Purpose: Provide guidance for examiners working cases involving net operating losses, net operating loss deductions, and excess business losses

Audience: LB&I and SB/SE personnel.

Policy Owner: SBSE HQ Director, Exam Quality and Technical Support

Program Owner: SBSE EQTS

Primary Stakeholders: LB&I and SB/SE personnel

Program Goals: To assist examiners working cases involving net operating losses (NOLs), net operating loss deductions (NOLDs), and/or excess business losses (EBLs) with relevant information

Due to numerous changes in tax law, it is important to know applicable law for the years that the NOL arose, the intervening years and the years to which the loss can be carried. For example, an NOL from a taxable year beginning in 2017 can generally be carried back 2 years, but can only be carried forward 20 years. An NOL from a taxable year beginning in 2021 can generally only be carried forward, but it can be carried forward indefinitely. An NOL from a taxable year beginning in 2018, 2019, and 2020 can generally be carried back 5 years, and carried forward indefinitely; but NOL deductions for years beginning after 2020 are subject to the 80% of taxable income limitation as discussed in IRM 4.11.11.2.1 if the NOL deduction is attributable to an NOL from a tax year beginning after 2017.

It is important to know the applicable law regarding the amount of the NOL that is absorbed in the intervening years. This is particularly important with individual returns that have varying modifications to the taxable income used to arrive at the amount absorbed.

It is important to note the exceptions to the general rules. For example, for tax year 2021, business losses that are attributable to farming or insurance other than life insurance are permitted to be carried back 2 years. For losses attributed to a farming business, the 80% taxable income limitation still applies. For insurance companies other than life insurance companies, the 80% taxable income limitation does not apply, but the carryforward period is limited to 20 years.

A taxpayer who has an overpayment of tax as a result of an NOL carryback can file a tentative refund application (also referred to as a TENT) or a restricted interest (RINT) claim for adjustment or refund with respect to the carryback year. IRM 21.5.9, Account Resolution, Carrybacks, provides details on carryback rules including the difference between a carryback claim filed using an amended return form and tentative carryback application using a Form 1045, Application for Tentative Refund for Individuals, Estates and Trusts, or Form 1139 Corporation Application for Tentative Refund, for corporations (other than S Corporations).

As noted in IRM 4.11.11.2.3, an Excess Business Loss is treated as an NOL carryover for subsequent years.

As noted in IRM 4.11.11.4, Examining Tax Returns Reporting Net Operating Losses, examiners adjusting returns that report a net operating loss are responsible for addressing the impact on other years.

Special ordering rules apply to carrybacks of NOLs, capital losses (corporations only), and certain nonrefundable credits.

Special rules apply to REITs, life insurance companies and carrybacks to years to which IRC 965 applies (IRC172(b)(1)(D)).

After a reorganization or other change in corporate ownership, the use of certain carryforwards may be limited or prohibited under IRC 382, Limitation on net operating loss carryforwards and certain built-in losses following ownership change or 26 CFR 1.1502-21(c) Limitations on net operating loss carryovers and carrybacks from separate return limitation years. See also IRM 4.11.11.10, Effects on Other Areas Including Ordering Rules. It includes other code sections that may have an impact on the amount of the NOLD.

It is important to ensure the NOLD receives the proper tax treatment because of the potential impact that the NOLDs may have on multiple year returns. A key element of the process is the correct determination of the loss year’s NOL and computation of the NOLD, both of which should be verified for accuracy as part of the examination process. For individuals, SB/SE examiners can use the RGS Special Application on the Virtual Library located Losses Book in the 1040 Knowledge Base. The chapter named Net Operating Losses contains the spreadsheets used to compute the NOL, the NOLD and the amount of the NOL carryover that is absorbed in the intervening years. These spreadsheets can be used as supporting schedules on the examination report.

In general, the NOL will be carried to the earliest possible year. Earlier NOLs are absorbed first. See special elections in IRM 4.11.11.12 below for exception. In general, NOLs are generated from the following sources:

NOL deductions may have an effect on the following areas depending on the year of the tax return. The list below is not all inclusive.

