NOL Audits. An area ripe for audit by the IRS is net operating losses (“NOL”) carried forward from past years to the current tax year. In a significant amount of audits, the taxpayer may lack detailed evidence to substantiate the NOL. What is to be done in such a case?
The Tax Court was recently faced with a situation in Martin v. Commissioner of Internal Revenue where the taxpayer claimed NOLs in the amount of $1.7 million for losses incurred in the 1990s and carried forward for use in tax years in 2009-2010.
Standard of NOL Substantiation. The IRS audited and the taxpayer provided very little proof to substantiate the existence and amount of the NOLs from the 1990s. The Tax Court set forth the standard of proof the taxpayer must show to claim the NOLs:
- Taxpayer bears the burden of substantiating its NOLs by establishing their existence as well as the amount that may be carried over to the years at issue.
- Taxpayer must file with its return a concise statement setting forth the amount of the NOL deduction claimed and all material and pertinent facts, including a detailed schedule showing how they computed their NOL deductions. See Sec. 1.172-1(c), Income Tax Regs.
- Taxpayer’s factual showing should include:
- that taxpayer had an NOL for at least one tax year before 2009;
- that taxpayer elected to waive a carryback of that NOL, or if not, whether the NOL carried forward for the number of years in question;
- that the NOL could not be applied against income for the tax years immediately following the tax year of the NOL.
Taxpayer’s Lack of NOL Evidence. In Martin, the taxpayer offered next to no evidence of these NOL items. Rather, it argued that the IRS had left its NOLs untouched on previous audits and therefore the NOLs could not be challenged in the present audit. However, the Tax Court rejected the argument on the basis “that each tax year stands on its own, with each year being the origin of new liability and a separate cause of action.” The conclusion therefore is that “just because the Commissioner accepted the [taxpayer’s] treatment of their NOLs in prior years doesn’t mean he has to in later years.”
The taxpayer’s minimal testimony and piecemeal parts of some tax returns was not enough evidence to establish the existence of the NOLs. The Tax Court denied the NOLs.
Practice Point. Allowance of NOLs on audit and appeal comes down to substantiation. The taxpayer should produce past tax returns that show consistent treatment of NOLs and financial data, or strong corroborating testimony and recreated records. Otherwise, the taxpayer will suffer the same fate as Martin.
Taxpayers with audit issues, including those involving NOLs, are encouraged to contact Jared Le Fevre to discuss how the deductions can be substantiated.
About the Author. Jared M. Le Fevre is a Partner in the Tax, Trusts and Estates Practice Group of Crowley Fleck PLLP. Mr. Le Fevre represents taxpayers before the IRS, IRS Independent Office of Appeals, Tax Court, Federal District Court and state tax agencies throughout Montana, Wyoming, North Dakota, Idaho, and Utah. Mr. Le Fevre is involved in federal, state and local tax audits, appeals, and tax resolution throughout these western states. Mr. Le Fevre also advises clients on the tax effects of business and real estate transactions.
 Martin v. Comm’r of Internal Revenue, T.C.M. (RIA) 2021-035 (T.C. 2021)