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The JGTRRA's effect on NOL planning.

Individuals who expect to incur net operating losses (NOLs) during 2003 are already at a disadvantage over 2002, as some of the enacted tax cuts may do more harm than good. Tax advisers will need to address new NOL planning considerations, particularly the effects of the tax rate reductions and bonus depreciation increase.

The struggling economy will likely increase business losses, due to shrinking product or service demand. Tax advisers will be able to make the most of these unfortunate circumstances by maximizing the Sec. 172 benefits available to NOL taxpayers.

Individual NOEs

An individual can have an NOL from ,an S corporation, a partnership or a personal business or farm. If an individual does not have a loss on Schedule C, E or E an NOL is generally impossible.

NOLs arise only from business losses, as nonbusiness deductions are limited to nonbusiness income, under Regs. Sec. 1.172-3 (a) (3) (i). A traditional taxpayer with normal income items cannot have an NOL, as his or her itemized deductions cannot reduce taxable income below zero; only when he or she has a business loss can there be an NOL.

Generally under Sec. 172 and the regulations, if an individual has a loss on Schedule C, E or E his or her NOL will be very close to that loss when he or she has more itemized deductions than other income.

Example: Individual V has $10,000 in interest and dividend income and $15,000 of itemized deductions. The itemized deductions do not lower taxable income below zero and create an NOL. However, V owns a small business and reports a $2,500 loss on Schedule C, which creates an NOL. Thus, V's adjusted gross income (AGI) is $7,500 and his itemized deductions are $15,000. V's itemized deductions eliminate all income and reduce his taxable income to zero. V decides to itemize his deductions up to the nonbusiness income level, thus allowing $10,000 of deductions. He then sets this off against the $7,500 AGI, leaving a $2,500 NOL. V uses Schedule A of Form 1045,Application for Tentative Refund, to calculate the NOL.

Rate Cuts

The individual tax rate reductions over the past few years were a gift to the overwhelming majority of taxpayers. However, the rate differential between the carryback years and carryover years can have a major effect on taxpayers with NOLs, especially in 2003 and 2004.

NOLs are unique, in that taxpayers can use them in a range of tax years, if they so elect. Obviously, they would want to use this asset to maximize benefits. For example, a $1,000 NOL that offsets income at the highest tax bracket in 2001 (39.1%) would result in a $391 tax refund. The same NOL carried forward into 2004 that offsets the highest-taxed income (35%) would trigger a $350 tax savings. A $41 savings is not material; however, it represents 10.5% deprecition in the NOL's "value."

The difference in the rates makes the carryback of an NOL to 2001 and 2002 much more desirable than a carry forward. The rate differential will only last for two years. NOLs arising in 2003 will carry back to a 39.1% rate in 2001. NOLs arising in 2004 will carry back to a 38.6% rate in 2002. Those arising in 2005 will carry back to 2003, which will have the same income tax rates as 2004-2008, resulting in no differential rate.

JGTRRA Marriage Penalty Relief

Sections 102 and 103 of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) offered marriage penalty relief by expanding the tax brackets for married individuals to almost mirror those of their single counterparts. Basically, this translates into an overall lower effective tax rate for married individuals in 2003 than in previous years. Income formerly taxed in the 27% bracket will now be taxed in the 25% bracket; because the lower brackets expanded, more income will be taxed in the 10% and 15% brackets. Although this is generally good news for married taxpayers, the change in the effective tax rates further depreciates the "value" of NOLs.

In general, for 2003, the lower rates and expanded married filing jointly brackets produce a $9,494 tax savings to a couple with $400,000 of taxable income. The effective tax rate on $400,000 under the pre-JGTRRA brackets was 31.18%. After the JGTRRA, it is 28.8%. Because a married couple will now" pay less tax on the same income, NOLs that are carried forward will be less valuable.

Capital Gain Tax Relief

The reduction in the overall marginal rates and the lowering of the effective rates for married taxpayers create a general rule for the use of the NOLs--an NOL should be used against income taxed at the highest marginal rate. Because the lower capital gain rates after the JGTRRA reduce an NOL's overall effectiveness, once again, it becomes more attractive to carry back NOLs.

