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NOLs are so bizarre (Post-2017 Net Operating Loss)

Technical topics regarding tax preparation.
#1
makbo  
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I've never liked working with NOLs, although having good software helps a lot.

So I have a client, recently widowed, with only about $25K AGI, including a few thousand net profit on Schedule C. And the itemized deductions are high enough to bring taxable income to zero, so only SE tax is owed on the return.

Yet, there is an NOL, despite the business activity being profitable. Why? The one-half Self Employment tax adjustment, of course. All of $155.

Now, me being lazy, can someone remind me what changed for NOLs under TCJA? My software identifies this as a carryover of "Post-2017 Net Operating Loss", so do we no longer need to elect to waive the carryback if we only want to carry forward, but we have to track potentially two different types of NOL carryforward?
 

#2
AlexCPA  
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Our friends at Baker Tilly did a great job summarizing the changes (https://www.bakertilly.com/insights/unt ... oncorpora/) -- emphasis mine:

NOL limitations for post-2017 losses. The rules for NOLs arising in tax years beginning after Dec. 31, 2017, are modified such that a corporation’s NOL carryover can only offset 80 percent of taxable income without regard to the new section 199A deduction. However, these NOLs can now be carried forward indefinitely instead of limited to 20 years. Carrybacks of these losses are no longer permitted.

NOL limitations for pre-2018 losses. Rules for existing NOLs remain the same. These losses can be carried back two years and forward 20 years. There is no taxable income limit to usage of pre-2018 losses.

Observation. This effective date means losses that arose in tax years that began before Jan. 1, 2018, will not be subject to the 80 percent of taxable income limit. As a result, taxpayers will have to distinguish between the two types of losses when computing the NOL deduction. Pre-2018 losses should be tracked separately from post-2017 losses. Also, fiscal year taxpayers with NOLs arising in tax years beginning before Dec. 31, 2017, and ending after Dec. 31, 2017, would not be subject to the 80 percent limitation but would also not be eligible for a carryback; instead, these could be carried forward indefinitely.

Example. ABC Corporation has a $2 million cumulative NOL from 2017 and prior tax years. ABC generated a $15 million NOL in 2018. 2019 taxable income is forecast to be $15 million. ABC can use its entire $2 million pre-2018 NOL and $12 million of the 2018 NOL (80 percent multiplied by pre-NOL income of $15 million). As a result, 2019 taxable income would be $1 million with a $3 million NOL carryforward.


But wait...there's more!

Limitation on losses for noncorporate taxpayers. In a significant departure from prior law, the TCJA restricts use of business losses of noncorporate taxpayers. Previously, business losses recognized by individuals could reduce nonbusiness income (such as interest, dividends and capital gains) without limitation. Beginning in 2018, through the 2025 tax year, taxpayers can only deduct up to $500,000 (for married filing joint taxpayers) of these losses against nonbusiness income. Amounts above the threshold are considered “excess business losses” and carried forward and treated as part of the taxpayer’s NOL carryforward in subsequent taxable years. These NOL carryforwards are also subject to the new 80 percent NOL limitation.


Please enjoy the above-quoted information while I contemplate how a member with over 6,200 posts can also be "lazy". :shock:
Last edited by AlexCPA on 2-Aug-2019 11:56am, edited 1 time in total.
 

#3
supdat  
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Makbo, good question. I thought only business deductions can generate an NOL. I can't see how any of the itemized deductions would generate an NOL.
 

#4
Doug M  
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Form 1045 Schedule A. Are you saying his NOL is $155? Forget about it..........
 

#5
Doug M  
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I thought only business deductions can generate an NOL.


I can't see how any of the itemized deductions would generate an NOL.


There are business deductions that are included in itemized deductions. State income taxes is the major one.
 

#6
sjrcpa  
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Beginning in 2018 there is no carryback of NOLs (except farming ones). No need for an election to waive the carryback.
And if you have pre-2018 NOLs then yes you need to track two types of NOLs.
 

#7
supdat  
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Doug M: Given that net income is required to generate state income taxes, it seems unlikely that state income tax would generate an NOL, especially given that the SALT deduction is now limited to $10,000 total. But granted the situation is possible.
 

