A primer on individual NOLs.

In the aftermath of the 2005 Atlantic hurricane season, new laws were enacted to give relief to individuals affected by Katrina, Rita and Wilma, and to promote economic recovery in the affected regions. Some of the newly enacted provisions relate to casualty losses and retirement plan withdrawals; however, significant relief for individuals has already been available for decades, through the Sec. 172 net operating loss (NOL) deduction. (For coverage of Hurricane Katrina Relief, see the Tax Clinic in the January 2006 issue.)

The year of NOL creation provides some interesting planning opportunities that are unique to NOL years. However, the planning benefits in the year of NOL creation may be offset with planning for use of the NOL and to minimize exposure to the alternative minimum tax (AMT). A multi-year tax projection that represents the effect of an NOL carryback and carryforward will likely be the best tool to maximize an NOL'S benefit.

Creation of the NOL

Put simply, an individual NOL is created when business deductions in excess of business income also exceed net nonbusiness income; see Sec. 172(d)(4). Thus, as a general rule, an individual taxpayer cannot have an NOL unless the return contains business deductions. Ordinarily, taxpayers with losses (i.e., excess business deductions), reported on Schedules C, E or F, have the greatest likelihood of having an NOL.

Casualty losses: A significant exception is casualty losses. Personal casualty losses are business deductions for purposes of calculating an NOL; see Sec. 172(d)(4)(C). Once a taxpayer satisfies the 10% adjusted gross income (AGI) limit (not applicable to Katrina-, Rita-and Wilma-related losses; see Gurene, Tax Clinic, "Hurricane Katrina: Claiming Casualty Losses," TTA, January 2006, p. 19), any deductible casualty loss will be deemed a business deduction. In addition to its special designation as a "business deduction," a taxpayer can elect to deduct a casualty loss in the tax year prior to the loss year. However, this applies only to casualty losses occurring in Presidentially declared disaster areas; see Sec. 165(i)(1). Further, for individuals who created an NOL due to casualty losses, the carryback period is extended from two years to three; see Sec. 172(b)(1)(F). Thus, with the combination of the Sec. 165(i) election and the three-year carryback, taxpayers can effectively use Katrina-, Rita- and Wilma-related losses to offset income from 2000-2004 first and then in 2005 and beyond.

However, the Gulf Opportunity Zone Act of 2005 (GO Zone Act) Section 101 (a) extended the two-year carryback to five years for tax years ending after Aug. 27, 2005; see P.L. 109-135 and Sec. 1400N(k). The 2005 NOL created by the hurricanes can thus be carried back to the 1999 tax year. It is thus possible to have an NOL created by casualty losses and by operating business losses resulting in a split carryback--the hurricane casualty loss going back five years and the nonhurricane loss going back only two. (The GO Zone Act is discussed in further detail at the end of this item.)

Calculating the NOL

As noted above, the NOL is a product of excess business deductions (including casualty losses) in excess of nonbusiness net income. While this theoretical definition may seem convoluted, Schedule A of Form 1045, Application for Tentative Refund, makes the mathematical calculation a little less daunting. Many software programs calculate Schedule A (Form 1045) with the preparation of the NOL-originating return.

In calculating the NOL in the year of creation, the starting point is taxable income, which is first adjusted upward to add back the deduction for personal exemptions and net capital losses; see Sec. 172(d)(2) and (3).The capital loss add back is required only to the extent that the taxpayer's AGI includes all or part of the $3,000 capital loss deduction under Sec. 1211(b)(1). This addback will, in many cases, effectively increase the capital loss carryover (as compared to a non-NOL year) because the $3,000 loss was not "used"; see Sec. 1212(b)(2).

Definitions: The final adjustment is to add back nonbusiness deductions to the extent they exceed nonbusiness income. First, however, one must understand the definitions of "business" and "nonbusiness." According to Regs. Sec. 1.172-3(i), nonbusiness deductions and nonbusiness income are those items not attributable to, or derived from, the taxpayer's trade or business. Everything else (including wages) is considered business income. Tax attributes connected with a taxpayer's business, but not related to trade or business income (e.g., interest income), that are reported on Schedule K-1 will be considered business income for this purpose, even though the same type of income earned outside of a partnership or an S corporation will be deemed nonbusiness income.

Rules: Having defined nonbusiness income and deductions, a series of rules can be derived: 1.A taxpayer's itemized deductions (excluding business deductions) cannot exceed nonbusiness income from Form 1040, p. 1. Most of a taxpayer's itemized deductions are included in this general rule, with the exception of casualty losses, unreimbursed employee business expenses and state income taxes related to business income. Any itemized deductions in excess of net nonbusiness income included in AGI will be an addback. In addition, certain deductions unique to individual taxpayers are considered business deductions, including moving expenses, one-half of self-employment taxes and educator expenses, all of which are above-the-line deductions on Form 1040, p. 1.

2. Business income or deduction from Form 1040, p. 1, includes wages, and income and loss from entities reported on Schedules C, E and E 3. As nonbusiness deductions effectively cancel out nonbusiness income, this results in an NOL equaling business income, less a greater amount of business deductions--this is the result that generates an operating loss in a traditional business context.

