Over the weekend, The New York Times reported that it had in its possession what appeared to be three pages from Trump’s 1995 personal income tax returns. According to The Times, the documents included the first page of state tax returns from New York, New Jersey, and Connecticut. The newspaper reached out to Jack Mitnick, a former Trump tax advisor, who confirmed that the pages appeared to be authentic copies of parts of Trump’s returns.
(You can read my colleague, Peter J. Reilly’s take on Mitnick’s confirmation here.)
The jaw-dropper, according to The Times is that the returns show a tax loss in 1995 in the amount of $916 million ($1.4 billion in today’s dollars). Tax analysts hired by The Times suggested that, with those numbers, Trump might have paid no income taxes for nearly two decades.
(You can read more about the story from Forbes editor Janet Novack here.)
We don’t know what’s actually in those tax returns (though the Washington Post put together a timeline of what they do know here). Speculation has, of course, run high ever since Trump announced that he would not release his tax returns because he says he is under audit from Internal Revenue Service (IRS). While the IRS has confirmed that there is no federal law that would preclude a taxpayer from releasing a return under audit, many tax professionals – including me – have suggested that we would never advise a client to do so. Indeed, during the last debate, Trump reiterated that he would not release his returns because his attorneys have advised against it.
When Clinton suggested that the real reason that Trump wouldn’t release the returns is that he doesn’t pay federal taxes, Trump didn’t disagree, saying “It makes me smart.” It’s a position the candidate has taken before, saying:
You know what? And I have said this many times, so it is not exactly breaking news. I pay as little as possible. I fight like hell to pay as little as possible, for two reasons. Number one, I am a businessman, and that’s the way you are supposed to do it. And you put the money back in your company and employees and all of that. But the other reason is that I hate the way our government spends our taxes. I hate the way they waste our money, trillions and trillions of dollars of waste and abuse. And I hate it.
Earlier this year, Trump released a letter from Morgan Lewis tax partners Sheri Dillon and William Nelson who confirmed to Trump, to whom the letter was addressed, that “[e]xaminations for returns for the 2009 year and forward are ongoing.” The letter also confirmed that the IRS examination of Trump’s return from 2002 through 2008 “have been closed administratively by agreement.”
Why not release those earlier returns – the ones that have already been audited – then? According to Dillon and Nelson, the returns involved items reported on earlier returns which caused the pair to conclude, “in this sense, the pending examinations are continuations of prior, closed examinations.” At the time, I suggested that “[w]hat that likely means is that certain tax preference items, like losses, may be carried forward or back on the returns.”
That, suggested The Times, is likely what happened. The paper claims the 1995 tax returns reveal “just how much Mr. Trump may have benefited from a tax provision that is particularly prized by America’s dynastic families, which, like the Trumps, hold their wealth inside byzantine networks of partnerships, limited liability companies, and S corporations.” That tax provision is called a net operating loss (NOL).
If you think you’ve heard about NOLs from me before, you’re not wrong. I’ve written about NOLs from time to time including, not-so-ironically, after a review of Mitt Romney’s 2010 tax return in 2012.
Under the Tax Code, an NOL results when certain of your tax deductions exceed your taxable income before you deduct your personal exemptions. In other words, if line 41 on your federal form 1040 (or line 39 of your federal form 1040NR) is negative, you may have an NOL. If that number is negative in one year – but has been positive in other years resulting in tax payable – that doesn’t quite seem fair. The NOL exists so that you can balance that inequity. In other words, you can use the loss in one year to lower your taxable income and reduce your tax burden in another year.
(Don’t confuse capital losses with an NOL: they are not the same thing.)
Most taxpayers think of losses in a business context. The real benefit to reporting business losses isn’t found on a Schedule C: it’s the result of losses which are passed through from other entities, like partnerships, limited liability companies and S corporations (it’s worth mentioning that shareholders do not directly benefit from C corporations which report an NOL since those corporations don’t pass through tax attributes).
But you don’t have to run a business to take advantage of an NOL. Nonbusiness deductions can still result in an NOL: those can include losses due to moving expenses, rental real estate expenses, or casualty and theft losses.
But here’s what The Times was getting at: under existing tax laws, if you have an NOL, you first carry back the entire NOL amount to the two prior tax years. You can carry part of the NOL back for three years, as opposed to two years, if the loss is attributable to a casualty or theft, or due to a federally declared disaster for a qualified small business (generally those making $5 million or less) or certain qualified farming businesses. Qualified disaster losses, qualified GO Zone losses, and specified liability losses qualify for even longer carryback periods.
