Taxpayers often ask me if a net operating loss can be a problem for their small business or corporation, and whether the IRS can audit the net operating loss. This is not a simple question because, like many business tax questions, the answer depends on a few factors. Let’s look at rules around the net operating loss and whether the IRS can audit your business’ loss.
First off, with respect to income tax purposes, a net operating loss is the result of when a business’ deductions exceed its taxable income within a tax period. For example, a San Francisco company’s income is $50,000, but their deductions are $60,000 in a taxable year. That $10,000 is considered a net operating loss. There is a provision called the net operating loss deduction that allows a taxpayer with a loss in one year and income in another year to pay tax on the net amount as if it were earned evenly over the same period.
However, only certain groups of taxpayers are allowed to deduct a net operating loss. These include individuals, C corporations, estates and trusts, insurance companies, exempt organizations with unrelated business taxable income, participants in a common trust fund, and personal holding companies. The taxpayers that are not eligible to deduct net operating losses are partnerships, S corporations, common trust funds, and regulated investments companies.
To answer the larger question, yes, the IRS can audit a net operating loss. It can review any years where the loss was used in order to verify there were no other additional income sources that were not reported.
More recently, net operating losses have become an IRS audit trigger since the government passed the CARES Act that modified the rules for losses for taxpayers other than corporations. There is a statue of limitation in which the IRS may conduct an audit of a tax return related to a net operating loss. That timeframe is three years from the filing date of the return.
Trying to navigate all the nuances of a net operating loss can be tricky. If you are confused about how to declare a net operating loss or if you received an IRS audit notice about your net operating loss, be sure to contact a tax professional or experienced San Francisco tax attorney to help you through the process.
Allison Soares is a partner and tax attorney at Vanst Law. Before starting her own practice, Soares was a partner at a tax law firm where she honed her skills handling a wide variety of tax and employment-related cases. In addition to her legal work, she has worked in accounting and utilizes that knowledge to her advantage while handling cases involving EDD audits.
