Revenue Administrative Bulletin 2020-23

INDIVIDUAL AND FIDUCIARY INCOME TAX NET OPERATING LOSS

Approved:  December 17, 2020

(Replaces Revenue Administrative Bulletin 2017-14)

RAB 2020-23. Revenue Administrative Bulletin (RAB) 2017-14 described how to compute a net operating loss (NOL) and an NOL deduction for Michigan individual, trust and estate (fiduciary) income tax and described the impact of a federal NOL on Michigan tax credits.   This RAB replaces RAB 2017-14 and addresses changes to the computation of Michigan NOLs and the use of NOL deductions as a result of the federal 2017 Tax Cuts and Jobs Act (TCJA)[1] and the 2020 Coronavirus Aid, Relief, And Economic Security (CARES) Act[2].

INTRODUCTION

Under Part 1 of the Michigan Income Tax Act (MITA), a Michigan NOL occurs when a business has losses in excess of its gains in a particular tax year, referred to as the loss year.  An individual or a fiduciary can sustain an NOL, which may be carried to certain other years to offset income in those years.  The resulting offset to income in those other tax years is referred to as the NOL deduction.^[3]  The Michigan NOL follows the same general format and procedures as the federal NOL, but is computed independently of the federal NOL.

ISSUES

1. What is a Michigan NOL and how is it different from a federal NOL?
2. How is a Michigan NOL computed?
3. How may a Michigan NOL deduction be used?
4. What are the requirements to claim a Michigan NOL deduction?
5. What NOL deduction, if any, may be used to establish eligibility for certain Michigan tax credits?

CONCLUSIONS

1. A Michigan NOL occurs when business losses exceed income in a particular tax year, with certain modifications.  The Michigan and federal NOLs are distinct because itemized deductions factor into the federal NOL but not the Michigan NOL.  Additionally, the Michigan NOL includes only Michigan-sourced income, losses and deductions, while the federal NOL applies to income, losses, and deductions from any source.  In all other manners, the Michigan NOL is determined in accordance with the federal NOL provisions.
2. A Michigan NOL begins with adjusted gross income (AGI) as defined in the Internal Revenue Code (IRC) subject to Michigan adjustments. IRC 172(c) and the modifications in IRC 172(d) are then applied to Michigan-sourced income, losses and deductions.
3. Generally, NOLs incurred in 2017 or earlier years may be carried back and used to offset income in the two taxable years preceding the loss year and may be carried over to each subsequent year for up to twenty years following the loss year.  The CARES Act generally allows losses from 2018, 2019, and 2020 to be carried back for up to five years to offset 100% of taxable income and losses from tax years 2018 and 2019 and may be carried forward to offset 100% of taxable income for 2019 and 2020 and then 80% of taxable income for subsequent years. Nonfarming losses incurred after 2020 may not be carried back and may only offset 80% of taxable income in each carryforward year. The 20-year limitation does not apply to NOLs incurred in tax years after 2017; NOLs incurred in 2018 or later may be carried over indefinitely until fully absorbed.
4. A Michigan taxpayer claiming an NOL must complete Form MI-1045 and attach it to Form MI-1040 to carryforward the loss. To carryback the loss, a taxpayer must complete a Net Operating Loss Carryback Refund Request Form 5603-CARES Act for 2018, 2019 and 2020 or a Michigan Request from a Farming Loss Carryback Form 5603 for farming losses incurred in 2021 and subsequent years.
5. For tax years beginning in 2012 and thereafter, a federal NOL deduction may not be used to determine a taxpayer’s eligibility for the homestead property tax credit or home heating credit.  However, the federal NOL deduction, as limited by federal modified taxable income, may be used for all tax years to compute eligibility for the farmland preservation tax credit.

LAW AND ANALYSIS

Group 1 NOLs and Group 2 NOLs.  To facilitate the different tax treatment of NOLs created after the enactment of the federal 2017 Tax Cuts and Jobs Act, the Michigan Department of Treasury (“Department”) has designated NOLs created through 2017 as Group 1 NOLs and those created in 2018 or later as Group 2 NOLs.  The CARES Act changed the TCJA carryback and carryforward rules for 2018, 2019, and 2020 NOLs.   To clarify carryback and carryforward rules for the NOL deduction, Group 2 NOLs are designated as “Group 2 CARES” for 2018, 2019, and 2020 NOLs and “Group 2 TCJA” for NOLs incurred after 2020. This RAB uses “Group 2” without a federal act designation, when a statement applies to all NOLs incurred after 2017.

