Impact of NOL Carrybacks or Carryovers
Calculating penalties is more complicated with NOL carrybacks and carryovers. As stated above, an accuracy-related penalty may apply if a taxpayer underpays its tax liability for the year. Thus, if a taxpayer has a loss in a year and, after the IRS proposes adjustments reducing the amount of the loss, the taxpayer remains in a loss position, an accuracy-related penalty will not be assessed. However, if that loss was carried back or over to another year to reduce the taxable income in that year, then an understatement of tax and accuracy-related penalty may result because the IRS adjustments to the loss year reduced the NOL amount.
The substantial-understatement penalty applies to any portion of an underpayment for a year to which a loss, deduction, or credit is carried that is attributable to a “tainted item” for the year in which the carryback or carryover of the loss, deduction, or credit arises (the “loss or credit year”) (Regs. Sec. 1.6662-4(c)(1)). Thus, whether an understatement is substantial for a carryback or carryover year is determined with respect to the tax return for the carryback or carryover year. Tainted items are taken into account with items arising in a carryback or carryover year to determine whether the understatement is substantial for that year (Regs. Sec. 1.6662-4(c)(1)).
Except in the case of a “tax shelter item” (see Regs. Sec. 1.6662-4(g)) a “tainted item” is any item arising in the loss or credit year for which there is neither substantial authority nor adequate disclosure (Regs. Sec. 1.6662-4(c)(3)(i)). A tax shelter item is “tainted” if, with respect to the loss or credit year, it lacks both substantial authority and a reasonable belief that its tax treatment is more likely than not proper (Regs. Sec. 1.6662-4(c)(3)(ii)).
Although a loss, deduction, or credit that is carried back or carried over to another tax year could result in the imposition of a substantial-understatement penalty in the carryback or carryover year, a taxpayer cannot reduce a substantial understatement for a carryback year by an allowable carryback of a loss, deduction, or credit to that year (Regs. Sec. 1.6662-4(c)(2)). A similar rule applies for the valuation misstatement penalty.
The penalty for a substantial or gross valuation misstatement applies to any portion of an underpayment for a year to which a loss, deduction, or credit is carried that is attributable to a substantial or gross valuation misstatement for the year in which the carryback or carryover of the loss, deduction, or credit arises (see Regs. Sec. 1.6662-5(c)(1)).
Example 3. Adjustments do not overcome NOL; no carryback/over: ABC Corp. reported a current-year loss of $4.5 million on its year 1 original income tax return. ABC excluded from its year 1 income a $2.5 million payment it received as a return of capital. An IRS examination determined that the $2.5 million payment was actually a dividend and was includible in ABC’s year 1 taxable income. After adjustment, ABC’s taxable income is shown in Exhibit 6.
It is determined that there was no substantial authority to exclude the $2.5 million payment from ABC’s year 1 income. Moreover, ABC did not attach a Form 8275 to its year 1 tax return to disclose the position, and ABC does not meet the reasonable-cause and good-faith exception of Sec. 6664.
Although the adjustment to ABC’s year 1 taxable income reduces its NOL, the adjustment does not result in ABC’s incurring taxable income for year 1. Because the accuracy-related penalty is based on an understatement of tax and ABC does not owe any tax for year 1, it is not subject to an accuracy-related penalty for the year. However, if this loss is carried over or back to another year, an accuracy-related penalty may apply in the carryback or carryover year.
Example 4. Adjustments do not overcome NOL; loss carried over to another year: In year 2, ABC reported income on its originally filed return but used the NOL from year 1 to offset the income (see Exhibit 7).
ABC’s underpayment of income tax for year 2 attributable to the year 1 NOL adjustment is calculated as shown in Exhibit 8.
As discussed above, the substantial-understatement penalty can apply to a carryover year as a result of “tainted items” from a loss year. The tainted items are taken into account with items arising in the carryback or carryover year to determine whether the understatement is substantial for that year. The adjustment to the year 1 NOL is considered a tainted item because there was neither substantial authority for the position nor adequate disclosure.
ABC’s understatement of its year 2 tax liability is substantial, since it exceeds 10% of the tax required to be shown on the return for the tax year and exceeds $10,000. As a result, ABC is subject to a penalty of $175,000 ($875,000 × 20%).
At first glance, the formula for calculating the substantial-understatement penalty seems straightforward and easy, but numerous factors may cause complications. Because applicable defenses, coordination with other penalties, and carryback and carryover implications may increase the complexity, practitioners must exercise care in computing and verifying penalty amounts.
by John Keenan, J.D., Washington, D.C., and Whitney Lessman, J.D., Chicago. Rona Hummel, CPA, an adjunct professor with the College of Business at Bloomsburg University in Bloomsburg, Pa., contributed to this item. “Tax Clinic” The Tax Adviser, March 01, 2013 – Original Blog Editor: John Almeras, Tax Manager, Delloitte Tax LLP in Washington D.C.
Edited and posted by Harold Goedde CPA, CMA, Ph.D. (taxation and accounting)