US Tax Court Dictates Demonstrating Continuation of Net Business Loss Commitment
The United States tax system necessitates individuals to disclose their income and expenses annually (for instance, a year based on the calendar). This requirement can sometimes lead to financial irregularities due to taxpayers incurring losses in certain years but profits in others. For example, an individual with a business loss of $100,000 in 2023 and business income of $100,000 in 2024 would have a zero net balance if both years are combined. Should this taxpayer be obligated to pay income tax on the $100,000 earnings in 2024 merely because they were reported in a separate tax year?
Section 172 of the Code offers a rational solution. Under this provision, taxpayers can claim a net operating loss deduction (NOL), which in our scenario, helps lower the 2024 income.
However, there exists a notable disparity between filing for an NOL carryover on a tax return and proving entitlement to an NOL carryover when the IRS disputes the deduction. In light of three recent U.S. Tax Court decisions, all of which upheld the IRS's denial of the contested NOL carryovers, taxpayers should be aware of the stringent substantiation rules connected with validating NOL carryovers.
Net Operating Losses
Section 172 of the Code allows taxpayers to claim an NOL. Essentially, the size of the deduction is equal to the taxpayer's permissible expenses for the tax year minus their gross income for the same period, subject to adjustments. Traditionally, taxpayers could carryback NOLs to preceding tax returns, but the Tax Cuts and Jobs Act of 2017 revised the NOL rules to allow only carryovers.
Recent Tax Court Decisions
In late 2024, the U.S. Tax Court handed down three judgments concerning NOL carryovers. See Shaut v. Comm’r, T.C. Memo. 2024-103; Aboui v. Comm’r, T.C. Memo. 2024-106; Greenblatt v. Comm’r, T.C. Memo. 2024-109. In every case, the court reached the conclusion that the taxpayers had inadequately provided evidence to support the claimed NOL carryovers. Moreover, in each of these decisions, the U.S. Tax Court emphasized that prior year federal income tax returns (those claiming the NOLs) were insufficient by law to substantiate the taxpayers' entitlement to the NOL carryovers.
The Tax Lesson
If the IRS challenges an NOL carryover, taxpayers must present:
- Proof of the existence of an NOL.
- The correct amount of the carryover.
The safest approach to meet both these requirements is to preserve copies of the tax returns (those claiming the NOLs) along with all documentation supporting each relevant line item on the return (such as bank statements, receipts, invoices, etc.).
Taxpayers often encounter difficulties due to the length of time they must retain these records. Generally, the IRS has three years following the filing date to make additional income tax assessments. However, the NOL carryover rules grant the IRS some leeway by permitting it to challenge the size of a prior-year NOL deduction (even if outside the 3-year period) due to the fact that this deduction forms the basis of the NOL carryover.
Example:
John submits a 2018 tax return reporting an NOL of $100,000. John carries the NOL forward until it is fully utilized in 2027. If the IRS examines John's 2027 tax return, the agency can mandate John to provide supporting documentation for his 2018 claim to an NOL of $100,000. This is true despite the general three-year statute of limitations period.
Therefore, taxpayers who declare NOL carryovers should ensure that they maintain all relevant documentary evidence for the NOL returns. As shown in the above example, taxpayers may need to preserve these records for an extended period beyond the general three-year statute of limitations period.
In the context of tax disputes, it's important for taxpayers to be aware that while Section 172 of the Code allows for a net operating loss (NOL) deduction, proving entitlement to an NOL carryover in a tax court can be challenging. For instance, the U.S. Tax Court recently denied NOL carryovers in three cases due to insufficient evidence, emphasizing that prior year federal income tax returns alone are not sufficient to substantiate the taxpayers' entitlement to the carryovers (nol carryover, tax court, nol).
Furthermore, if a taxpayer's NOL carryover is challenged by the IRS, it is crucial to present proof of the existence of the NOL and the correct amount of the carryover. This usually involves preserving copies of the tax returns claiming the NOL and all supporting documentation for each relevant line item (nol carryover, prove entitlement). Taxpayers should be mindful that the IRS can challenge the size of a prior-year NOL deduction, even outside the general three-year statute of limitations period, due to its connection to the NOL carryover (nol carryover, IRS challenge, statute of limitations).