See IRM 21.5.9.5.10, Carryback Net Operating Loss for more details.

Examination of tax returns reporting net operating losses often involve a carryback for the amount of the NOLD. It is important to know if the carryback has been paid. If you are examining an unpaid claim (RINT), follow the procedures in IRM 4.10.11, Examination of Returns, Claims for Refund and Requests for Abatement. If you are examining a carryback year with a paid tentative refund (TENT), see IRM 4.10.8.14.3.3, Reports After a Tentative Refund or Credit.

Examiners adjusting returns that report a net operating loss are responsible for addressing the impact of the adjustment on any carryback(s) filed. To help ensure all actions taken by the taxpayer are considered during the examination, examiners should ask the taxpayer if the loss was carried back, and review IDRS at the beginning of the examination and again during the preparation of the proposed adjustments report for all eligible carryback years in search of category and/or transaction codes indicating the loss was carried back.

The SUMRY record of the taxpayer may show case controls on the carryback year(s):

The control base and history information section of the TXMODA record of the loss year may show:

When a tentative refund request has been filed, the IMFOL/BMFOL record of the carryback year may show:

When a restricted interest refund claim has been filed, the IMFOL/BMFOL record of the carryback year may show:

If the existence of a carryback is indicated as a result of the IDRS review, examiners should secure the relevant information from the taxpayer or the Correspondence Imaging System (CIS) and address the impact of the proposed loss-year adjustment(s) on any carryback refund(s) claimed or processed. CIS information may be secured through an AIMS/ERCS Coordinator. If the tentative refund/claim has not been processed but there are open case controls, see IRM 4.10.2.2.5, Other IRS Business Units Working with Taxpayer

In addition to the above forms, examiners should include in their workpapers a spreadsheet analysis covering the loss year and any carryover/carryback year(s) to which the loss is carried. The spreadsheet should begin with taxable income per return or as previously adjusted and conclude with the proposed deficiency or overassessment.

A workpaper or schedule should be prepared for charitable contribution carryovers and the alternative minimum tax net operating loss deduction.

Every case should have a complete summary of all carryback and carryover items. The following is a listing of items requiring a summary when they are applicable:

IRC 6676 calls for a civil penalty on erroneous claims for refund or credit unless it is shown that the claim has a reasonable cause.

See IRM 20.1.5.3.4, Carrybacks and Carryovers, for additional guidance on penalty applicability.

See IRM 20.1.5.18, IRC 6676, Erroneous Claim for Refund or Credit Penalty, for possible application of this penalty in NOL carryback or carryover adjustment situations.

The period of limitations on assessment in carryback years can be different from the general period of limitations on assessment. See IRC 6501, Assessment Statute of Limitations Controls, IRM 25.6.1.10.2.8.1, Net Operating Loss (NOL) Carryback or Capital Loss Carryback andIRM 4.10.11.5.1.2, Assessment Statute Expiration Date (ASED) - NOL Carrybacks.

IRC 6501(a) provides that a tax generally must be assessed within three years after the filing of the return. If a deficiency exists on a tax module that is not attributable to a carryback allowance (net operating loss carryback, capital loss carryback, credit carryback) on the same tax module, the statutory period of time to make the assessment is generally the later of the following:

IRC 6501(h) and IRC 6501(k) provide exceptions to this general rule with respect to NOL carrybacks. If a deficiency exists on a tax module that is attributable to a carryback allowance (net operating loss carryback, capital loss carryback, credit carryback), the statute for assessment of the deficiency generally is the later of the following:

Under IRC 6501(h), a deficiency in the gain year resulting from an NOL carryback may be assessed at any time before the assessment statute expiration date (ASED) of the loss year. However, IRC 6501(h) only extends the ASED for deficiencies attributable to the NOL carryback deduction and provides exceptions to this general rule with respect to NOL carrybacks. See IRM 25.6.23, Examination Process—Assessment Statute of Limitations Controls.