#8
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I find it highly unlikely that someone with a net profit on Schedule C of several thousand, without other business-related losses like on F4797 or Sch. E, could end up with an NOL. (I want to say "impossible", but there may be some corner case I'm missing.) It's also unlikely, though it could happen entirely by coincidence, that the amount of the NOL is exactly equal to the SE Tax deduction. This would happen if the business-related deductions on Schedule A exactly equaled the net profit from Schedule C.

makbo, I suspect the software is incorrectly defaulting to treating all state income tax as business-related. Only the portion allocable to business income (which in this context includes W-2 wages and unemployment) is business-related.
 

#9
supdat  
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I suspect the software is incorrectly defaulting to treating all state income tax as business-related. Only the portion allocable to business income (which in this context includes W-2 wages and unemployment) is business-related.


Even if the software was doing that, I still don't see how state income taxes would generate an NOL with AGI of $25,000, given that the maximum SALT deduction is $10,000.
 

#10
Doug M  
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supdat

It's not that state income taxes generate an NOL. What it does is the following:

You start with AGI minus standard/itemized deductions.

Nonbusiness deductions are added back to the extent they exceed nonbusiness income. Most preparers take all the itemized deductions and treat as nonbusiness. If preparer's don't make the state tax as an adjustment, you could materially change the NOL amount. Under the new law, up to $10,000.
 

#11
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That's right. It's just barely possible for the incorrect classification of state taxes could cause an erroneous NOL:

Code: Select all

 23,000  Nonbusiness Income (e.g. retirement)
  2,194  Business income
   (155) Deduction for SE Tax
--------
 25,039  AGI

(26,000) Itemized Deductions, including (2,200) state tax
--------
   (961) AGI minus deductions


Now, if state tax is erroneously classified as a business deduction, then the nonbusiness deductions are 23,800. The excess of nonbusiness deductions over nonbusiness income is 800. This 800 gets added back, and a (161) NOL is generated. (Note: In this context, W-2 wages and unemployment are considered business income.)

This is incorrect, because the 2,200 state tax should be allocated between business and nonbusiness income. If done proportionally, the nonbusiness portion is 2,021 and the business portion is 179. The total nonbusiness deductions are 25,821, and 2,821 should be added back to find the NOL. Since the total is greater than zero, there is no NOL.
 

#12
supdat  
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MSchmahl and Doug: I am feeling pretty dense on this one. Putting aside the question of state tax, none of the other itemized deductions should be business. So how can there be an NOL, even if the state taxes are improperly allocated?
 

#13
Nilodop  
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... the 2,200 state tax should be allocated between business and nonbusiness income..How do you determine the amount of state income taxes to use in the NOL calculation? It has to be otherwise deductible, which causes you to determine the amount that couldn't be deducted because of the $10,000 TCJA limit. Yes?
 

#14
Chay  
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supdat wrote:how can there be an NOL, even if the state taxes are improperly allocated?

The rest of the itemized deductions are taken against nonbusiness income.
 

#15
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supdat wrote:Putting aside the question of state tax, none of the other itemized deductions should be business.

Chay wrote:The rest of the itemized deductions are taken against nonbusiness income.


That's right. Nonbusinesss deductions are allowed in computing an NOL to extent that there is nonbusiness income.
26 USC 172(d)(4). Continuing with the same example as I used before, another way to think of this is to separate the income and deductions into two categories:

Code: Select all
Nonbusiness Income
 23,000  Pension
(23,800) Nonbusiness itemized deductions
    800  Adjustment for limitation on nonbusiness itemized deductions
--------
      0  Total net nonbusiness income

Business Income
  2,194  Net profit from Schedule C
   (155) SE Tax deduction
 (2,200) State tax deduction erroneously treated as 100% business-related
--------
   (161) Total net business income


Combining the two categories gives us a (161) NOL, which is the same result we had before.

Nilodop wrote:... the 2,200 state tax should be allocated between business and nonbusiness income..How do you determine the amount of state income taxes to use in the NOL calculation? It has to be otherwise deductible, which causes you to determine the amount that couldn't be deducted because of the $10,000 TCJA limit. Yes?


