Section 1211(a) of the American Recovery and Reinvestment Act of 2009 (ARRA) provides a special election under IRC Section 172(b)(1)(H) for an "eligible small business" (ESB) to carry back a 2008 net operating loss (NOL) for three, four, or five years. The statutory definition of ESB includes a corporation or partnership that satisfies a $15 million average gross receipts test for the three taxable-year period ending with the taxable year of the 2008 NOL (Gross Receipts Test). An ESB also includes a sole proprietorship that would satisfy the Gross Receipts Test if the proprietorship were a corporation. Two recent IRS releases have clarified the application of the Gross Receipts Test in determining whether a business qualifies as an ESB and, in the process, may have increased the number of individual taxpayers eligible to make the NOL election.

There is no question that the statute permits an ESB that is a corporate taxpayer to make the NOL election. For businesses that are not conducted in corporate form, however, the statute's meaning is less clear because the ESB may not necessarily be identical to the taxpayer that sustains the NOL. Specifically, while a partnership may have more items of deduction than items of  income, those items do not create an NOL for the partnership but are passed through to its partners -- who then determine whether an NOL exists on their individual returns. Correspondingly, an individual taxpayer's NOL may be attributable both to items recognized directly through one or more sole proprietorship businesses and to items passed through from businesses operated by partnerships and S corporations. Yet, the statute not only requires application of the Gross Receipts Test to the corporate, partnership, or sole proprietorship business but also literally requires that the ESB (and not the taxpayer) make the election. Moreover, the statute does not indicate whether, and to what extent, the NOL election may be available for taxpayers that have generated an NOL from businesses conducted by S corporations.

Within a month after ARRAs February 17 enactment, the IRS issued Revenue Procedure  2009-19 to address some uncertainties in the statute. This revenue procedure provides that  the NOL election is made by the taxpayer with the NOL and not by the partnership or other pass-through entity that owns the ESB. Thus, a taxpayer that is a minority (or majority) partner in a partnership may make the NOL election with respect to its distributive share of items of loss or deduction from an ESB conducted by the partnership, without  the necessity of a concurrent election by the partnership. Moreover, the revenue procedure  interprets the term "corporation" in the new statute to include an S corporation, notwithstanding the fact that the provision it cross-references in deriving the Gross Receipts Test (IRC Section 448) does not generally apply to S corporations. Therefore, an S corporation shareholder also may make the NOL election under the revenue procedure with respect to its distributive share of items of loss or deduction from an ESB conducted by the S corporation.

Revenue Procedure 2009-19 further indicates that the Gross Receipts Test is to be determined on a business-by-business basis, unless certain aggregation rules apply that  require all commonly controlled businesses to be taken into account. Thus, a taxpayer may make the NOL election with respect to items of loss and deduction originating from several partnerships or S corporations that, collectively, have average gross receipts in excess of $15 million, provided that the commonly controlled-entity aggregation rule is inapplicable. Gross receipts from all sole proprietorships operated by a taxpayer would be subject to aggregation, however, because such proprietorships would (by definition) be under the taxpayer's common control. It should be noted, moreover, that the revenue procedure provides that the NOL election may be made with respect only to the portion of a taxpayer's 2008 NOL that is attributable to items of income, gain, loss, and deduction from an ESB (partnership, S corporation, or sole proprietorship), even though the statute literally refers to making the election for "the taxpayer's [entire] net operating loss."  The remainder of the NOL presumably remains subject to the regular carryback period limitations.

In a well-intentioned effort to provide tax relief to victims of the Madoff and other Ponzi schemes, the IRS released Revenue Ruling 2009-9 on March 17. Among other issues, this ruling makes the NOL election available to Ponzi scheme victims by developing an expansive reading of the phrase "sole proprietorship."  Specifically, it concludes that a casualty or theft loss sustained after 2007 would be considered a loss from a sole proprietorship for purposes of the NOL election because IRC Section 172(d)(4)(C) "treats any deduction for casualty or theft losses …. as a business deduction."  The revenue ruling adds, however, that the Gross Receipts Test would also have to be satisfied. Presumably, that means that to be eligible to make the NOL election, a defrauded taxpayer's average gross receipts from the Ponzi scheme for the three-year period preceding the year the fraud was discovered must not exceed $15 million.

While the recent IRS guidance is extremely helpful (and perhaps even generous), some issues may still remain in applying the NOL provision of ARRA. In particular, the application of the Gross Receipts Test in circumstances where the taxable year of NOL origin is ambiguous. For example, if a 2008 NOL is created for a taxpayer through a current-year elimination of  a passive-activity loss, at risk or basis limitation with respect to its distributive share of items from a pass-through entity, an uncertainty exists as to whether the gross receipts relevant to the Gross Receipts Test are those attributable to the three taxable years ending with the 2008 year with respect to which the taxpayer's NOL is generated, or those receipts attributable to the three taxable years ending with the year in which the ESB generated the items of loss or deduction that passed through to the taxpayer. Because a current-year NOL may be attributable to the freeing up of pass-through items from several taxable years of the ESB, this calculation could, in the latter circumstance, be quite complex. However, the necessity for resolving this issue may be eliminated if Obama administration proposals to expand the NOL election to all business taxpayers are adopted.

The Internal Revenue Service may issue additional guidance on availability of the NOL election. The Tax Group of Ballard Spahr Andrews & Ingersoll, LLP advises businesses concerning the NOL election and other tax issues arising under ARRA. For more information, please contact Wayne R. Strasbaugh at 215.864.8328 or strasbaugh@ballardspahr.com.


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