Under IRC 6501(k) if an NOL carryback results in a tentative carryback allowance per IRC 6411, the ASED for assessing the deficiency in the gain year is extended to include the applicable period in IRC 6501(h). If the ASED under IRC 6501(h) is still open to assess deficiencies in the gain year attributable to the carryback, the assessment period also is still open to assess a deficiency in the gain year that is unrelated to the carryback. The amount that may be assessed, however, is limited to the amount applied, credited, or refunded under IRC 6411, less any amount the Service may assess under IRC 6501(h).

Regular statute open in carryback year—If the regular statute of limitations under IRC 6501(a) has not yet expired for the carryback year, a decision should be made on Form 9984, Examiner's Activity Record, (and/or supporting workpapers) documenting as to whether the normal statute will be protected or the carryback statute will be controlling.

A deciding factor in determining whether to use an alpha statute or the original statute is if there are 180 days left on the statute. If there are more than 179 days left on the statute, in general, the examiner will use the original statute date. If there are fewer than 180 days left on the statute, the examiner will use the alpha statute described in IRM 25.6.23. If the normal statute will not be protected, the statute should be updated to AA if the carryback claim has not been paid, and BB if it has been paid, and the decision not to protect the normal statute documented on Form 895. See IRM Exhibit 25.6.23-3, Instructions for Updating the Statute on AIMS for additional requirements when updating the statute to an alpha code..

Adjustments can be made for the purpose of determining how much of a net operating loss may be carried over and deducted in a subsequent year. The authority for doing so is IRC 7602(a) which states, "For the purpose of ascertaining the correctness of any return, the Secretary is authorized to examine any books, papers, records, or other data which may be relevant or material to such inquiry."

Substantiation of the net operating loss deduction must satisfy IRC 6001. IRS can look at records as far back as is necessary in order to determine the correct amount of the NOLD being utilized in the current year and subsequent years. Copies of tax returns are not proof nor are accountants’ workpapers. In Owens v. Commissioner, T.C. Memo 2001-143, the Court concluded that "Although each of the returns for 1990, 1991, and 1992 shows a loss attributable to petitioners’ Schedule C business, petitioners failed to introduce any evidence establishing the loss claimed in each of those returns. The returns for 1990 through 1992 constitute nothing more than the position of petitioners that they had the respective losses claimed in those returns."

A carryover from a carryback year with barred items provides for the carryover of the correct taxable income. In essence, errors in a closed year are corrected for purposes of determining the taxable income of an open year.

The examiner should verify that the proper amounts and transaction codes are entered on Form 5344.

Item 12, Tax, Penalty, and Interest Adjustments—If a portion of the adjustment is due to a carryback multiple entries may be required in Block 12.

Item 44, NOL Carryforward Disallowed Amount—This item is used if all or part of an NOL carryforward is disallowed and the carryforward year return is not picked up for examination (return not due). See IRM 4.4.12, Examined Closings, Surveyed Claims, and Partial Assessments, specifically IRM 4.4.12.5.53, Item 44: NOL C/F Disallowed Amount, and IRM Exhibit 4.4.12-1, Item 44 and 45, NOL Information Examples.

Item 45, NOL Indicator—This item is entered whenever an NOL return (taxable income line is less than zero) was audited. See IRM 4.4.12.5.54.3, Item 45: NOL Indicator for Non-NOL Years Offset by Carryover, and IRM Exhibit 4.4.12-1.

Form 5346, Examination Information Report, is used by examiners when it is determined that a related tax return should be considered for examination. When examination adjustments are made that reduce or eliminate the amount of NOL being carried over to subsequent years not yet filed, Form 5346 should be completed by the examiner and submitted to planning and special programs (PSP). This is important since it safeguards against the possibility of taxpayers claiming unallowable losses in future unfiled years.

