Tax Recognition of the Corporate Entity
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When carrying a capital loss from 1 year to another, the following rules apply:
1. When figuring this year’s net capital loss, any capital loss carried from another year cannot be used. In different words, capital losses may only be carried to years that would otherwise have a total net capital gain.
2. If capital losses from 2 or more years are carried to the same year, the loss from the earliest year is deducted first. When that loss is completely used up, the loss from the next earliest year is subtracted, and so on.
3. A capital loss carried from another year cannot be used to produce or increase a net operating loss in the year it is carried to (§1212; Reg. §1.1212- 1(a)(3)).
S Corporation Status
A capital loss should not be carried back from, or to, a year in which the company had in effect an election to be taken as an S corporation (§1371(b)(1)).
Whenever gain or loss is recognized as a result of asset disposition, the character of the gain or loss will depend upon the nature of the asset so disposed of. There are three types of corporate property, these are:
1. Section 1231 assets are tangible non-inventory assets that are used in a trade or business and have been used for more than a year. The character of the property as being real or personal is immaterial for purposes of § 1231 but, the benefit can be recaptured when such assets are further subcategorized as §1245 or §1250.
2. Capital assets are assets held for investment, whether tangible or intangible. Gains and losses from certain dispositions of capital assets are treated as gains or losses from the disposition of either §1231 assets or ordinary assets.
3. Ordinary assets are assets that are held for sale in the ordinary course of the corporation’s trade or business and all other assets that do not qualify as being either capital assets or §1231 assets.
Five-Step Characterization Process
The special classification of recognized gains and losses into one of the preceding three categories can be accomplished by using the following “five-step” approach:
STEP 1. Determine the character of the asset that was disposed of (i.e.). (was it held for business purposes, investment purposes, etc.)
STEP 2. Determine whether the property was real or personal.
STEP 3. Determine whether the tax character of the asset was §1231, capital or ordinary.
STEP 4. Determine the proper classification of the recognized gain or loss by considering the nature of the disposition, holding period, and the applicability of any recapture rules.
STEP 5. Net all gains and losses for the year. Netting Capital Gains
At the close of each tax year, the corporation must net all capital gains and losses that were recognized during the year for the purpose of determining the existence of either a net capital gain income (NCGI) or a net capital loss (NCL).
The netting procedure is as follows:
(a) First, combine all short-term capital losses and short-term capital gains to determine whether there is a net short-term capital gain or a net short-term capital loss;
(b) Next, combine all long-term capital gains and losses to determine whether there is a net long-term capital gain or a net long-term capital loss; and
(c) Finally, combine the net short-term capital gain (loss) with the net long-term capital gain (loss) to determine the amount of the NCGI or NCL.
Capital losses are deductible when the extent of capital gains (an individual may deduct capital losses to the size of capital gains plus $3,000). However, nondeductible capital losses can be carried back three years and forward five years (against capital gains only). An individual cannot carryback unused capital losses but he can carry them forward indefinitely (§1211(a) and §1212(a)).
Netting Section 1231 Gains (Losses)
As is the case with capital gains and losses, all gains from the dispositions of §1231 assets that are not recaptured must be netted with all losses from §1231 asset dispositions. The netting of §1231 gains and losses is to determine whether they will be treated as long-term capital gains and losses or as ordinary gains and losses.
The character of Section 1231 Gains (Losses)
In general, if gains from the disposition of §1231 assets exceed the losses from §1231 assets, the net profit is recognized as a long-term capital gain. However, if the losses exceed the benefits, then the net loss is treated as an ordinary loss.
5 Year Averaging
It is easy to see why this “best of both worlds” phenomenon caused a great many people to begin bunching their transactions to yield losses only in one year, and all gains in the next. Congress did not agree that this was a terrific rule. As a result, TRA ‘84 introduced the five-year averaging rule.
In effect, a net §1231 gain is treated as ordinary income to the extent that it does not exceed all §1231 losses for the preceding five taxable years. Net §1231 losses that are used in this manner to recapture §1231 gains as ordinary income in one year cannot be used again to recharacterize additional §1231 gains from a subsequent year.
NOL Carryback & Carryover
All corporations (except mutual insurance companies, regulated investment
companies, and S corporations) are entitled to the net operating loss deduction in computing their tax. The general rules governing NOLs are similar to those for individuals, but the adjustments for figuring the losses and loss carryovers differ.
An NOL may be charged back to each of the two preceding years and carried over to each of the 20 following years. The loss is charged first to the earliest year, and then to the next earliest year, and so forth.
Note: Thus, for 2017, an NOL may be used until exhausted in 2015, 2016, and 2017 through 2037. This sequence must be followed. No part of the 2017 loss may be used to offset 2016 income until 2015 income has been absorbed.
A corporation may elect to give up the two-year carryback if it makes the election by the due date (with extensions) for filing the return for the year of the loss
(§172(b)(1) & §172(b)(3)(C)).
Note: A corporation that is in fact dissolved cannot carry back an NOL, even if it is not legally dissolved.