The U.S. tax system requires taxpayers to report their income and expenses on an annual accounting basis (e.g., a calendar year). Because taxpayers may have profits in some years but losses in others, this reporting requirement can sometimes cause financial distortions. For example, a taxpayer with a business loss of $100,000 in 2023 and business income of $100,000 in 2024 is at a net zero if the two tax years are combined. Should the taxpayer be required to pay income tax on the earnings of $100,000 in 2024 merely because those earnings were recognized in a separate tax year?
Section 172 of the Code provides a somewhat commonsensical answer. Under that provision, taxpayers may claim a net operating loss deduction (NOL), which in our example above, functions to reduce the taxpayer’s 2024 income.
However, there are significant differences between claiming an NOL carryover on a tax return and proving entitlement to an NOL carryover when the IRS challenges the deduction. In light of three recent U.S. Tax Court decisions—all of which sustained the agency’s disallowance of the NOL carryovers at issue—taxpayers should be mindful of the often cumbersome substantiation rules associated with supporting NOL carryovers.
Net Operating Losses
Section 172 of the Code allows taxpayers to claim an NOL. Generally, the amount of the deduction equals the taxpayer’s allowable expenses for the tax year minus the taxpayer’s gross income for such year, subject to modifications. Although taxpayers have historically been allowed to carryback NOLs to prior tax returns, the Tax Cuts and Jobs Act of 2017 modified the NOL rules to permit only carryovers.
Recent Tax Court Decisions
In November and December of 2024, the U.S. Tax Court issued three decisions concerning NOL carryovers. See Shaut v. Comm’r, T.C. Memo. 2024-103; Aboui v. Comm’r, T.C. Memo. 2024-106; Greenblatt v. Comm’r, T.C. Memo. 2024-109. In all three cases, the court concluded that the taxpayers had failed to provide sufficient evidentiary proof to support the claimed NOL carryovers. And in all three decisions, the U.S. Tax Court reminded the taxpayers that copies of prior year federal income tax returns (that claimed the NOLs) were insufficient as a matter of law to substantiate their entitlement to the NOL carryovers.
The Tax Lesson
If the IRS challenges an NOL carryover, taxpayers must show: (i) the existence of an NOL, and (ii) the proper amount of the carryover. The safest method to satisfy both of these elements is to maintain copies of the tax returns (that claimed the NOLs) in addition to all of the underlying documents that support each relevant line item on the return (e.g., bank statements, receipts, invoices, etc.).
Where taxpayers often run into trouble is the duration of time they must maintain these records. As a general matter, the IRS has three years from the date a return is filed to make additional assessments of income tax. However, the NOL carryover rules provide the IRS with some flexibility in that the IRS may challenge the amount of a prior-year NOL deduction (even if outside the 3-year period) because that deduction necessarily makes up the NOL carryover. See, e.g. Brock v. Comm’r, T.C. Memo. 1982-335; The State Farm Co. v. Comm’r, 40 T.C. 774 (1963).
Example:
John files a 2018 tax return that reports a NOL of $100,000. John carries the NOL forward until it is used completely in 2027. If the IRS examines John’s 2027 tax return, the agency can require John to provide substantiation to support his 2018 claim to a $100,000 NOL. This is so regardless of the general three-year statute of limitations period.
Therefore, taxpayers who claim NOL carryovers should ensure that they maintain all supporting documentary evidence for the NOL returns. As shown in the above example, taxpayers may need to maintain these books and records well after the general three-year statute of limitations period.
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