There is a requirement to offset all taxable income in a carryback year before applying the carryback to other years including years subsequent to the loss year. IRC 172(b)(2) states that the entire amount of the NOL for any taxable year (referred to in this section as the 'loss year') shall be carried to the earliest of the taxable years to which (by reason of IRC 172(b)(1)) such loss may be carried. The portion of such loss which shall be carried to each of the other taxable years shall be any excess of the amount of such loss over the sum of the taxable income for each of the prior taxable years to which such loss may be carried.

An NOL carryback may necessitate a recomputation of tax liability for the carryback year. Typical deductions that may require recomputation include itemized deductions based on adjusted gross income (AGI). Any credits that are based on or limited by the amount of tax must also be refigured.

The credit ordering rules can be complicated. The examiner must establish the correct taxable income before applying any credits or capital loss carrybacks, etc. There would have to be regular tax before application of any credits. For example, if the current year return has no regular tax (before credits), there would be a carryback of the credit to the taxable year preceding the unused credit year and a carryover of the credit with a 20 year carryover period for general business credits. See IRC 39(a)(1) and IRM 21.5.9.5.12.1, Carryback Credits Ordering Rule.

Never recompute charitable contributions when there is an NOL carryback. The amount of charitable contribution deduction is impacted by an NOL carryover only. Regarding the interaction between NOLs and charitable contributions, refer to IRC 172(d), IRC 170(d), Treas. Reg. 1.170A-10 (for individuals), and Treas. Reg. 1.170A-11 (for corporations).

See Notice 89-3, 1989-1 CB 623, IRC 170(d)(1)(B), and Treas. Reg. 1.170A-10 regarding the following:

As noted in IRM 4.11.11.2 a refund can be requested using a Form 1045, Application for Tentative Refund for Individuals, Estates and Trusts, or Form 1139, Corporation Application for Tentative Refund, for corporations (other than S Corporations).

A Form 1045 or Form 1139 should not be filed with the examiner. The form should be sent directly to the service center per the instructions to avoid delays. As noted in (4) below, action must be taken on a timely basis from the date of receipt. The examiner can request a copy.

If a taxpayer's tax liability is reduced due to an NOL carryback, the taxpayer may request a refund or credit or a tentative refund. Upon receipt of any claim or tentative carryback, the examiner should verify and update the statute of limitations with consideration of the source year return statute and the potential for use of alpha statutes under IRM 25.6.23. Also, the examiners should request a transcript of account before preparing the examination report to verify the correct statute and determine if the refund has already been made.

A request for refund or credit for an NOL carryback can be accomplished by a taxpayer filing Form 1040X (individuals) or Form 1120X (C Corporation). See IRC 6511(a) and IRM 4.10.11, Examination of Returns, Claims for Refund and Requests for Abatement.

Below are some important things to keep in mind :

Due to the TCJA and the CARES Act, effective for tax years beginning 2021, most taxpayers do not have the option to carry a loss back. Exceptions to this rule are losses related to farming businesses and insurance companies other than life insurance. Such taxpayers are eligible to carry the NOL incurred relating to such losses back two years. Prior to the changes for most taxpayers, and currently for taxpayers that meet the exception, a taxpayer can elect to forgo the carryback period. See IRC 172(b)(3). The election must be made by the due date (including extensions) for filing the return for the loss year, unless an exception applies. Taxpayers usually attach a statement to the filed tax return notifying the Service that the taxpayer has elected to forgo the carryback period.

When a taxpayer claims an NOL during audit that was not previously claimed, the taxpayer’s option to forgo carrying the NOL back will most likely be unavailable. The IRC 172(b)(3) election to waive carryback must be made by the due date, including extensions, for filing the taxpayer’s return for the taxable year in which the NOL arises.

Due to the CARES Act, special rules apply to elections for taxable years beginning in 2018 and 2019:

The timing for elections for prior years as well as the number of years that the NOL could be carried back depend on the provisions effective during those years. For example, former IRC 172(b)(1)(H) discussed the rules for carryback of 2008 or 2009 NOLs.

