Thursday, March 15, 2012

NOLs and Self-Employment Tax

Here is another one of those tax cases where you wonder how it got so far. Let’s set this up:
(1)    say that you are self-employed, and
(2)    you lost money, so you have a net operating loss carryover; and
(3)    you fail to file a later year tax return, and
(4)    the IRS prepares one for you, and
(5)    you owe a lot of tax, and
(6)    you ignore matters until you receive the statutory notice of deficiency, and
(7)    you clue the IRS that you have an NOL carryover, which reduces but does not eliminate your tax, and
(8)    the IRS still wants some tax (both income and self-employment) from you, and
(9)    you disagree because the you think the NOL reduced both your taxable income and self-employment income, and
(10) the IRS wants to know where in the tax code it says you can do that.
To understand what is happening here, think of your income tax and your self-employment tax as side-by-side railroad tracks. You use the same numbers to calculate how much is subject to income tax and to employment tax, but there comes a point where the tracks diverge. In our situation, that point is the net operating loss. There is no question you get a deduction for the NOL on your income taxes, but what is the answer for your self-employment taxes? Remember: different tracks = different trains.
Did I mention that you are an accountant?
So you are now preparing for the Tax Court. While preparing you come across this sharp rock from the tax code:
1402(a) Net Earnings from Self-Employment – The term “net earnings from self-employment” means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed…; except that….
                                (4) the deduction for net operating losses provided in section 172 shall not be  allowed.
Oh no. Now what do you do? Well, our taxpayer (Joseph DeCrescenzo v Commissioner T.C. Memo 2012-51) comes up with a two-pronged attack:
(1)    Argue that the IRS cannot raise the issue because they did not raise the issue in the notice of deficiency. The problem with this is … that they did by including the NOL in the notice.
(2)     And even if the IRS did, it was not binding on you because you suffer from acute anxiety disorder.

You can probably guess that this did not turn out well for the taxpayer. It cost him over $70,000 in penalties (late filing, late payment and etc.) alone.
It would have been much cheaper to have hired a competent tax CPA.

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