An NOL carried into a tax year that would otherwise have taxable income results in a reduction of ordinary income to zero; any additional NOL would be used to reduce capital gain. In some instances, an NOL is taxpayer-favorable, because it offsets ordinary income first, then capital gain. However, an NOL sufficiently large to reduce all income in a given year will eliminate both high- and low-bracket income. When an NOL is used to offset a blend of ordinary income and capital gain, the overall tax savings will be reduced. The reduction after the JGTRRA will be even more severe than in years past, as the spread between the highest ordinary income rate (35%) and the new capital gain rate (15%) is 20%, an increase from 18.6% before the JGTRRA. The greater the spread between the rates, the larger the reduction in the effective tax rate for a taxpayer with blended classes of income.

The new lower overall effective rate may make it more beneficial to carry back an NOL. The dividend tax cut makes carrying forward an NOL even less appealing.

The Dividend Tax Cut

NOL carryforwards: The dividend tax cut has further lowered the effective tax rates for 2003 and beyond. The new dividend rates will affect the decision to carry forward or carry back an NOL, similar to capital gains.

Effect on NOL computation: In implementing the dividend tax cut, the JGTRRA language effectively converts dividends from ordinary income to capital gain. In computing an NOL, the tax cut has virtually no effect. However, a material change in the dividend tax cut may affect a small percentage of individual taxpayers, regardless of whether they have NOEs.

JGTRRA Section 302(a) converts dividends from ordinary income to capital gain for purposes of the investment interest deduction; see Sec. 1(h)(11)(D). Generally, under Sec. 164(d), taxpayers can take this deduction up to their net investment income during the tax year; any additional investment interest expense is carried forward. The crucial change after the JGTRRA is that dividend income is no longer investment income for purposes of the investment interest deduction.

An individual with a 2003 NOL has an opportunity to elect under Sec. 164(d)(4) to convert dividend income to net investment income. What are the benefits of this election? If an individual has a 2003 NOL, the loss will already be calculated by including the dividend. The election will merely allow more income to be deemed eligible for investment income treatment and will permit more interest to be itemized. While a negative effect is that dividends that are deemed investment income are taxed at ordinary income rates, the taxpayer has no income. This election has always existed for long-term capital gain; thus, tiffs discussion applies equally to traditional long term capital gain.

However, the election decision is not that simple. The deductions allowed from AGI in computing an NOL are all business deductions, and all nonbusiness deductions to the extent of nonbusiness income. Before the investment income election, dividends are nonbusiness income. Thus, if there are more Schedule A nonbusiness deductions than there is nonbusiness income, the excess will be lost. If a taxpayer were to elect to deduct all investment interest expense and there is insufficient nonbusiness income to absorb the deduction, it will effectively be lost.

Why make the election? Basically, to "super-charge" an NOL. By electing to increase an investment interest deduction, a taxpayer has converted investment interest (a miscellaneous itemized deduction) into an NOL. An NOL can be carried forward or back; excess investment interest can only be carried forward. An NOL's power to be carried back, to offset income presumably taxed at higher rates, makes this election quite attractive.

Other New Law Provisions

JGTRRA Sections 201(a) and 202 also extended bonus depreciation and the Sec. 179 dection. While the former is a pro-taxpayer development, the latter generally is not. Both deductions permit taxpayers a greater current deduction for capital assets placed in service during the year; however, the Sec. 179 expense election is limited to the lesser of the deduction or income. An NOL taxpayer generally does not have income and, thus, cannot take the deduction.

On the other hand, bonus depreciation accelerates depreciation into the current year, increasing both business deductions and a business loss (if any). A drawback is that the deductions will be lower hi future yeas; however, a carryback of an NOL based on the accelerated deduction will offset income taxed at higher rates. Such an NOL provides a unique opportunity; ill effect, the taxpayer "borrows deductions" from future years and increases the current-year NOL. The NOL can then be carried back to 2001 and 2002, when the effective tax rates were higher. Tax advisers should closely review the 2003 returns of eligible clients, so as not to miss this opportunity.


The general theme is to use deductions against income taxed at the highest effective rates. The higher the effective tax on income, the more valuable an NOL is. By using an NOL strategically between tax years, an NOL taxpayer can yield the maximum benefit from the unfortunate circumstances that led to the NOL creation.

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Title Annotation:Jobs and Growth Tax Relief Reconciliation Act of 2003, net operating losses
Publication:The Tax Adviser
Date:Nov 1, 2003
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