How to help clients use carryforwards to lower their tax liability
Your clients might have used carryforwards or carryovers to their tax advantage in the past, so if you use them again in the future, realize that the IRS could pay more attention to abuse of this savings tool.
A carryforward (or carryover) allows your client to claim an unused portion of a credit or deduction on a future return. But, the Treasury Inspector General for Tax Administration (TIGTA) has found that recent returns claimed billions in unsubstantiated carryforward credits and deductions.
Chances are good your client wants to use carryforwards properly to mitigate taxes. Here’s how to help.
Know the details of this tax break
The tax code allows unused amounts of certain credits and deductions (that often have annual limits) to be carried into different years.
Credits and deductions differ, but generally your client can carry them forward up to many years until the full credit or deduction is taken. For example, your client may qualify for a specific deduction or credit in a tax year but be unable to take full advantage. The deduction may be higher than what your client is allowed to deduct for that year; the credit may be nonrefundable and exceed the amount of tax owed; or your client may have a net operating loss (NOL) greater than their taxable income.
Carryforwards can become valuable. They often come in the form of capital loss carryforwards (short- or long-term) or credit carryforwards, and basis carryforwards for business interests, home-office deductions or rental activity, to name a few. A carryforward deduction resembles the credit except they can directly reduce future income rather than reduce tax. Tax-loss carryforwards also allow offsetting of other capital gains and reducing of tax liability.
Note: The IRS has many exclusions when taking losses.
Periods for carryforwards vary. Post-reform, a NOL can offset 80 percent of taxable income in any given tax year. NOLs can only be carried forward but do now have an indefinite carryforward period. Also post-reform, excess business losses of a taxpayer other than a corporation are not deductible.
Authorities have found abuse
Many practices have clients who have some variety of carryforward, and forms of abuse can also vary.
Some clients (you hope not yours) intentionally try to outsmart the IRS and secure a tax benefit they otherwise aren’t entitled to. Clients may also have prepared their own returns in past years, or pinballed from preparer to preparer and relied on estimates for carryforward eligibility. In other cases, returns in sequential years that were completed by different preparers will have carryforwards appear one year, disappear the next and appear again in the third.
The TIGTA found that some 2.5 million returns in a recent year claimed $81.9 billion in carryforward credits, and that 6.5 million returns claimed carryforward deductions of $55.9 billion. The TIGTA found that 19,193 taxpayers claimed a carryforward credit or deduction with discrepancies that totaled more than $5 billion used to offset tax. The TIGTA also found problems with carryforward claims in two earlier reviews: In 100 returns, TIGTA found that also two-thirds of taxpayers submitted inadequate forms with their carryforward claims, and in other cases the claims didn’t match up with their prior-year returns.
The TIGTA recently said that the IRS still falls short in verifying the accuracy of carryforward claims, and recommended several changes, including expanded criteria and better technology. The IRS provides little guidance on insuring that correct numbers are carried forward to future years’ returns, preparers have added, and the agency reportedly lacks mechanisms for measuring and monitoring carryover deductions or credits and questioning what doesn’t match IRS records.
Note: The agency agreed with some of the TIGTA’s recommendations, but claimed its own sampling turned up no invalid claims, and that carryforward discrepancies can exist legitimately.
Here’s what you can look for
Tax reform and other factors figure into your due-diligence regarding clients and carryforwards. For instance, the increased standard deduction may have lead some clients to self-prepare – with the odds being that they missed legitimate carryforwards.
Among other points:
- Most taxpayers, no matter their situation, know little or nothing about the compliance details of carryforwards.
- Carryforwards should be considered on both the federal and state level. Some states, for instance, may allow deduction carryforwards for excess annual contributions to a 529 college-savings plan.
- Some local taxing agencies now inform taxpayers that they took a carryforward in a previous year.