Historically, New Jersey has allowed a deduction for net operating loss carryovers—the carryover period is generally seven years. From 2002 through 2005, however, New Jersey disallowed this deduction and extended the traditional seven-year carryover period by the number of years the deduction was disallowed.
Many taxpayers think that to get the extended carryover period they need income during the suspension period. Other taxpayers think that, to get the extension, their NOLs must otherwise have expired during the suspension period. These views, in fact, are supported by various informal documents issued by the New Jersey Division of Taxation.
These views are, however, inconsistent with the statute and the legislative intent. In this article, we analyze those provisions and we conclude that:
- The carryover period of any NOL carried into the four-year suspension period is extended by four years, even if the taxpayer had no entire net income during the suspension period.
- The NOL carryover period is extended, even if the NOLs would not have expired during the suspension period.
New Jersey’s Net Operating Loss
New Jersey, like many states, starts with federal taxable income without regard to the federal net operating loss carryover provisions. Instead of following the federal NOL provisions, the state has its own. This has allowed the state to tinker with NOL deductions in order to achieve its revenue goals. For example, the carryover period in New Jersey is only 7 years, compared with the 20-year period under federal law.
As part of the Business Tax Reform Act of 2002, New Jersey disallowed the deduction for net operating loss carryovers for the 2002 and 2003 tax years: [F]or privilege periods beginning during calendar year 2002 and calendar year 2003, no deduction for any net operating loss carryover shall be allowed. In addition, the 2002 law extended the carryover period—which is otherwise seven years. The extension provision is as follows:
If and only to the extent that any net operating loss carryover deduction is disallowed by reason of this subparagraph (E), the date on which the amount of the disallowed net operating loss carryover deduction would otherwise expire shall be extended by two years.
Under the statute, therefore, there are two questions that must be answered to determine whether and to what extent an NOL carryover period is extended. First, what portion of the NOL carryovers to this period would have been “allowed” as deductions, were it not for the suspension? And second, what portion of those deductions were disallowed?
To answer the first question, consider the general rule regarding NOL deductions in New Jersey: New Jersey allows a deduction for an NOL carried into a tax year—regardless of whether (or to what extent) the taxpayer has entire net income in that year. Specifically, the statute provides that “[t]here shall be allowed as a deduction for the privilege period the net operating loss carryover to that period.” Of course, the deduction will provide no tax benefit if a taxpayer has no entire net income. Still, if a NOL deduction is carried to a tax year, the entire amount of the carryover is allowed as a deduction.
This allows us to answer to our first question: What portion of the NOLs carried over to this period would have been “allowed” were it not for the suspension? The answer is all of the NOLs from the prior seven years that have not been absorbed in prior years and that are not disallowed for some other reason. Consider a taxpayer that had NOLs totaling $1,000 carried into 2002 ($200 from each of the five preceding years, 1997–2001). This taxpayer would have had, but for the suspension, an NOL deduction in 2002 of $1,000. The taxpayer would have been allowed that deduction even if it had no income in 2002.
The second question, for most taxpayers, is relatively straightforward: What portion of the NOL deduction was disallowed by reason of the suspension provision? In our example, the entire $1,000 was disallowed by reason of the suspension provision. Therefore, each of the $200 NOL carryovers from the preceding five years were disallowed by reason of the suspension provision and the date on which they would have otherwise expired is, under the extension provision, extended by two years.
In 2004, the General Assembly again disallowed a deduction for NOLs carried into 2004 and 2005. This time, however, the disallowance was only partial. The 2004 legislation provided as follows:
[F]or privilege periods beginning during calendar year 2004 and calendar year 2005, there shall be allowed as a deduction for the privilege period so much of the net operating loss carryover as reduces entire net income otherwise calculated by 50%.
Accordingly, as a result of this provision, if a taxpayer has income during 2004 and 2005, then the NOL is allowed as a partial deduction. The portion of the NOL carryover that exceeds half of that income is disallowed. If the taxpayer has no income during 2004 and 2005, the NOL is, again, completely disallowed as a deduction.
Furthermore, under the 2004 suspension legislation, “the date on which the amount of the disallowed net operating loss carryover deduction would otherwise expire shall be extended by a period equal to the period for which application of the net operating loss was disallowed.” Thus, if an NOL is carried into the four-year suspension period, the NOL is extended by four years unless it is absorbed in 2004 or 2005.
Following our example above, if a taxpayer had no income in 2004 and 2005, then the entire amount of the $1,000 of NOL carried over to those years would be disallowed and the carryover periods for those NOLs would be extended by four years.
Under our example, therefore, the carryover periods of the NOLs generated in 1997–2001 are as follows:
**SEE PDF FOR IMAGE**
This approach is consistent with the intent of the General Assembly. In statements that were released with the original legislation, lawmakers indicated that the NOL was being suspended but that the carryover periods were being extended by the duration of the suspension.9 We believe, therefore, that the legislators intended the NOL suspension to be simply a matter of timing. They intended it to accelerate the payment of revenue, not permanently increase revenue.
The views suggested by the Division would not just accelerate revenue, they would increase revenue. Obviously if only those NOLs that would otherwise expire during the suspension period are extended, then NOLs generated in 1999–2001 are never extended. The number of periods in which those NOL carryovers may produce a tax benefit, therefore, would be significantly reduced. In our example, the NOL generated in 1999 could only produce a tax benefit in three years—2000, 2001, and 2006. This was not, we believe, the intent of the General Assembly.
Moreover, under the Division’s view, two income tests must be met in many cases in order for a taxpayer to benefit from a single NOL deduction. A taxpayer must have income during the suspension period; then, the taxpayer must again have income after the suspension period in the year it deducts the NOL. This significantly decreases the likelihood that a taxpayer will be able to benefit from its NOL.
NOL carryover periods affect not only tomorrow’s tax return, they affect today’s financial statements because they support deferred tax assets. For today, taxpayers should consider whether to try to convince the Division to abandon its ill-conceived views on NOL extensions. Or maybe just get an appropriate level of comfort from their tax advisors. For tomorrow, taxpayers should consider deducting NOLs in the manner described in this article. Although the Division may disagree with this position, the underpayment penalty in New Jersey is only 5%.