Kathleen K. Wright is the director of the State and Local Tax Program in the School of Taxation at Golden Gate University in San Francisco, and a regular columnist in this series.
In this article, Wright explains the 2013 California net operating loss carryback changes, including potential traps for the unaware taxpayer and practitioner.
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State rules for net operating losses vary significantly regarding the allowed carryforward and carryback as states use that provision for budget-balancing purposes. California will be added to the relatively short list of 17 states that allow business entities to carry back their NOLs in 2013.1 Eleven of these states provide the carryback through federal conformity, while the other six states have their own unique provisions.
The California NOL carryback provision appears to have been dropped into the statute with the thought that it might be repealed before it ever became effective. The NOL carryback provision has already been delayed once -- it was supposed to become effective in 2011 but was deferred until 2013.2 California has never allowed a carryback and limited the carryforward period until 2008, when the state adopted a 20-year carryforward period for income years beginning on or after January 1, 2008.3 California also adopted a two-year carryback starting in 2013 that is phased in over a three-year period. This article discusses the new carryback provision as well as provides a short summary of the California NOL's history over the years of economic recession.
The NOL Suspension
Largely because of budget constraints, California's NOL had been suspended for tax years beginning in 2008 through 2011. California has two sets of rules for NOLs suspended during that period.
2008 and 2009
Calif. Revenue and Taxation Code sections 17276.21 and 24416.21 suspend the NOLs for 2008 and 2009. NOLs were suspended for taxpayers with net business income of $500,000 or more for the tax year.
Revenue and Taxation Code sections 17276.22 and 24416.22 were amended to provide that NOLs incurred in 2008 and later years qualify for a 20-year carryforward period (which is the same carryforward period allowed for most NOLs under federal law).
2010 and 2011
As budget concerns continued to plague California, the State Legislature suspended utilization of the NOL for 2010 and 2011.4
Under Revenue and Taxation Code section 17276.21(d)(2), the NOL incurred in tax years beginning on or after January 1, 2010, and before January 1, 2012, was suspended for taxpayers with modified adjusted gross income of $300,000 or more. Modified AGI is defined as adjusted gross income as reported on the federal tax return.
Under section 24416.21 the NOL was suspended for business entities that have pre-apportioned income of $300,000 or more. Pre-apportioned income means net business and nonbusiness income after state adjustments but before the application of the apportionment and allocation provisions. That provision was applied to all members of a unitary group that were included in a combined report in the aggregate (not on a member-by-member basis).
Extended Carryforward Periods
The carryover period for each year's NOL was extended if the suspension provisions applied to that year's NOL. The NOL carryforward period is extended as follows:
- one year for losses incurred in tax years beginning on or after January 1, 2010 (and before January 1, 2011);
- two years for losses incurred in tax years beginning on or after January 1, 2009 (and before January 1, 2010);
- three years for losses incurred in tax years beginning on or after January 1, 2008 (and before January 1, 2009); and
- four years for losses incurred in tax years beginning before January 1, 2008.5
The Franchise Tax Board issued Legal Ruling 2011-04 (September 23, 2011) to explain how the extension of carryover periods will work.
Example: W Corp. has a $2 million NOL from the 2006 tax year and a $2 million NOL from the 2007 tax year. W has $550,000 of income subject to tax in California in 2008, and $575,000 of income subject to tax in 2009. W Corp. breaks even in 2010 and 2011.
Under California law (similar to federal law) the oldest NOL is applied first against the income reported in the succeeding year. Therefore, $550,000 of the 2006 NOL is suspended in 2008 and 2009. Because that NOL is incurred before January 1, 2008, it will get four years added to the carryforward period. The carryforward period for NOLs arising in tax years beginning on or after January 1, 2000, and before January 1, 2008, is 10 tax years. Without consideration of the extension of the carryforward period allowed by the suspension, the 2006 NOL would expire at the end of 2016. Because that NOL is suspended in 2008, it gets four years added to the carryover period. The result is that the 2006 NOL will now expire in 2020.
By the same token, no part of the 2007 NOL has been suspended (because there was no income against which to offset the loss that remains after the 2006 NOL is offset against the income generated in 2008 and 2009). Therefore, the 2007 NOL carryforward period is not extended. The result is that the 2006 NOL expires at the end of the 2020 tax year and the 2007 NOL continues to expire at the end of the 2017 tax year.6
Revenue and Taxation Code sections 17276.22 and 24416.22 provide that NOLs are eligible for a two-year carryback beginning with NOLs attributable to tax years beginning on or after January 1, 2013. The carryback is phased in as follows:
- 50 percent of the NOL for the year 2013,
- 75 percent of the NOL for the year 2014, and
- 100 percent of the NOL for the year 2015.7
If the 2013 NOL is carried back to 2011, it will not be subject to the suspension provisions, which apply only to NOL carryforwards, not carrybacks.8
Example:Y Corp. has $350,000 of pre-apportionment income and $100,000 of income subject to tax in California for the 2011 tax year. Y has a $100,000 NOL carryforward from 2010, which was unable to be utilized in 2011 because of the suspension rules. The 2010 loss carries over to 2012. In 2013 Y has an NOL of $200,000 apportioned to California, and carries $100,000 back to 2011.
