Tax Planning for NOLs in the Carryback Maze

In light of the recently enacted, temporary five-year net operating loss (NOL) carryback period, taxpayers have the opportunity to plan for which year(s) an NOL will be used to offset income. To maximize their NOL benefits, taxpayers should analyze their past, current and projected tax positions for the tax years to which an NOL may be carried.

This analysis involves determining both the income years for which the NOL may be used and also its effects on various tax attributes (e.g., credits and charitable contributions) and various potential limits (e.g., corporate equity reduction transaction (CERT), separate return limitation year (SRLY) and Sec. 382) in years NOLs are used. Without a comprehensive analysis, a taxpayer might fail to elect to forgo an NOL carryback period—unaware that absent an election, the carryback will free up credits that may never be used, or use of the NOL may be limited. In these situations, a perceived benefit of the carryback will be decreased or lost.

Background

Under Sec. 172, NOLs generated in a tax year can be deducted from net taxable income in previous years (to receive a refund), or in future years (to reduce tax due in future years) or in both. NOLs must be carried back to the earliest available tax year (various carryback periods apply) to reduce income in those years, and then carried forward for 20 years until the NOL is fully used by reducing income in the years to which it is carried. However, the taxpayer can elect to forgo a carryback period. If an NOL is not used by the end of the twentieth tax year, it expires.

Various carryback periods may apply to a taxpayer. If a taxpayer qualifies for one or more of the carryback periods, unless it elects to forgo the carryback, it must carry back the NOL to the earliest tax year available to it.

Carryback Options

Two-year. The general two-year carryback period applies to taxpayers that do not have NOLs that qualify for any of the longer carryback periods or have elected to forgo those periods. To forgo the two-year carryback period, a taxpayer must make an election on a timely filed (including extensions) return for the tax year in which the NOL arose.

Three-year. A three-year carryback period applies to taxpayers with "eligible losses" generated during a tax year. Eligible losses are defined as (1) for individual taxpayers, losses of property arising from fire, storm, shipwreck or other casualty, or from theft and (2) NOLs of small-business taxpayers and taxpayers engaged in the trade or business of farming attributable to Presidentially declared disasters. Only the portion of the NOL that is an eligible loss may be carried back three years. Any remaining NOL would be carried back using the two-year carryback period.

Five-year. Historically, a five-year carryback period applies to taxpayers with a farming loss for a tax year. The farming loss qualifying for the five-year carryback is the lesser of (1) the NOL for the tax year if only income and deductions attributable to a farming business are taken into account or (2) the NOL for the tax year. In addition, all taxpayers with NOLs generated in tax years ending in 2001 and 2002 may carry back their losses five years under the Job Creation and Worker Assistance Act of 2002 (the Act). A taxpayer may elect to forgo the five-year carryback period, and instead use the two-year or three-year carryback period or both, by electing to forgo the five-year carryback on a timely filed (including extensions) return for the tax year in which the NOL arose. Taxpayers that have filed returns for years ending in 2001 or 2002 and did not take advantage of the five-year NOL carryback could still take a five-year NOL carryback if they act by Oct. 31, 2002, under Rev. Proc. 2002-40.

10-year. A 10-year carryback period applies to a taxpayer with specified liability losses (SLLs). If a taxpayer has an NOL and SLLs, the lesser of the NOL or the SLL is carried back 10 years.

An SLL relates to product liability costs and liabilities under a Federal or state law. Qualifying product liability costs are amounts deductible under Sec. 162 or 165, attributed to (1) product liability or (2) expenses incurred in the investigation or settlement of (or in opposition to) claims against the taxpayer on account of product liability. Federal or state liabilities qualify if (1) they are the specific five types of costs provided for in Sec. 172(f), (2) the act (or failure to act) that created the liability arose more than three years before the beginning of the NOL tax year and (3) the taxpayer is on the accrual method. The five specified liabilities are (1) reclamation of land, (2) decommissioning of a nuclear power plant, (3) dismantlement of a drilling platform, (4) remediation of environmental contamination or (5) payment under any worker compensation act. A taxpayer may elect to forgo the 10-year carryback period and use one of the other carryback periods, by affirmatively electing to forgo the 10-year carryback on a timely filed (including extensions) return for the NOL tax year.

If a taxpayer elects to forgo each of the carryback periods for which it qualifies, it may then carry forward the NOL for 20 tax years following the tax loss year. Note: It is critical that a separate election be made for each applicable carryback that the taxpayer wishes to forgo.

AMTNOLS

Under Sec. 56(d), alternative minimum tax NOLs (AMTNOLs) follow the treatment of regular NOLs. Therefore, if a taxpayer elects to forgo an applicable NOL carryback period for regular tax purposes, it also has elected to forgo such period for AMTNOL purposes. Alternatively, if a taxpayer does not elect out of an applicable NOL carryback period, it also must carry the AMTNOL back to the earliest tax year available in the carryback period.

Generally, AMTNOL use is limited to 90% of alternative minimum taxable income (AMTI), determined without regard to the AMTNOL deduction. However, the Act temporarily suspended the 90% AMTI limit for AMTNOLs generated in tax years ending in 2001 and 2002 that were carried back, and for those carried forward to tax years ending in 2001 and 2002. Therefore, there is a limited amount of time to use AMTNOLs to the extent of 100% of AMTI.

From L. Michelle Carlone, CPA, Washington, DC