Tax Insights

Your Guide to State, Local, Federal, Estate + International Taxation

Record retention for net operating losses (NOL)

record retention, documentation, net operating loss, taxIndividuals are usually familiar with the general rule that they should keep their income tax returns and tax documents used to prepare those returns for 7 years (see our guide). This is the general rule because the IRS has the ability to audit and adjust tax returns for three years from the date you filed your return in “normal” circumstances and six years in situations where income is substantially understated by more than 25%. This three or six year period is called the “statute of limitations.” So, a 7 year record retention period allows the statute of limitations to run out or expire in most situations.

However, there are certain instances when an even longer record retention period is recommended. One of these instances is where the individual has a net operating loss. Net operating losses occur when a taxpayer’s business deductions exceed business income. Net operating losses can be carried back 2 years and forward 20 years. This means that a net operating loss generated more than 7 years ago could still be showing up on an individual’s current year tax return.

In the case of a net operating loss, the individual needs to keep:

  1. The tax return reporting the original loss,
  2. Any later year tax returns showing the loss being used
  3. Supporting documentation for the original loss.

This documentation should be kept for 7 years after the year that the net operating loss is entirely used up or expires. Supporting documentation includes:

  • Bank statements
  • Receipts
  • Invoices
  • Basis information
  • Other proof that the loss occurred

Retaining supporting documentation is essential, because the Tax Court has ruled that an earlier tax return, without supporting documentation, is not sufficient proof of the loss, even in a “closed” year where the statute of limitations has expired.

When an individual cannot provide supporting documentation for his or her loss, the IRS can reduce or eliminate the carryforward loss reported on returns in open years (where the statute of limitations has not expired), possibly causing tax to be owed in the open years. While general retention guidelines provide a helpful starting place, please consult with your tax advisor if you have any questions about how long to keep documentation.

Jennifer A. Maas