Although Y would not have been allowed an NOL deduction for an NOL carryover from any prior year in 2011 under the suspension provisions (it had $350,000 of pre-apportioned income subject to tax), it is allowed an NOL deduction for its 2013 NOL carryback (limited to 50 percent of the 2013 NOL or $100,000). Only the carryforward and not the carryback was subject to suspension. Although the 2013 NOL carryback might reduce the pre-apportioned income in the carryback year to below the suspension threshold, that will not free up any portion of the 2010 NOL carryforward that had previously been suspended.
Some states require that the NOL reported in the loss year be adjusted by the apportionment percentage for that year. The result is then carried forward or back and applied to the taxable income apportioned to the state in the carryforward/carryback year. In other words, in determining the amount of NOLs in states that compute NOLs on a post-apportionment basis, a state uses the apportionment factor in the year the loss is generated to determine the NOL. That is the method adopted by California. That may be very different from the apportionment percentage in the carryforward or carryback year. That is particularly true in California where the earliest carryback year is 2011 -- a year when taxpayers were allowed to elect to use either a three-factor-apportionment formula with sales weighted twice or a single-sales-factor-apportionment formula. In 2013 taxpayers are required to use a single sales factor. There is no restriction on using NOLs from 2013 in 2011 if they were computed using a different apportionment method.
California regulations provide that the NOL of a combined group is first apportioned to California based on the combined apportionment factor. Then the net NOL is attributed to each combined group member's relative contribution to the overall California apportionment factors. That is important because the NOL attributed to a member can only offset income that is later attributed to that same taxpayer member. In other words, any NOL attributed to a taxpayer member of the group is carried over (or back) only on a separate legal entity basis and cannot be applied to income computed on a combined basis.
California residents pay tax to the state on their worldwide income. Credit is allowed California residents for net income taxes paid to another state (which is not comparable to California's alternative minimum tax).9 The credit is allowed only for taxes paid to the other states on income derived from sources within that state. "Income derived from sources within the state" is determined by applying California's sourcing rules that apply to nonresidents generally.
Example:Joey is a California resident who operates a small multistate business as a sole proprietorship from his home in California. In 2011 the business reported net business income of $600,000 ($100,000 is apportioned to Illinois, $200,000 to New Mexico, and the balance to California). Joey filed income tax returns in all three states and claimed the tax paid to Illinois and New Mexico as a credit against his California tax liability on the full $600,000.
In 2013 Joey's business operated at a loss of $500,000. The loss apportioned to Illinois is $150,000 and the loss apportioned to New Mexico is $130,000. Illinois allows a two-year carryback, so Joey files an amended return with the state and claims a refund of the full amount of the tax paid to Illinois in 2011. New Mexico does not allow an NOL carryback but rather a five-year NOL carryforward.
Joey also files an amended return in California that is adjusted for the credit claimed for the Illinois income tax, which is now going to be refunded because of the amended return filed in Illinois claiming the NOL carryback. That adjustment will increase the amount owed California. Also, the amended return will report 50 percent of the NOL ($250,000) carryback that will offset the net business income of $600,000 reported in the carryback year. The refund is limited to the total amount of tax paid to California in the carryback year.
Joey might opt to elect out of the NOL carryback to avoid that complexity.
Claiming the NOL Carryback on the 2013 Returns
The February 2014 edition of FTB Tax News provides detailed guidance on how to claim the NOL carryback. What is clear is that the popular federal forms (Form 1045 for individuals and Form 1139 for corporations) are not available for the California carryback NOL. California does not conform to IRC section 6411, the code section that authorizes the "quick refund" (Form 1045 and Form 1139 Tentative Carryback and Refund Adjustment). Normally a taxpayer would file those forms because the IRS generally acts on the form within 90 days, enabling the taxpayer to get a quicker refund.
For California purposes, the taxpayer will file FTB Form 3805Q (corporations) or FTB Form 3805V (individuals, estates and trusts) to compute the NOL and include those forms in the 2013 tax return. Then the taxpayer will file a regular amended return on FTB Form 100X (Corporations) or FTB Form 540X (Individuals, Estates and Trusts) to request the refund in 2011 (carryback year).
Similar to federal law, if the taxpayer does not want to carry back the NOL, they must elect out of the carryback. That is done on FTB Form 3805Q and FTB Form 3805V.
