Wednesday, October 19, 2016

Presidential Candidate Tax Issues - Net Operating Loss

While there have been no shortage of splashy news stories during this year's presidential campaign, one major story has been about Donald Trump's $900 million business loss in the mid-1990's.  A New York Times headline exclaimed that he 'could have avoided taxes for nearly two decades' and in the following article stated that he used  'tax provision that is particularly prized by America’s dynastic families, which, like the Trumps, hold their wealth inside byzantine networks of partnerships, limited liability companies and S corporations.'

To which I say:  poppycock!

Any outrage against him for using a special loophole that only benefits the wealthy to avoid paying taxes for 18 years is simply uninformed.  To help understand why, here is a little background on the rules for the tax strategy he used, a Net Operating Loss (NOL), from accounting author Steven Bragg, CPA:

The basic rules for using an NOL are:
  1. Carry the amount back to the preceding two tax years and apply it against any taxable income, which can generate an immediate tax rebate. You can waive this action and instead proceed directly to the next step; if so, attached a statement to your tax return in the year in which the NOL was generated, documenting the waiver.
  1. Carry the amount forward for the next 20 years and apply it against any taxable income, which reduces the amount of taxable income in those years.
  1. After 20 years, any remaining NOL is cancelled.
Some version of the NOL provision has been in the tax law since 1918 and all Trump did was use it when he qualified to do so.

That's all well and good, but the fact that something is plainly legal does not mean it's not a quirk in the tax law that is 'prized by America's dynastic families.'

So then how, exactly, is NOL not a fat-cat loophole?  Here is a simple example:

Consider a farmer who struggles in a year when corn prices are down and loses $200,000 that year.  If farming is his family's only source of income, they pay no taxes that year but don't get any kind of a tax break for being out 200 large.

Then the next year corn prices spike because of a drought in Europe.  His farm business booms, and he ends up making a profit of $300,000.  After deductions and exemptions, it's likely that the farmer's effective federal tax rate is around 25% - or $75,000 on an income of $300,000.

Now look at this farmer's business over the past two years if there was no such thing as Net Operating Loss carryforward:

                                Income / (Loss)                 Taxes Paid
Year 1                     ($200,000)                             $0          
Year 2                      $300,000                               $75,000
TOTALS                  $100,000                              $75,000

The farmer put $100,000 in his pocket over two years, not a great result but at $50,000 a year probably still a lower-middle class wage.

But his taxes on that income was $75,000 - a 75% effective tax rate! 

No one in their right mind thinks this is fair.  Which is where the NOL comes in.

Using NOL provision allows the farmer to carry his loss from the first year and apply it to reduce his profits in the second year, resulting in him being taxed only on the $100,000 he actually put in his pocket over the years.  His effective tax rate would then be much lower at $100,000 of taxable income, but even at 25%, having him pay $25,000 on $100,000 of profits is at least a reasonable result.

The takeaway is certainly not that Trump should be exonerated on the issues that showed up on just three pages of one tax return. There are plenty of reasons to criticize Trump - running a business that loses almost a billion dollars is a failure of mind-numbing proportions, and as Allan Sloan pointed out in an article in the  Washington Post, other entries on the pages which have been made public point to true loopholes at which the public should be legitimately incensed.

But anyone who says that his use of the Net Operating Loss carryforward is an example of a loophole that only benefits rich folks is just plain wrong.

If you need someone to help you sort through the hype and find tax strategies that work for real people, we can help keep more of your hard-earned money in your own pocket.  Schedule a phone call to talk with us today.!

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