Taxpayers may find it useful to use a spreadsheet prepared by the Department to track the absorption of Group 1 and Group 2 NOLs.  The Michigan NOL Carryover Worksheet can be found at www.michigan.gov/taxes under Individual Income Tax forms.

Tax form changes.

Form MI-1045.  Form MI-1045 was significantly redesigned in 2018 and 2019 and may be e-filed with the loss year return beginning in 2019.  The form title and its uses have changed to accommodate changes in the law and allow NOLs to be e-filed.  Taxpayers should use the Form MI-1045 that is related to the loss year and follow the instructions for that year. This RAB references the current title, Michigan Net Operating Loss Schedule, but for the years before 2018 the title was Application for Michigan Net Operating Loss Refund.

Group 2 NOL loss year filing change. Beginning with tax year 2018, a Group 2 Michigan NOL is calculated on the Michigan Net Operating Loss Schedule MI-1045.  The MI-1045 is filed with the Group 2 loss year return and is no longer filed as part of the first NOL deduction carryover year. 

NOL Carryforward Forms

NOL Carryback Forms

Farmland Preservation Tax Credit form change. The NOL deduction for the Michigan farmland preservation tax credit formerly was located on page 3 of Form MI-1045 and is now part of the Michigan Farmland Preservation Tax Credit Claim, Form MI-1040CR-5, part 4.

Computing a Michigan NOL. A Michigan NOL occurs when business losses exceed income in a particular tax year. An individual, a trust, or an estate can sustain an NOL in one tax year and use that loss to offset income in other tax years.  The resulting offset to income in those other tax years is referred to as an NOL deduction.^[4] 

The Michigan NOL deduction is statutorily provided for in Section 30(1)(n) of the MITA.^[5]  Section 30(1) defines Michigan taxable income as federal AGI subject to certain adjustments.^[6]  Two of those adjustments pertain to the net operating loss.  Subsection 30(1)(m) adds back any federal NOL deduction to the extent it reduced AGI.  Subsection 30(1)(n) subtracts a Michigan NOL.  Specifically, subsection 30(1)(n) provides:

Deduct a net operating loss deduction for the taxable year as determined under section 172 of the internal revenue code subject to the modifications under section 172(b)(2) of the internal revenue code and subject to the allocation and apportionment provisions of chapter 3 of this part for the taxable year in which the loss was incurred.

A Michigan NOL therefore follows the general NOL provisions of IRC 172 for determining an NOL, but is applied only to Michigan-sourced income, losses and deductions.  The Michigan NOL, once created, is carried to other tax periods in the same manner as provided in the IRC.

The definition of a Michigan NOL deduction under MITA subsection 30(1)(n) can be broken into three parts: 1) determination of the NOL under IRC 172; 2) modification of the NOL to remove non-Michigan sourced income and losses, and; 3) determination of the carryback or carryforward amount per IRC 172(b)(2).  This RAB explains each of these parts and demonstrates the application of each.   

Determining an NOL under IRC 172 and IRC 461(l)

An NOL is a combination of net operating loss calculated under IRC 172 and an excess business loss excluded from the loss year’s AGI under the IRC 461(l) excess business loss limitation. 

IRC 461(l). Enacted as part of the 2017 TCJA, IRC 461(l) prohibits offsetting income with excess business losses generated in that same tax year.  IRC 461(l)(3) provides that the disallowed excess business loss is treated as an NOL carried over to the following taxable year under IRC 172. The disallowed excess business loss that is sourced to Michigan is calculated on Michigan Excess Business Loss Form MI-461.

The CARES Act suspended the excess business loss limitation for 2018, 2019, and 2020.[7]  As a result, a taxpayer who had losses limited by the provision in 2018 or 2019 should file an amended return.  For tax year 2020, business losses will not be limited under IRC 461 on the original return. The losses will be available to absorb and reduce income in those years and any remaining loss will be available for immediate carryback as an NOL to the five preceding years.   