Planning: On the return that generates an NOL, there are a few opportunities for maximizing the NOL. In NOL creation years, a taxpayer's AGI is usually low; consequently, itemized deductions subject to an AGI floor are generally more fully deductible than would normally be the case (e.g., medical deductions limited to the excess over 7.5% of AGI under Sec. 213, miscellaneous itemized deductions in excess of 2% of AGI under Sec. 67 and the overall 3% limit on itemized deductions under Sec. 68). However, while the lowered AGI threshold may provide an opportunity to take deductions often limited by the AGI floor, they are effectively deducted only when they offset, but do not exceed, nonbusiness income. This may be a rare opportunity to accelerate such deductions into the NOL year in a manner that increases the NOL, because such deductions reduce or eliminate excess nonbusiness income. Conversely, nonbusiness deductions should not be accelerated into the NOL year if the nonbusiness itemized deductions incurred in the ordinary course of the year will probably exceed nonbusiness income. The acceleration of business deductions over which the taxpayer has some control (such as unreimbursed business expenses deducted on Schedule A) should be maximized during the loss year, because they will act to increase the NOL in any event.

Effect of charitable contributions: Individuals expecting NOLs should carefully consider the timing of their charitable contributions, because their benefit will likely be severely limited in the NOL year, or simply converted to a charitable contribution carryover in the NOL year. Charitable contributions are subject to a ceiling under Sec. 170(b) that limits the currently deductible amount to 50%, 30% or 20% of AGI, depending on the property transferred and the donee's identity. However, any excess charitable deduction is automatically carried forward for use in each of the next five tax years, after which any remaining unused deduction is lost; see Sec. 170(d).

If a taxpayer expects to have an unusually small AGI in the loss-generating year, he or she might want to defer contributions until the following year. However, if the NOL is carried for ward, the AGI in the "use" year may also be unusually low, thus subjecting the taxpayer to Sec. 170(d)(1)(B). Under that provision, if an NOL from a different tax year is brought into the current one (for purposes of calculating the charitable contribution deduction in that year), the excess charitable contribution carryover that will be carried to the next year will be calculated without consideration of the NOL, resulting in a reduction of the carryforward; see Regs. Sec. 1.170A-10(d)(1)-(3) for a detailed explanation, including examples on the effect of NOL carrybacks and carryovers on charitable contributions.

NOL Use

An NOL can be used in two ways: it can be carried (1) back up to two years, to generate a refund (with the exception of the three-year carryback for casualty-loss-related NOLs described above); or (2) forward for up to 20 years, to reduce future income tax liabilities. The default position is to carry back an NOL for two years, with any unused NOL carried forward; see Sec. 172(b)(2). If taxpayers wish to carry only the NOL forward, they must irrevocably waive the carryback by filing an affirmative election with the tax return in which they report the NOL; see Sec. 172(b)(3) (a sample waiver can be found in Freitag, BNA Tax Management Portfolio #539-2nd: Net Operating Losses--Concepts and Computations, Worksheet 14). Taxpayers may file for an expedited carryback refund using Form 1045, but they must file the form by December 31 in the year following the loss (Dec. 31, 2006, for 2005 NOLs). If they miss the one-year deadline for filing Form 1045, they must use Form 1040X, Amended U.S. Individual Income Tax Return, to carry back the NOL.

Choosing whether to carry back or forward: The choice of carrying back or forward is best decided with a multiyear tax projection. Although many variables are involved, a basic rule is to use the NOL in the year with the highest marginal tax rate. When the highest rate may be in future years, the carryback should be waived. The time value of money of forgoing a current refund that would result from a carryback should be compared with the benefit of an offset to higher taxed income in future years.

The AMTNOL

No coverage of NOLs would be complete without mentioning the AMT treatment of NOLs. Unfortunately, the AMTNOL is often overlooked; it is created in the same way as a regular NOL, but after consideration of AMT adjustments and preferences. As a general rule, there will likely be a difference between a regular tax and an AMTNOL, approximately equal to the sum of the AMT adjustments on Form 6251, Alternative Minimum Tax--Individuals. Generally, because AMT adjustments and preferences act to increase AMT income relative to regular taxable income, AMTNOL deductions are generally less than their regular counterparts. Further, the AMTNOL is limited to 90% of alternative minimum taxable income in the year of use; see Sec. 56(d).The 90% limit intentionally creates a difference between regular tax and AMT and often results in owing AMT as a result of the unrestricted deductibility of the regular NOL. In combining the 90% limit with the generally reduced size of the AMTNOL relative to the regular NOL, the result is likely a significant AMT tax bill in one or more years in which the respective NOLs are used.

The GO Zone Act's NOL Provisions

On Dec. 21, 2005, President Bush signed the GO Zone Act into law, which addresses pro-taxpayer provisions for NOLs under Sec. 1400N(k).These provisions extend the NOL carryback period from two to five years for NOLs attributable to (1) new investment and repair of existing investment in the areas damaged by Hurricane Katrina; (2) business casualty losses caused by Hurricane Katrina; and (3) moving expenses and temporary housing expenses for employees working in areas damaged by Hurricane Katrina. The loss would be the lesser of the year's NOL (as normally computed) or the deductions for GO Zone casualty losses, employment-related moving expenses due to Hurricane Katrina, temporary housing for employees, depreciation of GO Zone property, and repair expenses. The Go Zone Act also eliminates the 90% limit on the use of the AMTNOL to offset a taxpayer's AMT; see Sec. 1400N(k)(1)(B).

FROM DAVID H. KIRK, J.D., CPA, CFP, WASHINGTON, DC