The Code, Regulations, and Publication 536 don't tell us how to do this. I did it proportionally in my example because that seemed the most reasonable way.

In the case that state and local income taxes plus property taxes exceed $10,000, I have only this to go by:

26 USC 164(b)(6) wrote:the aggregate amount of taxes taken into account under paragraphs (1), (2), and (3) of subsection (a) and paragraph (5) of this subsection for any taxable year shall not exceed $10,000 ($5,000 in the case of a married individual filing a separate return).


I think there is another general principle that taxpayers are allowed to, but not required to, take all deductions they are entitled to (except in certain cases impacting SE tax and EITC). I know this has been debated previously here. If this is true, I could take the state income tax into account first, before considering just enough property tax to bring the total to $10,000. In other words, all of the state income tax, up to $10,000 total, would be considered for purposes of computing an NOL. I freely admit I don't have much support for this position, but it seems the most reasonable to me.
 

#16
Chay  
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MSchmahl wrote:I think there is another general principle that taxpayers are allowed to, but not required to, take all deductions they are entitled to (except in certain cases impacting SE tax and EITC). I know this has been debated previously here.

Was there really a debate? This principle is real and it doesn't seem all that controversial to me.

If this is true, I could take the state income tax into account first, before considering just enough property tax to bring the total to $10,000. In other words, all of the state income tax, up to $10,000 total, would be considered for purposes of computing an NOL. I freely admit I don't have much support for this position, but it seems the most reasonable to me.

What seems reasonable to me is to allocate the reduction in the SALT deduction proportionately to the deductions that the taxpayer has claimed on lines 5a through 5c of Schedule A. So, to achieve the result you want, the taxpayer would have to claim all of his income taxes on line 5a and then just enough property taxes to reach the cap on line 5c.

However, the general principle you cited above might actually operate to prevent a taxpayer from doing this. In addition to SE tax and EITC, wouldn't other tax benefits derived from omitting deductions trigger the exception and disallow the benefit?
 

#17
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Yes, it seems to come up every other year or so: See viewtopic.php?f=8&t=12118, viewtopic.php?f=8&t=5390, and viewtopic.php?f=8&t=6486. The IRS has [url="https://www.irs.gov/pub/irs-wd/0022051.pdf"]a memo[/url] that says for self-employment purposes, allowable deductions are mandatory. The memo cites IRC 1402(a) for this proposition.

It seems to me that the definitions in 1402(a) and 63(a) are parallel enough that the question of the mandatory nature of deductions should be answered the same way for both business and nonbusiness deductions. This is why the question is debatable.
 

#18
Chay  
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I've read through most of what you linked and I must say, I am beginning to question my position.

Unless we consider the phrase "deductions allowed by _______" to mean "deductions under _______ that the taxpayer is entitled to claim", then both the memo you cited and Revenue Ruling 56-407 seem to be in conflict with statute.

At the same time, if omitting a deduction doesn't produce any tax benefit, there is no penalty provision that can operate, or would be enforced, as a repercussion. Thus, practically speaking, deductions aren't always mandatory under either position.

But if, technically speaking, deductions should always be taken into account, then any tax benefit that might arise from their omission must be disregarded, including the NOL that you proposed to generate in post #15.

That being said, it's also possible that the conclusion in Rev. Rul. 56-407 derives not from the Internal Revenue Code, but from this:
Section 208 of the Social Security Act, as amended, provides penalties for a person who makes any false statement or representation in connection with any matter arising under the Self-Employment Contributions Act of 1954, for the purpose of obtaining or increasing benefits under the Social Security Act.
 

#19
Nilodop  
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In the case that state and local income taxes plus property taxes exceed $10,000, I have only this to go by:. That's exactly what I was getting at. How do you know whether the excess over $10.000 of such taxes is comprised of property taxes or business-attributed state income taxes? We need to know because RR 70-40 concludes thusly (emphasis added):
Accordingly, it is held that expenditures for State individual income taxes on net income from business profits, interest on State and Federal income taxes that are related to income derived from a trade or business carried on by the taxpayer, and litigating expenses in connection with such taxes, are "attributable to a taxpayer's trade or business" for purposes of section 172(d)(4) of the Code and, provided they are otherwise deductible, are allowable deductions in determining the net operating loss deduction.
 

