Audit statute for net operating losses

Did you know that audits of net operating losses (NOLs) and other carryforwards can reach back past the otherwise applicable statute of limitation?

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. As this carryover period extends beyond the typical 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.

According to Sec. 7602(a), “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.” This includes NOL amounts created in years that are closed under the statute of limitation.

This creates two potential pitfalls for taxpayers. First, if taxpayers are familiar with the three-year statute of limitation and believe this period applies to all returns and in all circumstances, then they may discard the records that support the NOLs too soon. Secondly, taxpayers may assume that a closed statute-of-limitation period implies that the IRS has accepted returns from closed years as correctly filed. However, copies of tax returns are not proof of an NOL deduction. As such, taxpayers must keep the underlying records that confirm the NOL amount, even for closed years.

To avoid these pitfalls, the records supporting the loss carryforward should be kept until the NOL is fully utilized and the return including the final NOL deduction expires under the three-year (or other applicable) statute of limitation.

For more information on this topic, contact a ShindelRock tax professional.