa thank you for your input. I am considering passing on this, one with the prior year errors and second, showing the huge loss carryforwards from year to year.

makbo - thank you for your input as well. I like to be a detailed as possible when I am asking a question, but I do see your point.

I wanted to also learn from this example as well, one if I calculated the NOL correctly and if I would have carry forward the correct amount to the 2016.

I always say, no matter how many years experience one person has, each day we may learn something new or take an old way of doing something do it a different way.

Thanks again for all your input.

State income taxes withheld from W-2 are a business deduction, and need to be modified on line 6 of Schedule A. From the size of the W-2 it can't be a big number.

however still bit confused on the business income vs non business income, what gets added back in and what does not.

The idea of eliminating non-business deductions is because an NOL is basically gross income minus business deductions. You start with income before personal exemptions. Next step is eliminate non business deductions to the extent they exceed non-business income. (assume no cap gains, DPAD or Sec 1202 stock and most of the lines in Schedule A do nothing more than eliminating some items from line 41). The NOL pub has a pretty good listing non-business income and non-business deductions.

Look at your NOL from 2015. It is three numbers W-2 less Schedule C and Schedule E losses or ($1,160)

Your numbers in #5 are right (I should never try to fill out forms by hand). And Doug M in #7 is right about the state income tax being a business deduction.

Doug M - I did read the publication and yes I did forget to eliminate the state w/h. as non-business deduction. So I modified line 6 on NOL worksheet by subtracting out $522 because that was amount withheld. So after recalculating everything
Line 1 = (49142)
Line 6 = 20357
Line 9 = 20357
Line 24 = 27103
Line 25 = (1682)

So now if take the NOL from 2015 = (27103) + (1682) = carryforward for 2016 would be (28785)

There were no capital gains or DPAD or Sec 1202 for 2015).


Dave829 - you were just testing me. Did I pass? LOL!

Don't forget about what dave829 mentioned about the election to forgo the c/b.

Doug M - Yes I remember Dave829 message about the carryback. I will have to ask the client about if they did carryback 2 years before carrying forward or did they forego the carryback.

I am just leery seeing how 2015 and 2016 are incorrect, how many prior years could be possibly wrong. And if they indeed were calculated incorrectly, wouldn't those years have to be amended to show the correct NOL carryforward or carryback before moving on to the 2017?

I just don't like seeing NOLs showing large amounts on this individual return year after year. To me, its a red flag waiting to happen.

Consider "passing" on the Engagement, too risky. [ ]
IRC Sec 6701 looms large here, you don't want to be accused of "assisting in the preparation of a fraudulent return".
Easy win for the Prosecutors.
Why take the risk, don't be desperate for fees.

The risk belongs to the prior preparer and the taxpayer, not to the one that makes corrections. I see no risk here. Just get all the prior returns and fix it.

Frankly - thank you for your input.

So now if take the NOL from 2015 = (27103) + (1682) = carryforward for 2016 would be (28785)

I don't recommending taking the NOL carryover from 2015 without assuring yourself that (1) prior returns calculated it correctly, and (2) that it was carried back first before carried forward, or that the election to forego the carryback was made.

I contacted the potential client and they will be emailing me their 2014 and will have to find their 2013.

I mentioned to them about the error on these two years and need to see the past years. Also asked about the 2 year carryback or election forego, they were unsure and said they would have to ask their prior tax preparer.

Also, they said, well, the husband of the tax preparer worked as an IRS auditor for 15+ yrs and when the wife prepared the return who is a CPA and when he double check it, why didn't they see the error. My reply was, sir I can not answer that question. All I know, that these current year calculations are not correct.

I wanted to say nobody is perfect and we all make mistakes. The key is not to repeat the same mistake twice.

Consider "passing" on the Engagement, too risky. [ ]
IRC Sec 6701 looms large here, you don't want to be accused of "assisting in the preparation of a fraudulent return".
Easy win for the Prosecutors.
Why take the risk, don't be desperate for fees.

The risk belongs to the prior preparer and the taxpayer, not to the one that makes corrections. I see no risk here. Just get all the prior returns and fix it.

Frankly - that is Bad Advice - review IRC Sec 6694 - says nothing about "prior preparer(s)" as an excuse to avoid Preparer Penalties:

https://www.thetaxadviser.com/issues/20 ... -6695.html

The risk belongs to the prior preparer and the taxpayer, not to the one that makes corrections. I see no risk here. Just get all the prior returns and fix it.

Frankly - that is Bad Advice - review IRC Sec 6694 - says nothing about "prior preparer(s)" as an excuse to avoid Preparer Penalties:

The title of § 6694 is "Understatement of taxpayer's liability by tax return preparer".
I see no risk for a new preparer fixing errors on past returns. Is there a problem amending past returns?

Back to part of the state income taxes paid being a business deduction. I suppose this means that part of a state income tax refund from prior years will be business income as well. Has anyone addressed that issue?

Good point smokeytax. Although there is not a lot of info out there, the state deduction on Schedule A that comes from W-2 withholding is treated differently than the state taxes attributable to investment income or retirement income that might have come from estimated tax payments or withholdings on 1099-R.

If you have a refund whose source could be attributed to estimated tax payments, you might want to look at that. The balance due from the prior years return that is in Schedule A would be also be included in business deductions if the bulk of the income in the prior year was business income.