Statute of Limitations
In the case of a deficiency attributable to the application of an NOL carryback under federal law, "such deficiency may be assessed at any time before the expiration of the period within which a deficiency for the taxable year of the net operating loss . . . which results in such carryback may be assessed."10 In other words, if the year in which the NOL arose is open for assessment, then the year to which the NOL is carried back is also open for purposes of assessing a deficiency attributable to the carryback. Under the extended limitations period of IRC section 6501(h), the Service may assess a deficiency only to the extent that the deficiency is attributable to the loss carryback.11 Under subsection (h), the Service may not use the extended limitations period to assess a deficiency attributable to items unrelated to the loss carryback.
IRC section 6501(k) provides, in part, that when an amount has been applied, credited, or refunded under IRC section 6411 (regarding a tentative carryback and refund adjustment) by reason of an NOL carryback to a prior tax year, the period of assessment under IRC section 6501(h) is still open to recover deficiencies attributable to the carryback, and the assessment period is still open to recover a deficiency that is unrelated to the carryback.12 The amount the IRS can recover, however, is limited to the amount erroneously refunded.
Example:ABC, a calendar-year corporation, reports an NOL of $50,000 on its 2013 return filed March 15, 2014. It files for a quick refund (tentative carryback refund) for the 2011 tax year in the amount of $50,000. In 2015 the IRS determines that the NOL for 2013 is actually $30,000 and that ABC would have owed $40,000 of additional tax for 2011 because it failed to report some income. The IRS has until March 15, 2017 (three years after the filing date for the loss year), in which to assess the $20,000 tax refund attributable to the impermissible NOL carryback. Also, the IRS has until March 15, 2017, in which to assess tax attributable to the unreported income. That assessment, however, is limited to $30,000 ($50,000 refund less $20,000).
The California statute does not have IRC section 6501(h) or (k) and therefore the carryback year might very well be closed under the statute of limitations by the time FTB commences an audit of the loss year. Generally, the FTB must issue a notice of proposed deficiency assessment within four years after a return is filed (or four years after the due date, if the return was filed earlier).13
Example: Assume that ABC Corp. was located in California and had filed its return for 2013 by the extended due date (October 15, 2014). The FTB commenced an audit of the year 2013 on September 15, 2018, which is within the statutory period. The FTB determines that the amount of the NOL carryback ($50,000) should have been $20,000. Also, the FTB identifies unreported income of $40,000 in the carryback year (2011). The statute of limitations on 2011 closed for California purposes on October 15, 2016 (if return filed on extension). There is no provision in the California statute to automatically reopen the carryback year.
The issues addressed above represent the consequences of the new NOL carryback provisions; however, this is just a small piece of the changes that became effective in 2013, a year of more significant change in California tax computations than almost any other year in recent history. In addition to the NOL carryback, the single sales factor became the only available apportionment option. The single sales factor computation brought with it the required use of market based sourcing for service income, resulting in considerably different results for many taxpayers. All of the above will interact to present tax planning opportunities and tax traps for taxpayers for the 2013 tax year. Perhaps the most significant "trap" for the taxpayer with an NOL is the taxpayer who files as a member of a combined report and receives a portion of the combined reporting group's overall NOL. If that member is not profitable, then the NOL might not get utilized as it gets permanently attached to a loss company (such as a manufacturing concern who sells all of its output to another member of the same combined reporting group who sells the merchandise to the third party). Although California did enact provisions that allow a member of a combined reporting group to assign its credits to another eligible member of the same combined reporting group,14 no such benefit applies to NOLs. The NOL carryback nonetheless does provide the taxpayer with some additional flexibility towards meeting the objective of utilizing the loss.
1 Alaska, Delaware, Georgia, Hawaii, Idaho, Indiana, Kansas, Louisiana, Maryland, Mississippi, Missouri, Montana, New York, Oklahoma, Utah, Virginia, and West Virginia.
2 SB 858 (CH 721, Oct. 19, 2010).
3 Calif. Revenue and Taxation Code sections 17276.22 and 24416.22.
4 Calif. Revenue and Taxation Code sections 17276.21 and 24416.21.
5 Calif. Revenue and Taxation Code sections 17276.21(b) and 24416.21(b).
6 Situation 1, Legal Ruling 2011-04 (Sept. 23, 2011).
7 Calif. Revenue and Taxation Code sections 17276.20(c) and 24416.20(d).
8 Calif. Revenue and Taxation Code sections 17276.21(c) and 24416.21(c).
9 Calif. Revenue and Taxation Code section 18001.
10 IRC section 6501(h).
11 Jones v. Commissioner, 71 T.C. 391, 397 (1978).
12 Id. at 396-98.
13 Calif. Revenue and Taxation Code sections 19057(a) and 19087.
14 Calif. Revenue and Taxation Code section 23663.
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