The statute of limitation for net operating losses.

• Author: Young, Marilyn

The statute of limitation defines the time within which the IRS may initiate an audit of a tax return. According to Sec. 6501(a), the statute of limitation for income tax returns is three years from the filing date of the return or the due date if the return is filed early.

While most of the income and deduction amounts reported on a return are generated in the current tax year, some amounts that are created in a prior year and carried over to the current year's return can be included in the calculation of taxable income. For example, a net operating loss (NOL) from a business activity can be carried back two years and carried forward 20 years (Sec. 172(b)(1)(A)). As this carryover period extends beyond the three-year statute of limitation, the use of an NOL deduction can create circumstances where amounts generated in closed years affect the calculation of taxable income in an open year. If a taxpayer's return is selected for audit and it includes an NOL deduction from a closed year, can the 1RS challenge the calculation of the prior-period carryover amount and, in effect, reopen a closed return?

The tension between the statute-of-limitation provision that can close a tax year for future audits and carryover amounts that are created in closed years but reported and subject to audit in an open year is resolved in Sec. 7602(a), which states, "For the purpose of ascertaining the correctness of any return ... the Secretary is authorized--(1) to examine any books, papers, records, or any other data which may be relevant or material to such inquiry."

With respect to audits including NOL amounts created in years that are closed under the statute of limitation, the 1RS applies the rules of Sec. 7602(a) in the following ways in the Internal Revenue Manual (IRM). IRM Section 4.11.11.13(2) instructs revenue agents that they may redetermine the correct taxable income for a closed year to determine either the amount of the carryforward deduction reported in the open year or the amount of an NOL deduction that is absorbed in a closed year and supports the determination of the available NOL deduction for the open year under examination.

IRM Sections 4.11.11.13(5) and (6) provide two examples that may prompt a revenue agent to identify a problem in an NOL deduction under examination. In the first example, a 2011 tax return that included a substantial NOL deduction that was created in 2007 is under audit. In the course of the investigation, the revenue...