Thursday, March 19, 2020
In the event that a farmer or rancher is confronted with the situation where expenses exceed income from the business, an operating loss may result. Losses incurred in the operation of farms and ranches as business enterprises as well as losses resulting from transactions entered into for profit are deductible from gross income. A net operating loss (NOL) may be claimed as a deduction for individuals and is entered as a negative figure on Form 1040.
Special rules apply to farm NOLs. Today’s post examines the proper way to handle a farm NOL and also discusses the changes to NOLs contained in the recently enacted Tax Cuts and Jobs Act (TCJA).
Farm NOLs – The Basics
Carryback rule. Until the TCJA changes, a farm NOL could be carried back five years or, by making in irrevocable election, a farmer could forego the five-year carryback and carry the loss back two years (or three years for a loss attributable to a federally declared disaster). I.R.C. §§172(b)(1)(F) and (h). An election to waive the five-year carryback resulted in a 2-year carryback. A “farming NOL” is defined as a the lesser of the NOL applicable for the tax year considering only income and deductions attributable to the farming business, or the NOL for the tax year.
Those were the rules in place through 2017. A beneficial aspect of the loss carryback rule is that a loss that is carried back to a prior year will offset the income in the highest income tax bracket first, and then the next highest, etc., until it is used up. Determining whether a loss should be carried back two years instead of five depended on the farmer’s level of income in those carryback years and the applicable tax bracket.
Another beneficial rule can apply when an NOL is carried back to a prior year. Because two years back (as opposed to five years under pre-TCJA rules) involves an open tax year, any I.R.C. §179 election that has been made can be revoked if the loss carry back eliminates the need (from a tax standpoint) for the election. By revoking the I.R.C. §179 election, the taxpayer will get the income tax basis back (to the extent of the election) in the item(s) on which the I.R.C. §179 election was made. That will allow the taxpayer to claim future depreciation deductions. This is the case, at least, on the taxpayer’s federal return. Some states don’t “couple” with the federal I.R.C. §179 provision.
Under the pre-2018 rules, taxpayers could elect to forego an NOL carryback in favor of a carryforward (for 20 years). However, if a taxpayer elected not to carry a NOL back to offset income in prior years, the taxpayer was limited to carrying forward the NOL.
Impact of receiving farm subsidies. For tax years beginning before 2018, in which an individual taxpayer receives farm subsidies (essentially limited to CCC loans), farming losses were limited to the greater of $300,000 (married filing jointly) or the taxpayer’s total net farm income for the prior five taxable years.
Excess business loss. An excess business loss (EBL) for the taxable year is the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer (determined without regard to the limitation of the provision), over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount. The NOL carried over from other years may not be used in calculating the NOL for the year in question. In addition, capital losses may not exceed capital gains. Non-business capital losses may not exceed non-business capital gains, even though there may be an excess of business capital gains over business capital losses. In addition, no deduction may be claimed for a personal exemption or exemption for dependents, and non-business deductions (either itemized deductions or the zero-bracket amount) may not exceed non-business income. Deductions may be lost for the office in the home, IRA contribution and health insurance costs.
Post-2017 Tax Years
The TCJA made changes to how farmers can treat NOLs. For tax years beginning after 2017 and before 2026), a farm taxpayer is limited to carrying back up to $500,000 (MFJ) of NOLs. NOLs exceeding the threshold must be carried forward as part of the NOL carryover to the following year. For tax years beginning before 2018, farm losses and NOLs were unlimited unless the farmer received a loan from the CCC. In that case, as noted above, farm losses were limited to the greater of $300,000 or net profits over the immediately previous five years with any excess losses carried forward to the next year on Schedule F (or related Form).
Also, under the TCJA, for tax years beginning after December 31, 2017, NOLs can only offset 80 percent of taxable income (the former rule allowed a 100 percent offset). Technically, the NOL deduction is limited to the lesser of: (1) the aggregate of NOL carryforwards and carrybacks to the tax year, or (2) 80% of taxable income computed for the tax year without regard to the NOL deduction allowed for the tax year. I.R.C. §172(a).
Carryback issues. In addition, effective for tax years ending after December 31, 2017, NOLs can no longer be carried back five years (for farmers) or two years (for non-farmers). Instead, under the TCJA, farmer NOLs can only be carried back two years. Non-farmers cannot carryback NOLs. As noted, NOLs that are carried back can only offset 80 percent of taxable income. However, NOLs that are carried forward will not expire after 20 years (as they did under prior law). Similar to the carryback rule, NOLs that are carried forward can only offset 80 percent of taxable income.
An individual taxpayer claiming a tax refund from an NOL carryback has the option of filing either Form 1045 or Form 1040X. The IRS instructions can be helpful in determining the best approach.
When filing an NOL carryback refund claim Form 1045 or 1040X can be filed. IRS transcripts and statements of account to verify the amounts reported for previous years can be helpful when preparing either Form. The Form 1045 and 1040X instructions also contain detailed lists of attachments to be included with each Form. Also, on Schedule A, an NOL must be included with the carryback claim.