With respect to taxpayers eligible to carryback, if the IRC 172(b)(3) election is not timely made, the NOL must generally be carried back 2 years per IRC 172(b)(1)(A)(i). However, for tax years beginning after December 31, 2020, most taxpayers can only carry their NOLs forward.

Once the election is made to forgo the carryback, it is generally irrevocable. An exception to this is when new legislation specifically allows taxpayers to revoke the election, such as the provision in the American Recovery and Reinvestment Act (ARRA) 2009, section 1211, which allowed taxpayers until April 17, 2009, to revoke a prior election to waive the carryback period or as discussed in (4) above regarding the CARES Act. See IRM 21.5.9.5.10.9.2, Revocation of an Election to Waive the Carryback Period for Farming Losses - CTRA of 2020.

If a taxpayer did not make the election to forgo the carryback period and just carried the NOL forward, the examiner should disallow such carryover. However, if the NOL year statute is still open, the loss can still be carried back by the taxpayer via Form 1120X or Form 1040X or by the IRS if the examination includes the carryback year(s).

If the statute of limitations on refunds has expired for the NOL year, a taxpayer cannot get a refund for carrying back the NOL. However, the taxpayer must still offset the NOL by the prior years’ modified taxable income in compliance with IRC 172(b)(2). Only the excess of the NOL over the modified taxable income in those carryback years can be carried forward and utilized.

Any corporation can ask for Treas. Reg.1.6164-1 Extension of Time for Payment of Taxes by Corporations Expecting Carrybacks relief. Prior to TCJA and CARES, under 172, a loss must generally be carried back. Only if an election is made under IRC 172(b)(3) is a taxpayer permitted to carry forward without first carrying back. See Farmer v. Commissioner, TC Memo 1998-327 in which the Tax Court disallowed a claimed NOL carryover where the taxpayer did not first carryback the NOL and did not file an election to forego the carryback period under IRC 172(b)(3). The Tax Court’s analysis relied entirely upon the statute, IRC 172.

An election to forgo the carryback period applies to both the regular tax NOL and the AMT NOL. See Rev. Rul. 87-44, 1987-1 CB. 3, and Plumb v. Commissioner, 97 T.C. 632, 638, 1991.

NOLs incurred in years when the taxpayers were not married to each other can only be applied against the separate income of the spouse who generated the loss. In other words, an NOL sustained by one spouse before marriage cannot be carried over to offset the other spouse’s income on a joint return; it can only be applied against the income of the spouse who incurred the loss. See Calvin v. United States, 354 F.2d 202 (10th Cir. 1965).

Losses incurred and carried back by a spouse after a divorce or the death of a spouse can only be applied against the separate income of the spouse who incurred the loss even if the taxpayers filed joint returns in the year to which the loss is carried. See Zeeman v. United States, 395 F.2d 861 (2nd Cir. 1968).

A spouse who did not incur the loss may claim a refund if his or her share of the joint tax was reduced by the other spouse's NOL.

When the amount of an NOLD is material, it constitutes a large, unusual, or questionable (LUQ) item under the auditing standards. This is especially true if the NOLD was generated from the same business that gave rise to an adjustment for unreported taxable income in the current year under examination.

It is important to determine the correct taxable income in the source year as well as all of the earlier years that gave rise to the NOL carryforward (NOLD). The Service may redetermine correct taxable income in a closed year in order to ascertain either the amount of an NOL, or the amount of an NOL that is absorbed in the closed year for purposes of determining the correct net operating loss deduction for an open year. The authority for doing so is IRC 7602(a), which states, "For the purpose of ascertaining the correctness of any return, …the Secretary is authorized to examine any books, papers, records, or other data which may be relevant or material to such inquiry."

The examiner will determine the amount of NOLD allowed upon examination of the facts and records provided. The taxpayer is required to maintain such records as will allow the examiner to verify the accuracy of the deduction. If the taxpayer declines to produce the records or the records are unavailable, the examiner may disallow the entire NOLD for lack of substantiation.