IRC 172. Subsection (c) of IRC 172 defines an NOL as the excess of the allowed deductions over gross income subject to the modifications in subsection (d).^[8]  Seven of the eight modifications in subsection (d) apply to individuals and fiduciaries.^[9]    When calculating the NOL for the loss year, IRC 172(d) requires removal of the following deductions or adjustments from the calculation:

1. The net operating loss deduction.^[10]
2. The deduction for excess capital loss over capital gain and any deduction granted under IRC 1202 for the sale of certain qualified small business stock.^[11]
3. The deduction for personal exemptions.^[12]
4. The adjustment of nonbusiness deductions in excess of nonbusiness income.[13]
5. The adjustment for real estate investment trusts (REIT).[14]
6. The deduction for nonbusiness qualified business income (QBI).[15]
7. The deduction for foreign-derived intangible income (FDII).[16]

No other loss modifications are permitted except those enumerated by IRC 172(d).  The modifications are the same for both the federal and the Michigan NOL. 

Notwithstanding the fact that the same modifications are applied to both NOLs, the federal and the Michigan NOLs are distinct from one another because the starting points for each include different items.  The federal NOL begins its computation with federal taxable income.  The Michigan NOL begins with taxable income, which is defined under MITA as AGI.^[17]  The distinction arises because the computation of federal taxable income includes all itemized deductions.^[18]  The starting point for the Michigan NOL computation, AGI, does not include itemized deductions.^[19]  For this reason and for reasons outlined in the following section, the federal and Michigan NOLs need not equal one another, and a Michigan NOL can exist without a federal NOL.^[20]

Applying the MITA Allocation and Apportionment Provisions to the NOL

The Michigan NOL also differs from the federal NOL as the Michigan NOL excludes income, losses, and deductions from other states because the MITA requires that an NOL deduction be calculated subject to the allocation and apportionment provisions of chapter 3 for the tax year in which the loss was incurred.^[21]  Chapter 3 of the MITA requires a taxpayer with income from business activity which is taxable both within and outside the state to allocate and apportion net income.^[22]  Therefore,  a Michigan NOL and the attendant deduction can be based only on Michigan-sourced income, losses and deductions. 

Additionally, since income, losses and deductions from oil and gas production and nonferrous metallic minerals extraction or beneficiation that are subject to Michigan severance tax are not taxable under the MITA, they must also be excluded from the NOL computation.^[23] 

Claiming an NOL for a loss year.

A Michigan taxpayer claiming an NOL must file a Form MI-1045, Michigan Net Operating Loss Schedule with the loss year return.  To expedite the review of tax returns reflecting a Michigan NOL, the Department requests that taxpayers attach:

• copies of the completed federal Form 1040 for the loss year and any supporting federal tax schedules and statements that substantiate the NOL
• a copy of the completed federal Form 1045 (if applicable)
• a listing of the state(s) of location for any claimed business losses on federal schedule(s)
• a copy of any attachments indicated on federal schedules
• any K-1s issued to the taxpayer
• Form MI-4797, Adjustments of Gains and Losses from Sales of Business Property
• Form MI-1040D, Adjustment of Capital Gains and Losses
• Form MI-1040H, Schedule of Apportionment
• Form MI-461, Michigan Excess Business Loss
• the Michigan Business, Rental, and Royalty Activity Worksheet
• any other pertinent form or data related to calculating the NOL 

Carryback and Carryforward of the NOL Deduction

Generally, a loss is carried backed to the earliest year and then to each subsequent tax year consecutively.  However, when calculating the remainder to be carried to each subsequent tax year, the taxable income for the tax year in which the NOL deduction was taken must be re-computed with the modifications in IRC 172(d)(2)(3)(6)(8) and (9).   Thus, before any remaining NOL can be applied to subsequent tax years, taxable income in the tax year prior to the carryback or carryforward year must be modified to remove the deductions for excess capital loss, excess nonbusiness deductions, personal exemptions, QBI, FDII and adjustments for REITs.   The NOL is then subtracted from the modified taxable income and the remainder carried to the next succeeding tax year.  The modifications must be repeated for each tax year to which an NOL is carried. 

