Brilliant or not, Donald Trump had big losses in 1995. And that means a big pot of losses than he can—and probably did—use to offset other income across many years. That’s the system, one that makes everyone file tax returns annually, but that can allow losses to span many years. A net operating loss or NOL is the excess of a taxpayer’s deductions over gross income.
You count income and expenses in only one year. After all, our tax system is annual. But then, you can use the loss in the two prior years (in what’s called a carryback) or in the following twenty years. As has been widely said, this can allow someone to legally not pay taxes for up to 20 years. You apply a portion of the NOL every year to your current year income. You can thereby immunize the current year income from tax.
Normally, the IRS statute of limitations allows the IRS to audit for three years. In some cases, the IRS gets six years. A few things are unlimited, with no limit on how long the IRS can go back. Curiously, though, there is not a special statute of limitations for NOLs. And that might make you think. For example, suppose that Trump made a mistake in calculating his $916 million NOL?
Does that mean that after three years, the IRS can’t touch him, even if it later learns that the $916 million NOL is overstated? Not exactly. The IRS has rules for what it regards as mistakes in the calculation of the NOL. The statute of limitations can be quirky in this context, and the rules can seem downright inconsistent. The IRS generally doesn’t allow you to go back beyond the statute of limitations to add to an NOL that you failed to claim properly. Conversely, the IRS can try to adjust your NOL, even if the statute of limitations on that year has expired.
If the IRS discovers mistakes in a closed tax year, the IRS can try to prevent you from using the losses based on that error many years later. Thus, in one case, a company had an NOL for 1945 that it was trying to use. A few years later, the IRS tried to reduce the use of the NOL, even though the year of the actual NOL was closed. The company and the IRS went to court, and the IRS won. The court agreed with the taxpayer that the tax year for calculating the NOL was closed. But the court said the year in which the NOL is used is really what matters. See Phoenix Coal Co., 231 F.2d 420 (2d Cir. 1956).
In another case, Barenholtz, 784 F.2d 375 (Fed. Cir. 1986), the IRS did something similar. There, the tax year for the NOL (like Trump’s big loss year of 1995) was already closed. Even so, when the taxpayer went to use the NOL, the IRS said it could adjust the NOL then. Once again, when the IRS and the taxpayer when to court, the IRS won. These rules suggest that the IRS could conceivably have been chipping away at Trump’s NOL for up to 20 years after he claimed it. But without tax returns, we don’t know.
For alerts to future tax articles, email me at Wood@WoodLLP.com. This discussion is not legal advice.
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