The 10-year carryback of SLLs.

Under the general net operating loss (NOL) rules, for tax years beginning after Aug. 5, 1997, NOLs can be carried back by a corporation to the two years immediately preceding the year the loss was sustained. (For tax years beginning before Aug. 6, 1997, the carryback period is three years.)

Under certain circumstances, Sec. 172(f) provides a unique opportunity for taxpayers to recover tax refunds through the carryback up to 10 years of certain NOLs. Recent law changes have significantly limited the use of the special carryback period.

First, Sec. 172(f) only applies to taxpayers using the accrual method, both at the time the loss is sustained and for the carryback year.

Pre-Oct. 22, 1998 Losses

Effective for tax years ending before Oct. 22, 1998, expenses falling in one of the following specified categories are not limited by the general rule, but are permitted a special 10-year carryback period:

1. Amounts attributable to product liability;

2. Amounts attributable to a liability that arises under Federal or state law; or

3. Amounts attributable to a liability that arises out of a taxpayer's tort.

Expenses within these categories are specified liability losses (SLLs) and are granted the more favorable carryback treatment. (The normal 20-year and 15-year carryforward rules continue to apply to SLLs.)

For torts or liabilities arising under Federal or state law, to qualify for the special 10-year carryback exception, the act (or failure to act) giving rise to the liability must have occurred at least three years before the year the expense was actually accrued for tax purposes (Sec. 172(f)(1)(B)).

Taxpayers have attempted to apply Sec. 172(f) to a broad range of deductions. The result was Notice 97-36; the IRS addressed a situation in which a taxpayer had improperly characterized ordinary expenses as an SLL to meet the three-year act requirement and obtain the benefit of Sec. 172(f). The taxpayer had carried back auditing fees incurred to comply with Federal securities law requirements.

It argued that the company's initial public offering (IPO) date triggered the need for an independent certified annual financial statement to meet Federal securities law. Because the IPO occurred more than three years before the expense year, the taxpayer argued it was entitled to the beneficial treatment.

According to the notice, such a tenuous link between the "act (or failure to act) giving rise to the expense" and the liability (the independent auditor's fees) is dearly not permitted under Sec. 172(f). The Service specifically denied special treatment to "routine current year costs" such as auditors' fees.

In Letter Ruling 9840003, the IRS National Office further tightened the breadth of Sec. 172(f). A taxpayer attempted to treat deductions from interest on Federal taxes, as well as legal fees paid to defend an income tax deficiency, as SLLs entitled to the 10-year carryback. It argued that the interest was imposed under a Federal statute; as a result of the interest imposition, the legal fees were incurred to defend the proposed deficiency.

In the ruling, the Service denied special carryback treatment, focusing on the legislative intent of Sec. 172(f), which was to grant 10-year carryback treatment in only certain very limited circumstances (specifically, when there is a substantial delay between the act giving rise to the liability and the timing of the deduction)." Routine" costs, such as interest on taxes, do not have a "delay in time element" The act giving rise to the deduction (the income reporting decisions that ultimately gave rise to the imposition of interest) and the date it is actually accrued on the books (the deficiency settlement date) is not inherent in the expense and, thus, does not warrant favorable treatment.

Post-Oct. 21,1998 Losses

The definition of SLLs was further clarified by the Tax and Trade Relief Extension Act of 1998, which replaced the three broad loss categories with five specific loss items. Effective for losses incurred in tax years ending after Oct. 21, 1998, the following expenses constitute permissible SLLs:

* Reclamation of land;

* Decommissioning of a nuclear power plant;

* Dismantling of a drilling platform;

* Remediation of environmental contamination; or

* Payment under a workers' compensation act.

Under the new law, torts are no longer listed as a specific category. Although the new law drastically limits the breadth of Sec. 172(f), the remaining five items (and specifically, environmental contamination and workers' compensation payments) are still subject to the beneficial carryback treatment and can provide a significant benefit to a taxpayer faced with these liabilities. Under either the old or the new rules, to qualify for special carryback treatment, an SLL must be included in the taxpayer's NOL for the loss year. An SLL will not be permitted to the extent that it exceeds the ordinary NOL for the tax year.

Example: For its tax year ended Dec. 31, 1998, taxpayer T has a $50,000 expense for an EPA-imposed environmental cleanup, related to a toxic spill dating back to 1994. After deducting the $50,000 cleanup costs in its 1998 tax return, T can carry back only a $20,000 NOL for the year. T can carry back only $20,000 of the SLL for the environmental cleanup. Although the full $50,000 was included in its calculation of the year's NOL, the SLL carryback is limited to $20,000, the ordinary NOL for the year.

To determine if Sec. 172(f) applies (and to calculate the monetary benefit of an SLL carryback), the following information should be obtained:

1. A list of prior years in which the taxpayer paid Federal income tax (the returns for these years will be needed to prepare the carryback claim).

2. Details of expenses that may fit within one of the above SLL categories and whether they arose before or after Oct. 21, 1998.

3. For each such expense, a list of the date(s) it was paid or accrued, and the date of the act (or failure to act) giving rise to the liability. This may be simple for expenses arising under a workers' compensation act tied to a particular year, but will be more difficult for items such as environmental liabilities (whose occurrence date may be disputed).

4. A detailed calculation of the taxpayer's NOLs.

Once a taxpayer has determined that it has a valid 10-year carryback claim, it must provide all details requested by the IRS to support it. Specifically, the Service requires a statement setting forth the part of the SLL attributable to a permitted category of loss. The statement should separately identify the specific type of deduction claimed in the carryback and set forth the act (or failure to act) giving rise to each deduction, and the year of such act (or failure to act). This detail is necessary to support the "three-year act" requirement.

Although the SLL list has been limited, Sec. 172(f) continues to offer a valuable opportunity for taxpayers to obtain income tax refunds for expenses falling within the remaining categories.

FROM STEPHEN C. ARBER, J.D., LL.M., NEW YORK NY