The things we take for granted these days. If you are younger than me, you may not realize it but there was a significant change that happened in the 1990s.
Personal computers were just starting to actually be useful in the workplace. The ability to type and use a 10-day calculator were sought after job skills.
Most computers were not connected to the internet or even to other computers. Most internet connections were dial-up and it was not unusual to have to unplug your phone or fax machine from the phone line to be able to access the internet.
Files were saved on floppy drives by and large. Large floppies, small floppies, to CDs, to thumb drives by the end of the 1990s. The most reliable storage was hard copy. Printers that pulled green bar paper from large boxes was the norm in business accounting departments. Everyone else used small dot matrix printers.
The workforce started using basic word processing and spreadsheets. Windows 3.1 was king. Computer file types came and went. From the Lotus to Word Perfect files (okay, yes, some people may still use these). Since computer accounting software as we know it wasn’t really around, records were kept in proprietary programs with basic user interfaces (they may have even been written in the BASIC programming language). These programs could do basic computations, but that is about it. Other records that are commonplace today were simply not created in the first place back then.
This was the 1990s. Given this history, here is the question: Can you really fault a taxpayer for not being able to produce records in 2021 that would have been created in the early 1990s? Let’s ignore the ups and downs from the 1990s until now (including all the fires, floods, hurricanes, etc.). Just looking at the technological limitations in the 1990s, can we impose a recordkeeping standard today, in 2021, for records that would have been created and somehow stored in the 1990s?
This is similar to the question of whether one has to keep records for 40 years to substantiate a research tax credit.
The court addresses this in Martin v. Commissioner, T.C. Memo. 2021-35, a case decided in 2021 involving a net operating loss carryforward from the 1990s.
Facts & Procedural History
The taxpayer-husband operated a car racing venture in the 1990s. It produced a loss of $1.7 million. The taxpayers filed for bankruptcy in 1997 due to the loss.
For income tax purposes, the loss is carried forward as a net operating loss (“NOL”). The loss carryforwards were reported on the tax returns each year.
The taxpayer was audited by the IRS and litigated various tax issues for several years. Those audits and tax litigation were settled with the IRS. The IRS did not challenge the NOL carryforwards.
Then, for the 2009 and 2010 tax years, the IRS audited the taxpayer’s returns and challenged the NOL carryfowards for the first time.
This court opinion was the result. It was issued in 2021–more than twenty years after the NOLs at issue.
About Net Operating Losses
As the phrase implies, a “net operating loss” involves a loss. The loss generally has to be characterized as an “ordinary” loss. This usually means that the loss is related to a business. The term “net” signifies that the loss exceeds the other items of income reported on the taxpayer’s tax return in the current tax year.
Our tax laws say that unused NOLs are carried to other tax periods. Congress continues to change the NOL carryover rules. The NOL carryback period has been three years, five years, and no years. Once carried back and used to offset income in the prior years, the NOL then carries forward to offset income in future years. The carryforward period has changed over time, 15 and 20 years, and, recently, the amount of the loss available in any one year is now limited to 80% of income.
Let’s take the longest period–five years back, twenty years forward. That’s 25 years. The IRS usually doesn’t audit a tax return immediately. So let’s add two more years to the current year. The administrative appeal and eventual tax litigation could add another five years. So for any one year in which the taxpayer has an NOL, they might have to keep records for the loss for 32 years.
Net operating losses are reported on income tax returns. Form 1045 is used for tentative refunds. Even if one does not apply for a tentative refund, one can use Schedule B to calculate the NOL carryovers. The IRS often asks for this schedule when it is processing tax returns that have NOLs. The tax return software may also generate a statement that has similar information.
IRS auditors will often explain that tax returns alone are not sufficient evidence of the loss. Thus, one has to produce the underlying records. In theory, this could include proving up all of the income and expenses on the prior year’s return, the carryback year returns, and then the carryforward returns. This means that one NOL could require the taxpayer to keep every record for every item of income or expense that they report on their tax returns.
That is the standard the court appears to adopt in this case:
The minimum showing that they must make is as follows:
• they had an NOL for at least one tax year before 2009;
• they elected to waive a carryback of that NOL, or if not, that the NOL could not be fully applied against the income of the three years immediately preceding the tax year of the NOL;
• the NOL could not be applied against income for the tax years immediately following the tax year of the NOL; and
• both 2009 and 2010 are no more than fifteen years after the tax years of the NOLs they want applied.
The court does not stop there. If the taxpayers who incurred a NOL filed bankruptcy, they are held to an even higher standard:
The Martins’ bankruptcy proceedings could also affect the viability of their NOLs, because when someone files a bankruptcy petition, a bankruptcy estate springs to life and takes over his interests in property, which includes certain tax benefits such as NOLs. See 11 U.S.C. sec. 541 (2000). And NOLs might not come out of bankruptcy untouched—a taxpayer who files for bankruptcy may elect to terminate his tax year after he files his bankruptcy petition. Sec. 1398(d)(2). If so, the bankruptcy estate gets to use any existing NOLs to offset income earned during the debtor’s own pre-petition tax year. See sec. 1398(d)(2), (i); Kahle v. Commissioner, T.C. Memo. 1997-91, 1997 WL 71701, at *3. And that’s not all— any amount of debt that is forgiven by the discharge is excluded from a taxpayer’s income, sec. 108(a)(1)(A), but reduces his NOL, sec. 108(b)(3).
The court concluded that the taxpayer was not entitled to the NOL carryforward.
Prior Year Audits & Litigation
The court also addressed the taxpayer’s argument that the IRS was precluded from changing the NOL carryforwards given the prior audits and litigation. It would seem that the IRS has acquiesced in the NOL carry forward as it did not adjust the NOL carry forward in the prior years.
The court denied this type of argument in other cases. It does so by saying that each tax year stands on its own: “The key point is that each tax year stands on its own, with each year being the origin of new liability and a separate cause of action.”
What isn’t addressed in the court case is what was not brought up about the prior year’s audits. The IRS may have assumed the NOL carryforwards would not ever be used. This would be true if the taxpayers were not earning much income and were retired and perceived as not being likely to earn much income in the future. The IRS may have passed on examining the NOLs in those years based on this perception.
Moreover, the IRS may have chosen not to audit other tax issues in the prior years due to the NOL carryforwards. From the IRS auditor’s perspective, does it matter if they disallow a $20K tax deduction in one year if the taxpayers have a $1.7 million NOL? The NOL carryforward may have provided cover for prior-year tax issues. This audit protection can be valuable for taxpayers–especially if the taxpayer has some other large transaction that produced a loss during the year that they do not want the IRS adjusting. Taxpayers in this position should take great care to document their NOL carryforwards.
This case shows the risk taxpayers face when using an older NOL. Just because the NOL is allowed by our tax laws does not mean that the loss will be allowed. As a general rule, in most cases, if the IRS questions the NOL, the taxpayer will not be allowed the deduction. Care should be taken to document NOLs in the year the NOLs are generated. This is especially true for those who are using NOL carryforwards as cover for other current-year tax exposure. If the taxpayer is audited by the IRS for any one year, when possible, the taxpayer should seek out a closing agreement to lock in their NOL carryforwards.
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