Planning for individual NOLs: converting to a Roth IRA.

• Author: Randolph, David W.
• Position: Net operating losses, individual retirement account

In tax years when an individual incurs negative taxable income, he or she faces the possibility of permanently losing the tax benefits of nonbusiness deductions, to the extent that such deductions exceed nonbusiness income. This may present an opportunity to convert a traditional IRA to a Roth IRA, thus capturing the benefits that would otherwise be permanently lost.

Individual NOLs

In computing taxable income for a tax year, a taxpayer can deduct, under Sec. 172(a), an amount equal to the aggregate of the net operating loss (NOL) carryovers and carry-backs to the tax year. This is known as the "NOL deduction." Under Regs. Sec. 1.172-1(b), this deduction is determined by calculating the NOL for any preceding or succeeding tax year from which all NOL may be carried over or back.

Even though an NOL can potentially exist in any tax year in which a taxpayer's allowable deductions for that year exceed his or her income, the determination of whether (and in what amount) an NOL was actually incurred for the tax year requires the taxpayer to consider modification of deductions listed in Sec. 172(d). Regs. Sec. 1.172-3(a)(1) disallows a deduction for personal exemptions, capital losses in excess of capital gains and nonbusiness deductions in excess of nonbusiness income.

For this purpose, nonbusiness deductions and nonbusiness income cannot be attributable to, or derived from, a taxpayer's trade or business; wages and salary attributable to the trade or business would be business income, according to Regs. Sec. 1.172-3(a)(3)(i).

In part, the Regs. Sec. 1.172-3(a) modifications permanently disallow the potential tax benefit of itemized deductions (other than casualty losses and employee business expenses) to the extent such deductions exceed nonbusiness income; see also Regs. Sec. 1.172-3(e) and IRS Pub. 536, Net Operating Losses (NOLs) for Individuals, Estates, and Trusts.

Example 1: In 2004, C has $310,000 in gross income and $410,000 in allowable deductions; her allowable deductions would exclude an NOL deduction or any deduction on account of a sale or exchange of capital assets. Her gross income includes $10,000 of ordinary nonbusiness income; her deductions include $35,000 of ordinary nonbusiness deductions. She has no other items of income or deduction to which Sec. 172(d) applies; for simplicity's sake, the personal exemption is ignored. As a result, C has a $75,000 NOL in 2004, calculated as shown in Exhibit 1 at left.

Example 1 illustrates...