Farmers. Farmers use Michigan NOL Carryback Refund Request Form 5603-CARES Act to claim a carryback for NOLs incurred in 2018, 2019 and 2020. For 2021, farmers use Michigan Farming Loss Carryback Refund Request Form 5603. To claim an NOL deduction for a carryforward year, use Form MI-1040 for individuals or Form MI 1041 for fiduciaries for years 2018 and 2019.  Form 5674 must be filed to use either a Group 1 or a Group 2 NOL beginning in 2021.    

TCJA and CARES Act.  The TCJA, as modified by the CARES Act, made significant changes to the use of Group 2 NOL deductions for losses incurred in tax years ending after 2017. The changes include:

1. Elimination of nonfarming NOL carrybacks after 2020.[24]
2. No carryback of excess business losses (including farming losses) under IRC 461(l) incurred after 2020.
3. Elimination of the 20-year carryforward limitation. NOLs may be carried over indefinitely until fully absorbed.
4. Limitation of the maximum NOL deduction to 80% of taxable income before exemptions in any carryback or carryforward year.[25] Except NOLs incurred in 2018 and 2019 may be carried forward to 2019 and 2020 without limitation.

The CARES Act allows losses from 2018, 2019, and 2020 to be carried back for up to five years.[26] Group 2 CARES NOLs may be carried to 2019 and 2020 to offset up to 100% of taxable income, as opposed to 80% of taxable income under the TCJA.  Group 2 CARES NOLs that are not completely absorbed in 2019 and 2020 are subject to the TCJA 80% rule for subsequent years.  The 2020 loss year NOL may be carried back and applied to 100% of the taxable income in the carryback years but to the extent that the 2020 NOL is carried over, it is applied to only 80% of taxable income.

Election to not carryback. The Michigan NOL can be used in the same manner as a federal NOL under IRC 172(b), but if a carryback is allowed for federal purposes (either because the loss occurred before 2018, was a Group 2 CARES loss or was a farming loss) the taxpayer may choose to carry the loss forward for Michigan purposes by electing to forgo the carryback.  Generally, for Group 1 NOLs, an NOL may be carried back to each of the two taxable years immediately preceding the loss year and to the twenty taxable years following the loss year.^[27]  Special carryback and carryforward provisions apply to certain other types of losses.^[28]  Specifically, Group 2 TCJA may only be carried forward, Group 2 CARES may be carried back 5 years rather than 2 years and Group 2 NOLs are not subject to the 20-year limitation (they may be carried forward indefinitely).

The amount of the NOL deduction for a given taxable year is equal to the sum of all NOL carryforwards and allowable carrybacks for the taxable year.^[29]  For Group 1 NOLs and Group 2 CARES, the entire amount of the NOL for a loss year must be carried back to the earliest of the taxable years to which the loss may be carried.^[30]  The earliest year’s loss must be used first until it is completely absorbed.  Later years’ losses can then be used until they are also absorbed or lost. 

A taxpayer with Group 1 NOLs, Group 2 CARES, and Group 2 farming losses may elect to relinquish the entire carryback period.^[31]  If a taxpayer wishes a federal NOL election to control the treatment of a Michigan NOL, a copy of the federal election must be provided to the Department with the taxpayer’s Michigan return.  A taxpayer who wishes to make a separate Michigan election may “check the box” to elect out of the NOL carryback on the Form MI-1045.  Once made, an election is irrevocable.^[32]

IRC 965 and Group 2 CARES carrybacks.   Taxpayers will generally include IRC 965(a) deferred income from foreign subsidiaries (repatriation income) in their taxable income either in 2017 or 2018. Note that if an NOL is carried back to a year in which IRC 965(a) applied, by default, the taxpayer will be treated as having made an IRC 965(n) election, which excludes IRC 965 income from determining the NOL deduction for that year.  This means that an NOL carryback will not reduce taxable income in the carryback year that is attributable to the mandatory repatriation income inclusion under IRC 965.  Alternatively, a taxpayer may affirmatively elect to exclude IRC 965 income years from the carryback period. 

Example:  The taxpayer has an NOL in 2019 and carries it back to years 2014 through 2018, and elects to exclude 2017 from the carryback because of recognition of IRC 965 income in 2017.  The 2019 NOL would be carried back to 2014, 2015, 2016 and 2018, but not to 2017. 