If the taxpayer has multiple carrybacks to a tax year, taxable income is reduced (without regard to the NOL deduction) in the carryback year in the order in which incurred starting with the earliest year. After deducting an NOL, the resulting taxable income is used to determine the deductibility of any remaining NOL. NOLs from years beginning before 2018 can offset 100% of taxable income (without regard to the NOL deduction) in the carryback year whereas NOLs from post-2017 years can only offset 80% of taxable income (without regard to the NOL deduction) in the carryback year.
Note: When figuring a refund claim for an NOL carryback year, the applicable law is the tax law in effect for the carryback year not the tax law in effect for the NOL year.
Once the amount of the NOL deduction after carryback has been determined for the carryback year, the AGI that results after applying the NOL deduction is then used to recompute income or deduction items that are based on, or limited to, a percentage of AGI,
Note: In the case of a partnership or S corporation, the NOL rules are applied at the partner or shareholder level. Each partner’s distributive share and each S corporation shareholder’s pro rata share of items of income, gain, deduction, or loss of the partnership or S corporation are taken into account in applying the limitation under the provision for the taxable year of the partner or S corporation shareholder.
Carryover of unused NOL carryback. The amount of unused NOL carryback available for carryover requires determination of the taxpayer’s modified taxable income for the carryback year. Modified taxable income for this purpose is defined as the taxpayer’s taxable income with certain modifications. See Treas. Reg. §1.172-5; IRS Pub. 536, Net Operating Losses (NOLS) for Individuals, Estates, and Trusts. Any items that are affected by the taxpayer’s revised AGI after making some of the modifications must be re-figured using that revised AGI. The calculation can be accomplished via Form 1045, Schedule B.
NOL carryover. Taxpayers carrying back a farming loss, must first carry the entire farming loss to the earliest carryback year. Any unused farming loss is then carried back to the next earliest carryback year, and so on. If the carryback period is waived or the loss is not fully utilized in the carryback period, the unused NOL is carried forward indefinitely until it is fully utilized. An unused NOL is the sum of: (1) any farming loss less the amount of the farming loss that is deemed to be carried back; (2) any nonfarm NOL; and (3) any EBL for the NOL year.
Note: Procedurally, the unused NOL is carried forward to the first tax year after the NOL year. Any NOL not utilized in that year is carried forward to the next year and so on until the NOL is fully utilized.
Marital status changes. Additional rules that apply if a taxpayer’s marital status is not the same for all years involved with a NOL carryback/carryforward. In that case, only the spouse who had the loss can claim the NOL deduction. Moreover, for years when the couple file jointly, an NOL deduction is limited to the income of the spouse to whom it belongs. Therefore, a taxpayer filing a 2020 joint return with their spouse who later divorces can only carryback an NOL from a future year to offset his/her share of the taxable income reported on the 2020 joint return. Additionally, the refund for a person filing an NOL carryback claim against a joint return with a former spouse may be subject to limitations.
On a joint return, the NOL carryback deduction is limited to the income of the spouse with the loss. Also, the refund for a divorced person claiming a NOL carryback against a joint return with a former spouse cannot be more than the taxpayer’s contribution to taxes paid on the joint return. The tax Code sets forth a step-by-step procedure to be used in calculating the portion of joint liability allocated to the taxpayer with the NOL carryback.
Change in filing status. Special rules also apply in calculating NOL carrybacks/carryforwards for couples who are married to each other throughout the subject NOL years, but who use a mix of MFJ and MFS filing statuses on returns in the carryback or carryforward years. A married couple who file jointly in the NOL year and the NOL carryback or carryover year, treat the NOL deduction as a joint NOL. If instead the couple file separately, then the spouse who sustained the loss takes the NOL deduction on their separate return.
When a married couple’s filing status differs between the NOL year and the NOL carryback or carryover year, special rules apply. If the couple filed separate returns in the NOL year but jointly in the carryback or carryforward year, then a separate NOL carryback/carryover is treated as a joint carryback/carryover to the carryback/carryover year. If the couple file jointly in the NOL year but separate returns in the carryback or carryforward year, then any joint NOL carryback/carryover is apportioned between the spouses based on the NOLs that would have resulted if the couple had filed separate returns in the NOL year.
Individual taxpayers report their NOL carryover as a negative figure on the “Other income” line of Schedule 1 (Form 1040) or Form 1040NR (line 21 for 2019). Estates and trusts include an NOL deduction on Form 1041, line 15b, for 2019.
For each NOL carryover, taxpayers should attach a statement to their tax return showing how the NOL deduction was figured as well as important facts about the NOL.
NOLs and Death
A NOL that has been carried forward is deductible on a decedent’s final income tax return. It cannot be carried over to a decedent’s estate. Also, an NOL of a decedent cannot be carried over to subsequent years by a surviving spouse.
Just because the farming business loses money doesn't mean that there isn't a tax benefit that can be taken advantage of to soften the blow. That's where the NOL rules come into play…and they get complex quickly.