Regardless of what you think about President Trump politically, there’s one thing we can all agree he knows how to do well: play the tax game.
While on the campaign trail last fall, The New York Times reported that Trump took an astounding $916 million loss on his 1995 income-tax return—which equates to more than 9,000 times the average amount claimed that year by all of the other Americans that applied business losses to offset personal income and, get this, opened the door to possibly protecting up to 18 years of his personal income from Uncle Sam.
Unethical or a genius move? We’ll let you vote on that privately. But first, let’s dig into the tax loophole that allowed Trump to make this bold move and how you can use the same perfectly legal strategy to help your clients turn net operating losses into tax wins.
As tax strategists, we’re always looking for creative ways to make lemonade out of the lemons life throws at us. In the tax world, this comes in the form of looking at net operating losses (the lemon) as tax assets (the lemonade). Liken it to finding 20 bucks in the pocket of the wool coat you haven’t worn in six months or finding a few bucks in change under the couch cushions right when you needed quarters for the laundromat. It’s kind of like “surprise money,” which is something most of us can appreciate.
Every type of loss, be it passive, investment, net operating expenses or capital, equals tax savings. How much you might ask? It depends on the effective tax rate of the taxpayer. For example, if a taxpayer pays a 25% tax rate, every dollar of loss deducted represents 25 cents of reduced tax or extra cash leftover to the taxpayer. If they effectively pay 50% in tax, every dollar of loss deducted equals 50 cents of extra cash.
Clear as mud? Keep reading…
In general, taxpayers have the option of carrying net operating losses back 2 years or forward 20 years. Since losses are automatically carried back, the taxpayer MUST do some planning if they want to carry them forward but yes, it absolutely can and in some cases, should, be done.
When determining whether your client’s net operating losses should be carried back or forward, consider how much your client needs cash right now. Also take a good look at current, past, and future tax rates. If tax rates are expected to increase, it may be best to carry the loss forward. However, if your client’s need for cash-in-hand outweighs potential future tax benefits, it may make more sense to carry back the loss and apply for refunds.
When choosing to carry-forward net operating losses, be sure to file an election to waive the net operating loss carry back period under Section 172(b)(3). All net operating losses automatically carry back without this election; and if you don’t file properly, the opportunity can be lost!
The Importance Of Tax Planning
The most common form of misused net operating losses seen on tax returns are net operating losses in a C corporation. Overzealous or inadequate tax planning used to “zero out” the C corporation to avoid double taxation can result in net operating losses which sit idle, trapped in the corporation. Be sure to look for these opportunities when reviewing a new client’s prior tax returns. Consider reducing payroll to use up prior losses and pass income through to shareholders as a dividend. The client will enjoy the benefit of receiving income at a lower tax rate (through the qualified dividends rate) by turning a loss into an asset!
Are your clients calling you with not-so “quick questions” about net-operating losses? To put an end to those pesky questions that eat away at your time and your bottom line, start inviting clients to have you create tax plans for them in the off-season. With a tax planning session on the books, you’ll have the time you need to research the best answers for them and you’ll get compensated for doing so. It’s another win-win.