Question

Explain under what circumstances a net operating loss of a partnership can be carried over and applied against income of a partner even after the 20-year carryover period provided for net operating loss carryovers has expired.

Answer 1

When a business reports operating expenses on its tax return that exceed its revenues, a net operating loss (NOL) has been created. An NOL can be used in some other tax reporting period as an offset to taxable income, which reduces the tax liability of the reporting entity. The basic rules for using an NOL are:

Under U.S. Federal income tax law, a net operating loss (NOL) occurs when certain tax-deductible expenses exceed taxable revenues for a taxable year.^[1] If a taxpayer is taxed during profitable periods without receiving any tax relief (e.g. a refund) during periods of NOLs, an unbalanced tax burden results.^[2] Consequently, in some situations, Congress allows taxpayers to use the losses in one year to offset the profits of other years.

1. Carry the amount back to the preceding two tax years and apply it against any taxable income, which can generate an immediate tax rebate. You can waive this action and instead proceed directly to the next step; if so, attach a statement to your tax return in the year in which the NOL was generated, documenting the waiver.

2. Carry the amount forward for the next 20 years and apply it against any taxable income, which reduces the amount of taxable income in those years.

3. After 20 years, any remaining NOL is cancelled.

It makes financial sense to apply the NOL against the earliest periods possible, since the time value of money concept dictates that the tax savings in these periods is more valuable than for any tax savings in later periods.

If NOLs are being generated in multiple years, use them in the order the NOLs were generated. This means that the earliest NOL should be completely drawn down before the next oldest NOL is accessed. This approach reduces the risk that an NOL will be terminated by the 20-year rule noted earlier.

The Section 382 Limitation

Since a net operating loss can be used to directly reduce the amount of taxable income, it can be considered a valuable asset. If a business acquires an entity that has an NOL, the reason for doing so should not be the presence of the NOL, for the Internal Revenue Service has placed a restriction on the use of an acquired NOL. The restriction is documented in section 382 of the Internal Revenue Code. Section 382 states that:

1. If there is at least a 50% ownership change in a business that has an NOL,

2. The acquirer can only use that portion of the NOL in each successive year that is based on the long-term tax-exempt bond rate multiplied by the stock of the acquired entity.

Despite this restriction, the presence of a large NOL can impact the price paid by an acquirer to the shareholders of an acquiree, since it impacts the net-of-tax cash flows that an acquirer will derive from the ongoing results of an acquiree.

Section 382 can create a significant problem when a business has large unused NOLs on its books. In these situations, a business that is attempting to gain additional investor funding should avoid any equity offering that could give the appearance of a change in ownership. For example, it could avoid triggering section 382 by issuing non-voting preferred stock that cannot be converted into common stock.