by Kitty Testa
In the New York Times article about Donald Trump’s avoidance of federal income tax, the paper quoted tax experts that implied that Net Operating Loss Carry Forward (NOL) is an unfair advantage to the wealthy. From the NYT:
The provision, known as net operating loss, or N.O.L., allows a dizzying array of deductions, business expenses, real estate depreciation, losses from the sale of business assets and even operating losses to flow from the balance sheets of those partnerships, limited liability companies and S corporations onto the personal tax returns of men like Mr. Trump. In turn, those losses can be used to cancel out an equivalent amount of taxable income from, say, book royalties or branding deals.
First, let’s just concede that the Federal Tax Code is dizzying in and of itself, but the implication that this is a tool of the wealthy is misleading.
Second, let’s address why business owners use pass-through entities, such as LLCs and S-Corporations, in which earnings, losses, bonus depreciation, charitable donations, etc., are passed through to partners and shareholders and taxed at the personal level. This is done to avoid the double taxation that occurs in Subchapter C Corporations, commonly known as C-Corps. The C-Corp is a tax paying entity, a “person” for taxation purposes. The business pays corporate income tax at the corporate tax level, and when income is distributed to shareholders, the shareholders then pay personal income tax on those dividends. The income is, in effect, taxed twice.
It’s also worth noting that in pass-through entities, the partners and/or shareholders are liable for income taxes regardless of whether the income has been distributed out to them from the company.
Most small business owners use these very same strategies for their business entities. Let’s use an average Joe as an example.
Joe owns a landscaping company which he operates as a single-member LLC. Joe started this business with his own money. He also is a 50% owner in a car wash which is an S-Corp which is funded through a revolving line of credit, and he has a personal guaranty on file with the bank for $100,000 related to that loan. He and two other partners own a six-flat apartment building in equal shares of a partnership LLC. The $500,000 building was purchased with 10% down from personal funds and a mortgage for the remainder.
Joe is eligible in all companies to use the NOL provision of the tax code because he has basis, meaning he’s personally at risk for any losses. If one business has a great year, that income can be offset by losses of another. If he incurs a very large loss in a tax year, he can use the provision to offset past and future income.
In Donald Trump’s case, he would have had to have basis to take the $918 million loss in the form of personal investment or personal guarantees. And it’s possible that his net worth was sufficient to cover those personal guarantees.
Trump stated that not having to pay federal income tax made him smart, but that’s a stretch. While losses can be incurred due to external factors, usually there is some mismanagement involved. In the New York Times article Trump’s former accountant took credit for the tax “strategy.”
He felt keenly aware that Mr. Trump was living a life of unimaginable luxury thanks in part to Mr. Mitnick’s ability to relieve him of the burden of paying taxes like everyone else.
This is ludicrous. It’s just the tax law, known well by staff accountants everywhere preparing tax returns, programmed into the tax preparation software that CPA firms use, and therefore widely used by business people. This isn’t a tax loophole for the wealthy, and it’s disingenuous of the NYT to portray it as such.
Business owners are often serial entrepreneurs. They don’t just have one company, but several. There are numerous reasons to set up companies as discreet entities: liability, capital structure, ownership structure, etc. The NOL carry forward provision is a crucial part of ensuring that entrepreneurs are not punished for taking risk.
After this story broke, Trump tweeted that he alone could fix the tax code. If his plan is to dump the NOL carry forward, every small business owner in America should march on Washington.