If you still have an NOL remaining after you carry those losses back, you can carry the loss forward. You can also opt not to carry back an NOL and only carry it forward for up to 20 years. A carry forward means that you can apply the loss towards your income in a future year. Let’s say, for example, that you have a $100,000 loss in 2015 and $75,000 in income in 2016. Assuming that you carry the loss forward for 2016, you would have no net taxable income for 2016 and would still be able to apply a $25,000 loss in 2017.
It sounds pretty simple, right? It is for most taxpayers. But when taxpayers are involved in passive activities, the rules are a little more tricky. The Internal Revenue Service defines passive activities as trade or business activities in which you do not “materially participate.” You “materially participate” in a trade or business activity if you are involved “on a regular, continuous, and substantial basis.” If you do not actively participate, you have a passive loss. When losses from passive activities exceed the income from passive activities, those losses are disallowed for the current year. Fortunately, you can carry them forward to the next tax year – if you have more income than losses that year, you can offset the income with the carryforwards. You cannot carry them back.
Defining trade or business activity should be pretty straightforward. It’s exactly what you think it is with one exception: a trade or business for passive loss purposes does not include rental and real estate activities. As a rule, rental activities are considered passive activities by the IRS even if you materially participate. There are some exceptions to the rule, including those who qualify as a “real estate professional” and certain dollar limitations. The rules regarding rental activities, including rental real estate activities, can be confusing and are best navigated with the help of a good tax professional.
If it sounds like there are a lot of rules, there are. Part of the criticism of the NOL provisions stems – rightly, I believe – from the level of complexity involved. This has led some taxpayers to believe that the provisions are a recent development, intended to benefit special interests. The rules actually date nearly 100 years back, to the Revenue Act of 1918. The idea behind the rule at the time was to aid businesses that might have losses due to slowdowns after the wartime economy. The first NOL rules (downloads as a pdf) allowed for losses to be carried back one year and then forward one year. During the Great Depression, Congress threw out the NOL rules altogether but brought them back in 1939 as a two year carry forward: the two-year carryback was added in 1942 (again, as a nod to the wartime economy). The NOL carryforward would be extended to five years, then seven, by the 1970s. It was President Reagan who was responsible for more than doubling the carry forward period: the carry-forward provision was extended to 15 years as part of The Economic Recovery Tax Act of 1981 (ERTA). The rule was tweaked again under President Clinton as part of the Taxpayer Relief Act of 1997 (TRA), landing us largely at the carryback and carryforward provisions we have today.
Of course, just because the rules have been in existence for nearly a century doesn’t mean that they have been without controversy. After the most recent recession, the IRS noted an uptick in companies claiming NOLs. On its face, this makes sense: as the economy overall dips, so, too, do many corporate profits. The IRS also noted that not all NOLs claimed were appropriate. As a result, the IRS has, over the past five years, ramped up efforts to assess NOL taxpayers to identify “large, unusual, or questionable items, including corporate taxpayers who may be overly aggressive in generating NOLs” (TIGTA report downloads as a pdf). Some of those efforts include new disclosure rules – rules that were not in existence in 1995.
Assuming that you abstain from being overly aggressive, the existence of an NOL isn’t evidence of tax evasion even if it does leave a bad taste in the mouths of some taxpayers. Using existing tax laws to reduce your tax burden is, in fact, smart, if you do it honestly. Losses due to economic downturns are understandable if that’s what happened. But the scale of the losses as reported in The Times – and Trump’s refusal to talk about them – seems to be raising eyebrows.
It’s well known that Trump had several business failures in the 1990s, including four bankruptcies involving Trump’s companies: Taj Mahal (1991); Trump Castle (1992); Trump Plaza & Casino (1992); and Plaza Hotel (1994). Trump gave up control of Trump Shuttle (doing business as Trump Airlines) in 1991 after missing an interest payment (though Trump maintains he did not lose any money in the deal). However, since corporations are separate from individuals, the personal fallout to Trump from those deals is fuzzy at best.
But assuming that Trump turned bad business into a good tax strategy, I don’t know that I would agree that it necessarily resulted in a free pass on taxes for Trump for the next two decades. Like my colleague, Peter Reilly, I believe the next piece of the puzzle is missing, and it’s an important one. Trump has long touted his ability to negotiate deals – and that includes writing down debt. For tax purposes, cancellation of debt is typically taxed as income (you may have heard about this with respect to forgiven or reduced credit cards or student loans). There are exceptions for insolvency and bankruptcy but those come with a price: you have to adjust any related NOL accordingly. If Trump did negotiate away some or all of his debt, that could mean that the tax benefit of the NOL didn’t last as long as has been suggested. Without seeing those tax returns, we just don’t know.