#20
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Not to reopen the whole can of worms, but No Thanks, Uncle Sam, You Can Keep Your Tax Break by James Edward Maule (2006) seems to be the most in-depth whitepaper considering the question.

J. Maule wrote:The IRS has not acted as though all deductions are mandatory. Aside from a poorly drafted, and ultimately extraneous remark in a Chief Counsel Advice, the IRS has not purported to compel taxpayers to claim all allowable deductions. Only in two limited situations, for limited purposes, has the IRS taken the position that certain deductions must be claimed. One involves the computation of self employment income for social security purposes. The other involves the earned income tax credit issue, itself tied by cross-reference to the self-employment question.
 

#21
Chay  
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Nilodop wrote:How do you know whether the excess over $10.000 of such taxes is comprised of property taxes or business-attributed state income taxes?

Section 67 presents the closest parallel I can think of. In the instructions for Form 8960, the limitation is treated as reducing each deduction pro-rata. That's how I think it should be done in this case too.

J. Maule wrote:Only in two limited situations, for limited purposes, has the IRS taken the position that certain deductions must be claimed. One involves the computation of self employment income for social security purposes. The other involves the earned income tax credit issue, itself tied by cross-reference to the self-employment question.

My point is that for the IRS to be able to take that position, it must be a plausible interpretation of some statute or other. There are only two possibilities I can conceive of:

  1. The IRC as written requires deductions that a taxpayer is entitled to claim be taken into account.
  2. The position derives from something outside the IRC such as section 208 of the Social Security Act.
The point here is not to argue over whether taxpayers are somehow legally or ethically bound to claim deductions no matter what. Clearly, this is not the case. The point is to examine whether or not the conclusion reached in Rev. Rul. 56-407 should be applied to all other situations where omitting a deduction produces a tax benefit.
 

#22
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Nilodop wrote:In the case that state and local income taxes plus property taxes exceed $10,000, I have only this to go by:. That's exactly what I was getting at. How do you know whether the excess over $10.000 of such taxes is comprised of property taxes or business-attributed state income taxes? We need to know because RR 70-40 concludes thusly (emphasis added):
Accordingly, it is held that expenditures for State individual income taxes on net income from business profits, interest on State and Federal income taxes that are related to income derived from a trade or business carried on by the taxpayer, and litigating expenses in connection with such taxes, are "attributable to a taxpayer's trade or business" for purposes of section 172(d)(4) of the Code and, provided they are otherwise deductible, are allowable deductions in determining the net operating loss deduction.


1. If, as Chay suggested, we claim e.g. $8,000 in state income taxes and $2,000 in property tax (even though we paid $12,000 in property tax) and if we believe James Maule, then all of the state income taxes are "otherwise deductible".

2. If we fall into the "all deductions are mandatory" camp, then I think proportionally reducing the state income tax by 10,000/20,000 = 50% is appropriate.

I know, that's a lot of "if"s. This is a case where I would present both options to a client with risk estimates and let them decide what to do. FWIW, my SWAG* is that option 1 is correct with about 75% likelihood.

*Scientific Wild-Ass Guess
 

#23
Nilodop  
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Section 67 presents the closest parallel I can think of. In the instructions for Form 8960, the limitation is treated as reducing each deduction pro-rata. That's how I think it should be done in this case too.. Mind illustrating it in an example? Does it matter what you do first? Let's keep it easy - state income taxes were 10,000, of which 4,000 is "attributable" to business income, and state property taxes, all personal, were 10,000. What's the effect on NOL calculation?
 

#24
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If I may resurrect this, most of the above was TL;DR for me because I don't think the situation I am looking at involves state tax limitations (but I could be wrong).

In this case, NOL = ( AGI - nonbusiness income)

The issue comes down to the Deductible part of Self Employment Tax. All of the Business Income is offset by the SEHI for this taxpayer (which is critical to this outcome), but the 1/2 SE tax adjustment for AGI is not offsetting anything, yet it is not included in Line 1 of the calculation below. So, it becomes an NOL all by itself.

