Ever since The New York Times reported on Saturday that the partial copy of Donald Trump’s 1995 income tax returns it had obtained showed a deduction for $916 million in business losses, has been nonstop. Trump’s losses for that year are so huge that he could conceivably have used them to avoid paying any federal income taxes for nearly 20 years. And that’s throwing a spotlight on a rarely discussed tax provision known as net operating losses (NOL).
The U.S. tax code has long included rules that allow a business to claim its excess losses (losses that exceed its current income) in a current year and then deduct those excess losses on tax returns of past and future years. However, you don’t have to be a billionaire (or even a millionaire) to use the NOL rule -- it can work for ordinary taxpayers and small-business owners, too. Here’s how:
If you have a business for which your deductions are more than your income for a particular year, you may be able to claim a NOL. And if the business loss is more than you can claim for a particular year (because the loss reduced your income to zero), you’re generally required to carry back the entire amount of the NOL to the two prior tax years and file amended returns with these new deductions.
If all of the NOL can’t be used against income in the two carry-back years, the remaining NOL is carried forward until it’s depleted, for up to the next 20 years. In 1995, the law limited the NOL carry-forward to 18 years.
It’s not a secret loophole for the rich, and, yes, it’s perfectly legal. The rules for deducting NOLs are spelled out in IRS publication 536, and any business owner with a good tax adviser will know about this tax-reduction strategy if it’s applicable.
Sole proprietors and LLCs
Small-business owners who use a sole proprietorship can also deduct any net loss from their business (calculated on Schedule C) from their other income on their individual tax return. If the small business is a limited liability company (LLC), an S corporation or a partnership, losses that are passed through the business entity to the individual can also be deducted.
In 1996, taxpayers claimed over $50 billion in NOLs, meaning the amount Trump claimed in 1995 was nearly 2 percent of all such deductions claimed in the following year. By 2014, more than 1.2 million taxpayers claimed about $200 billion of NOL deductions, with the average amount claimed being $163,292.
Any individual who has invested in mutual funds, stocks and bonds in a taxable account and has realized a loss in excess of their capital gains in a particular year should also be familiar with the NOL concept. Investors are allowed to deduct up to $3,000 of their excess losses (realized in taxable accounts) against income in the current year, and they can carry forward and deduct the excess losses in future years until the losses are offset by gains or other income (up to the $3,000 limit against income).
But what’s really the issue here? Is it that Trump, a billionaire businessman, could have arranged the reporting of his income and deductions to have paid little or no federal taxes? As Judge Billings Learned Hand famously argued: “Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”
The real issue may be that the tax code has grown so complex that Americans now spend over 7.6 billion hours a year preparing their tax returns. And most pay for software or advice from a tax pro for help -- and making sure they claim all the tax deductions and credits due them. After the 16th Amendment giving Congress the power to levy a federal income tax was ratified in 1913, the tax code was about 400 pages. At last count, it’s over 70,000 pages -- enough dead trees to print nearly 200 copies of Trump’s best-seller “The Art of the Deal.”