Whole Ball of Tax 2003

NET OPERATING LOSSES: SOLE PROPRIETORS FACING LOSSES
STAND TO GAIN TAX REFUNDS OR REDUCE FUTURE TAX OBLIGATIONS

(RIVERWOODS, ILL., January 2003) – While many headlines have focused on the layoffs and downsizing in corporate America, the self-employed have had their share of battles during the past year. If the economy or other factors caused these individuals’ 2002 business losses to exceed their income, they could be facing the confusing world of net operating loss (NOL) at tax time, according to CCH INCORPORATED (CCH), a leading provider of tax law information and software and publisher of CCH Business Owner’s Toolkit™ Tax Guide 2003.

But taking the time to understand what NOL is and how to apply it can have its rewards.

"If you qualify, you could significantly reduce your tax obligation – translating into a possible retroactive refund for taxes paid in earlier years or potentially resulting in future tax savings," said Paul Gada, JD, LLM, CCH small business analyst and editor of CCH Business Owner’s Toolkit Tax Guide 2003.

Following, CCH provides an overview of how the NOL works for sole proprietors. However, calculating an NOL can be tricky and it’s suggested that individuals consult a professional to help ensure they handle NOLs correctly.

The general income tax rule is that your taxable income is determined on the basis of your current year's events. However, NOLs are an exception to the rule, as they allow a sole proprietor to offset one year’s losses against another year’s income. So, if your business loss exceeds your total income for the year, any unused portion of the loss – the NOL – can be used to offset income and reduce taxes in another year.

There are restrictions on where the losses can originate. Generally, net losses from a trade or business are the most common losses applied to NOLs. However, casualty losses and losses resulting from employee business expenses also can be included in the computation.

If you’re working on your 2002 tax return and you find you have a negative number when you arrive at Line 39 of Form 1040 – the line showing your taxable income after all itemized deductions – you may have an NOL that could be carried over to other years. If so, 2002 will be called your "NOL year."

The next step is to determine whether or not you have a deductible NOL. This can become complicated, because a number of items that are ordinarily deductible on your tax return cannot be deducted for purposes of determining whether you actually have an NOL.

The deductibles excluded when calculating NOL are: personal exemptions for yourself, spouse and dependents; net capital losses, which are subject to different carryover rules; nonbusiness losses; NOL deductions from other years; and nonbusiness deductions such as alimony, medical deductions, charitable deductions, real estate tax on your residence, deductible IRA contributions or the standard deduction if you don't itemize.

Once you have omitted these from your computation, if you still have a loss, it’s likely an NOL.

Once you’ve determined the amount of the NOL in your sole proprietorship business, you need to decide whether to carry the loss backward and claim a retroactive refund or carry it forward.

Historically, the carryback period for NOLs was two years (or three years, in the case of a casualty loss) before the year of the loss. However, the Job Creation and Worker Assistance Act of 2002 temporarily extends the carry back period to five years for losses arising in tax years 2001 and 2002. Unless you elected out of this special treatment by October 31, 2002, you are required to use the five-year carryback for NOLs.

The NOL is used to offset the taxable income of those previous years, for the earliest year first. For example, if 2002 is your NOL year, and you did not opt out of the extended carryback, you’d carry your loss back to 1997. Any loss remaining would be moved to 1998, then 1999, etc.

Then, any unused portion of the loss may be carried forward for up to 20 years after the NOL year. If the entire loss isn't used up within the permitted period, no further net operating loss carryover is permitted.

Because carrying back a net operating loss to a prior tax year can result in a quick tax refund, it will usually be unwise to pass up the carryback period, unless you’re quite sure that your business will be in a higher tax bracket in the future, according to Gada.

To carry a loss back, you may either file a Form 1045, Application for Tentative Refund, within one year of the end of the NOL year, or you can file an amended tax return for the year in question within three years of the NOL year.

Whichever form you use to claim the carryback, you must use Schedule A of Form 1045 to compute the amount of the NOL.

When you carry back an NOL, it’s not just a matter of computing your 2002 income and losses to determine your NOL. You also must refigure your tax for the carryback year by recomputing your adjusted gross income (AGI) for that year. Then you must recompute any items that were limited by your AGI amount, such as the special allowance for passive activities, taxable social security benefits, IRA deductions and excludable savings bond interest.

Next, refigure your taxable income, if needed, to reflect the change in your itemized deductions for medical expenses, casualty losses, miscellaneous itemized deductions, and the overall limit on itemized deductions and phaseout of personal exemptions for higher-income taxpayers. You will also have to refigure your AMT, if it applied to you. However, do not refigure your self-employment tax for the carryback year.

If you don’t use up your entire NOL in the first carryback year, you may have a carryover to the next year, and you'll need to use Schedule B of Form 1045 to compute the amount.

It’s a lot simpler if you decide to carry forward an NOL. In this instance, you would just need to list your NOL figure as a negative amount on the "other income" line of your Form 1040 and attach a statement showing how you computed the NOL and assert that you are electing to forgo the carryback period under Section 172(b)(3) of the Internal Revenue Code.

CCH Business Owner’s Toolkit Tax Guide 2003 is available in bookstores nationwide, by phone at 800-248-3248 or online on the CCH Business Owner’s Toolkit site (www.toolkit.cch.com). The online site also offers additional information and software tools to help you start, run and grow your home office or small business, including instant access to federal and state information, calculations and forms.

About CCH INCORPORATED

CCH INCORPORATED, headquartered in Riverwoods, Ill., was founded in 1913 and has served four generations of business professionals and their clients. The company annually produces more than 700 electronic and print products for the tax, legal, securities, human resources, health care and small business markets. CCH is a wholly owned subsidiary of Wolters Kluwer North America. The CCH web site can be accessed at cch.com. The CCH tax and accounting destination site can be accessed at tax.cchgroup.com.

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