Copies of tax returns are not proof, nor are accountant's workpapers or testimony that is general, vague and unsupported. There are numerous court cases that address the requirement to provide adequate substantiation of the loss claimed in the NOL year when the year of the NOLD is under examination. See, for example, Owens v. Commissioner, T.C. Memo 2001-143 (2001).

Example 1

Example 2

When an NOL is carried forward, modified taxable income may need to be computed in order to determine the amount of the NOL absorbed in the intervening year and the amount that can be carried forward to the following year.

See IRM 4.36.1 through IRM 4.36.5 for Joint Committee procedures for IRC 6405 refunds of taxes in excess of the current statutory threshold of $2 million ($5 million for corporations, other than S Corporations).

Rentals or businesses in which the taxpayer does not materially participate are examples of passive activities.

IRC 469(b) provides that a PAL generally cannot be carried back. It can only be carried forward. A PAL is not an NOL subject to carryback. A PAL does not become an NOL until it is no longer subject to the IRC 469 limitations. For example, a loss will become an NOL in the following instances:

On disposition of a passive activity, the Service can make adjustments to prior year suspended PALs from this activity that were incorrectly computed in closed tax years. Similarly, if there is an NOL, credit, or capital loss carryover, the Service can adjust suspended passive losses that were incorrectly computed in barred years.

IRC 6501 provides the general rule regarding the period of limitations for assessing tax. Rev. Rul. 81-88 refers to 26 CFR 301.6511(d)-2(a)(3) that states that if a claim is for an overpayment based both on an NOL carryback and on other items, some of which are barred by a statute of limitations, the computation of any overpayment for the carryback year begins first by calculating the tax attributable to allowable items not barred by a statute of limitations. However, if the claim relates to barred items that decrease taxable income, the first adjustment is the net operating loss carryback.

Thus, PAL carryovers that were incorrectly computed in prior years but impact the current year tax can be adjusted. On a fully taxable disposition of a passive activity to an unrelated party, IRC 469(g) allows PAL suspended losses to be triggered. The triggering of these losses can create an NOL that can be carried back. On any NOL carryback, IRC 6501(h) indicates that the statute on the carryback years is governed by the loss year. Furthermore, in the carryback years, the Service can disallow unrelated deductions up to the refund amount generated by the loss carryback. Thus, unrelated passive losses could also be adjusted.

NOL carrybacks or carryovers and other deductions in a tax period for which an amount of restitution was ordered and assessed pursuant to IRC 6201(a)(4)(A) reduce a taxpayer's civil tax liability for that tax period.

Such deductions, however, do not in any way affect the Service's assessment or collection of the amount of restitution itself. The Service must collect the entire amount ordered as restitution under IRC 6201(a)(4)(A) regardless of whether the civil tax liability for the same period is less than the amount ordered as restitution under IRC 6201(a)(4)(A).

Taxpayers who experienced losses in certain investment arrangements discovered to be criminally fraudulent (commonly referred to as"Ponzi " schemes) may be entitled to claim an investment theft loss, which is an ordinary loss. Rev. Rul. 2009-9 describes the proper income tax treatment for losses resulting from these Ponzi schemes. Additionally, Rev. Proc. 2009-20 provides an optional "safe harbor" under which qualified investors may treat a loss as a theft deduction if the investor entered into a specified fraudulent arrangement discussed below, and the other requirements of Rev. Proc. 2009-20, as modified by Rev. Proc. 2011-58, are satisfied. Refer to IRM 21.6.4.4.1.7, Casualty and Theft Losses. An investment theft loss may result in an NOL. Special rules have applied to NOLs relating to an investment theft loss. Refer to IRM 21.6.4.4.1.7, Casualty and Theft, and American Recovery and Reinvestment Act of 2009—Net Operating Losses, to determine if Rev. Proc. 2009-19, Rev. Proc. 2009-26 or Rev. Proc. 2009-52 applies for extended carryback period.

A specified fraudulent arrangement is an arrangement in which a party (the lead figure):

For more information about the requirements for claiming investment theft losses, refer to the Ponzi and Investment Loss page in the Losses book of the Virtual Library.