In the case of my client, I'm going to be lazy and use actual instead of rounded numbers, but hopefully still not identifying the client by doing so:

NOL Operating Loss Worksheet
1. (2,426) subtract std/itemized deduction (28,361) from AGI (25,935)
6. 28,361 Nonbusiness deductions
7. 26,090 Nonbusiness income
9. 2,271 Line 6 - 7
25. (155) NOL (Line 1 + 9)

Nonbusiness deductions are:

Schedule A Medical Expense Deduction $ 5,864
Schedule A Taxes Paid 4,151
Schedule A Home Mortgage Interest 17,346
Schedule A Charitable Contributions 1,000

Nonbusiness income is:

Interest Income $ 5,493
Dividend Income 27
Taxable Pensions 20,006
Other Income 564
 

#25
makbo  
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CA also calculates the same NOL amount (which taxpayer will elect to carry forward) and they don't allow a deduction for state income tax, for whatever that proves.
 

#26
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makbo wrote:The issue comes down to the Deductible part of Self Employment Tax. All of the Business Income is offset by the SEHI for this taxpayer (which is critical to this outcome), but the 1/2 SE tax adjustment for AGI is not offsetting anything, yet it is not included in Line 1 of the calculation below. So, it becomes an NOL all by itself.


I think this is the issue. The SE tax deduction is supposed to reduce the profit available to be offset by the SEHI deduction. See the worksheet from page 91 of the 1040 instructions, specifically this part:

IRS wrote:[...]minus any deductions on Schedule 1, lines 27 [Deductible part of self-employment tax] and 28 [Self-employed retirement plans].


So I think your AGI is off by 155 and should be 26,090.

You should have something like:

2,194 on Schedule 1, line 12 (Business income),
155 on Schedule 1, line 27 (Deduction for SE Tax), and
2,039 on Schedule 1, line 29 (SEHI deduction).

Instead, I think you have 2,194 on line 29.
 

#27
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MSchmahl wrote:I think this is the issue. The SE tax deduction is supposed to reduce the profit available to be offset by the SEHI deduction.

Yes, you are correct. At first, I thought this was a new 2018 bug in my software, but now I see it is rather a data entry error that I think should have been flagged as a critical diagnostic, but it wasn't flagged at all.

Way back in my first post, I mentioned this taxpayer was recently widowed. 2018 is the first year with filing status single. When it is the taxpayer who is deceased, UltraTax seems to do a good job for the most part of automatically moving the spouse data entry over to the (single) taxpayer input for the following year, but in this case the Schedule C was still attributed to "Spouse", even though there was no spouse on the return and filing status was "Single". The SE tax itself was nonetheless calculated correctly, with the taxpayer's SSN, but the SEHI was not (it was calculated, but without the adjustment for 1/2 SE tax). Schedule C itself had blanks for the name/SSN of the proprietor.

So, I give myself partial credit for thinking something was odd about my software's result, even though I was too lazy to figure it out on my own. Then I give myself a tiny bit more credit for taking the time to bring up the topic here, which eventually let to the correct result, fortunately before the return is filed.

Thank you for taking the time to help me figure it out (and everyone else who contributed to a lively discussion as well).
 

#28
Doug M  
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I find most software companies don't have enough information to correctly identify the various components of an NOL computation. Business income and deductions, business capital gains, nonbusiness income and deductions.

What did you get when you prepared Schedule A, form 1045?
 

#29
makbo  
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Doug M wrote:What did you get when you prepared Schedule A, form 1045?

In my post #24, the section titled "NOL Operating Loss Worksheet" is the same thing as Schedule A, Form 1045 would be.

I think UT would probably do a pretty good job of figuring the NOL. Ironically, I started this thread by saying that "good software helps with NOLs". My problem was not caused by NOL calculations per se, but rather an inconsistent treatment of data entry made for S(pouse) on a return with single filing status (no spouse). For most purposes it was ignored and treated as taxpayer, but for the SEHI, it was incorrectly treated as belonging to the non-existent spouse, yet still reported on the return in some places but not others.
 


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