Net Operating Losses and Charitable Deductions — How Each Determines the Other

In July 2019, the IRS released a Chief Counsel Memorandum explaining how a corporate taxpayer should calculate their charitable contribution deduction and use charitable contribution carryovers when the corporation has current year taxable income — before using prior year net operating loss (NOL) carryforwards. The IRS also clarifies the ordering rules with respect to using prior year carryforwards. The interaction between NOLs, charitable contributions and carryover attributes (amount and year of origination) is especially important when a taxpayer has potentially expiring NOL carryforwards in a given year.

To eliminate a potential double tax benefit, Internal Revenue Code Section 170(d)(2)(B) requires a reduction to a taxpayer’s charitable contribution carryover to the extent an excess charitable contribution reduces modified taxable income and increases an NOL carryover.

• Under Sec. 170(b)(2), taxable income is computed without regard to the charitable contribution deduction or any NOL carryback to the taxable year. NOL carryovers from prior tax years are taken into account when calculating taxable income for purposes of determining the 10% limitation.
• Under Sec. 172(b)(2), modified taxable income is determined without taking into account the NOL to be absorbed or NOLs incurred in taxable years after the taxable year of the NOL to be absorbed. However, NOLs carried from years before the taxable year of the NOL to be absorbed are considered in determining modified taxable income, as are charitable deductions.

As a result, more charitable contributions may be allowable in computing modified taxable income under §172(b)(2) than are allowable in computing taxable income under §170(b)(2). By reducing modified taxable income, these charitable contributions result in less NOL being absorbed than the actual amount of NOL used to reduce taxable income. Thus, the additional charitable contributions allowed in determining modified taxable income increases the amount of NOL carryovers to a subsequent tax year.

The additional charitable contributions that are allowed in computing modified taxable income are not actually deducted when a taxpayer computes taxable income. If these additional amounts were allowed as charitable carryovers, then the contributions would produce a double tax benefit by reducing the amount of the NOL to be absorbed. Sec. 170(d)(2)(B) exists to prevent this result and provides that charitable carryovers must be reduced to the extent that an excess charitable contribution reduces modified taxable income in the absorption calculation of Sec. 172(b)(2) and increases an NOL carryover to a succeeding year under Sec. 172. The effect of these provisions is that some charitable contributions with a five-year carryover period are converted into an NOL with an indefinite carryover period.

Below is a simplified example based off the memorandum:

• X Corp had $1,000 of taxable income in 2017 (the current tax year in question) before considering its NOL carryovers or charitable contribution deduction.
• In 2017, X Corp made charitable contributions of $120.
• X Corp has charitable contribution carryovers of $300 and NOL carryovers of $5,000 from prior tax years as follows.

X Corp cannot deduct any charitable contributions in 2017 because the NOL carryovers reduce taxable income to $0. However, X Corp still must compute the 10% limit for purposes of determining modified taxable income and the amount of the NOL carryovers that are absorbed.

Step 1: Compute 10% charitable contribution limit.

• First, X Corp must subtract its 2012 NOL from its 2017 taxable income to determine the Sec. 170 taxable income ($1,000 - $100 = $900).
• Next, X Corp must multiply its Sec. 170 taxable income by the 10% limitation ($900 x 10% = $90). The $90 represents the amount of the 2017 charitable contribution that is allowed for purposes of calculating modified taxable income under Sec. 172(b)(2).

Step 2: Determine how much of the 2017 charitable contributions X Corp can carryover to 2018 after applying the Sec. 170(d)(2)(B) adjustment.

• X Corp must reduce its 2017 charitable contributions by $90 because that amount was allowed in the modified taxable income calculation ($900 - $90 = $810).
• This causes an increased NOL carryover to 2018 and the charitable contributions not actually being deducted.
• The result is that only $30 ($120 - $90) of the 2017 charitable contributions is allowed to be carried over to 2018.

Step 3: Calculate the amount of the 2013 NOL carryover that is absorbed under Sec. 172(b)(2) and the amount carried over to 2018.

• The 2013 NOL carryover is reduced by the amount absorbed, which is the 2017 modified taxable income, and the remainder is carried over to 2018 ($1,500 - $810 = $690).

In this example, only the current year charitable contributions are taken into account in calculating the Sec. 170(d)(2)(B) adjustment because the current year charitable contributions alone reduced modified taxable income in the absorption calculation of Sec. 172(b)(2) and increased the NOL carryover to a succeeding year under Sec. 172. Accordingly, X Corp loses the ability to use any charitable carryovers from 2012 as a result of the expiration of the five-year carryover period. The following tables illustrate the tax assets to be carryforward.

While the rules for the amount of current year charitable deduction you can take seem obvious, (10% limitation) the interplay with NOLs and other carryforwards needs to be carefully considered so the taxpayer fully understands what tax assets are expiring and can plan accordingly to minimize any surprises.

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Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.