Carryforward of an NOL deduction.  Both Group 1 and Group 2 NOLs are carried forward using the Michigan Operating Loss Deduction, Form 5674 beginning in 2021. For Group 2 CARES, the Michigan NOL deduction may be used up to 100% of taxable income in carryforward years 2018, 2019 and 2020 and then it is limited to 80% of taxable income for years after 2020.  For Group 2 TCJA, NOLs incurred after 2019, the NOL deduction is limited to 80% of taxable income in the carryforward year.  Group 1 NOLs are always deductible up to 100%, even after 2020, because the loss was incurred prior to 2018. 

Statute of limitations

A claim for refund based on an NOL must be filed within the four-year statute of limitations period under the Revenue Act.[33] Therefore, when carrying back an NOL to prior years, the NOL deduction must be claimed within four years of the date set for filing the original return for the year in which the NOL was incurred.  If an NOL is determined to have been incurred in a year that is outside the four-year statute of limitations period, a taxpayer may still claim the NOL deduction for the open tax years.  However, in doing so, the taxpayer must calculate the amount of the Michigan NOL that would have been absorbed by Michigan income subject to tax in the closed tax year(s) to determine the amount that can be carried over to the open year(s).  The Department may redetermine correct taxable income in a closed tax year in order to ascertain either the amount of an NOL or the amount of an NOL that is absorbed in the closed tax year for purposes of determining the correct NOL deduction for an open tax year.

EXAMPLE

Assume Taxpayer incurs an NOL of $76,000 in tax year 2012, and in 2018 files a claim to establish an NOL and request refunds.  The carryback years of 2010 and 2011 are outside of the statute of limitations period, as is the carryforward year of 2013.  Taxpayer may still file a claim for the NOL refunds in 2018 but applying the NOL to the closed years reduces the NOL and causes it to be fully absorbed in year 2017 as illustrated in the chart below.

Applying the NOL to the closed years reduces the available NOL for the open years from $76,000 to $51,000.^[34]  Taxpayer should file a Form MI-1045 for the 2012 loss year and file amended returns for the open years with a schedule demonstrating how the NOL is absorbed. The Department provides a Michigan NOL Carryover Worksheet under the income tax forms section on the Department website:  www.michigan.gov/taxes.

Where there are changes in the filing status of an individual taxpayer from the year of the loss to the year of the carryback or carryforward, a taxpayer must account for the change in status in the year to which the carryback or carryforward is applied.  If married taxpayers filed jointly in the year of the loss and file single or separate in the carryback or carryforward year, each individual must determine and apply their share of the joint NOL to their single or separate returns.  If a taxpayer filing single in the year of loss is filing jointly in the carryback or carryforward year, the joint filers must separate their income and deductions and apply the NOL deduction to the individual who sustained the NOL as a single individual.  For married taxpayers filing separately in the year of the loss who file jointly in the carryback or carryforward year, the total NOL or its remainder may be applied to the joint return. 

Using a Federal NOL Deduction to Establish Eligibility for Michigan Tax Credits

Historically, the federal NOL deduction was used to compute a Michigan taxpayer’s household income to determine eligibility for several Michigan tax credits, including the homestead property tax credit, home heating credit and the farmland preservation tax credit.[35]  Beginning in 2012, household income was replaced by total household resources for purposes of the homestead property tax credit.  An NOL deduction cannot be used to reduce total household resources for purposes of the homestead property tax credit or the home heating credit for tax years after 2011. 

The farmland preservation credit uses household income to determine eligibility for that credit for any tax year, subject to the statute of limitations.  As a result, the federal NOL deduction, as limited by federal modified taxable income, may continue to be used in the computation of that credit. 

Taxpayer option to use January 1, 2018 Internal Revenue Code. 

MITA provides the taxpayer with the option to file a return based on the Internal Revenue Code in effect for either the tax year or as of January 1, 2018.[36]  If a taxpayer opts to use the Code in effect on January 1, 2018, the CARES Act will not apply to the return, however the TCJA will apply.  The primary effect will be to prohibit carrybacks for the NOL deduction and to reinstate the IRC 461 excess business loss limitations.