Most states tax corporate capital gains and losses in the same manner as under federal law. But several states differ on the deductibility of capital losses and loss carrybacks.
How Are Corporate Capital Gains and Losses Treated Federally?
Under federal law, corporate taxpayers include in gross income:
- long-term capital gains; and
- short-term capital gains.
Corporate taxpayers generally do not receive preferential tax treatment for long-term capital gains. Taxpayers add capital gains to their ordinary income. The total is then taxed at the normal corporate rate.
What is the Capital Loss Limitation Under IRC Sections 1211 and 1212?
Corporations may deduct capital losses only to the extent of capital gains for the tax year. Long-term and short-term capital losses are deductible from all types of capital gains.
Corporations may not deduct excess capital losses from ordinary income. However, to offset capital gain net income, the excess of capital losses over capital gains may generally be:
- carried back for three years; and
- carried forward for five years.
A net capital loss that is carried to another tax year is treated as a short-term capital loss.
If capital losses are incurred in multiple years, they are carried back or carried over in the order in which they were incurred.
The deduction is lost if the capital losses are not used within the three-year carryback and the five-year carryover periods.
Interaction with NOLs
A corporation may carry back a capital loss to each of the three tax years prior to the loss year. But the amount that can be carried back cannot cause or increase a net operating loss (NOL) in the carryback year.
There is no election to forego a capital loss carryback, such as the election with NOL deductions.
How Do States Treat Corporate Capital Gains and Losses?
Most states tax capital gains and losses like the federal government. However, there are several states that treat capital losses differently.
States Not Allowing Capital Loss Carrybacks
The following are examples of states that do not allow capital loss carrybacks.
- Arkansas does not limit the deduction of capital losses to the amount of capital gains. A capital loss may be fully deducted in the year realized. As a result, no carryback or carryover is allowed.
- California does not allow capital loss carrybacks, but generally follows the federal treatment of capital loss carryovers.
- Massachusetts requires that the full amount of the capital loss must be claimed and deducted in the year of loss. No carryover or carryback of any excess capital loss will be allowed. Any loss claimed on the taxpayer’s federal return must be added back.
- North Carolina allows taxpayers to include all losses recognized on the sale or other disposition of assets in the year of disposition. No carryover or carryback of capital losses is allowed. Taxpayers must add back all federal capital loss carryovers. A taxpayer can subtract all capital losses in the tax year that are not taken on the federal return.
- Tennessee allows the full amount of capital losses to be deducted in the year sustained. Any capital loss carryback or carryover allowed for federal purposes must be added back to Tennessee net earnings or losses. A subtraction is then allowed for the portion of the current year’s capital loss not included in federal taxable income.
Why Are Capital Losses Limited?
Enactment of the capital loss limitation arose from concerns over taxpayers being able to control the timing and recognition of gains and losses from individual investments. The capital loss limitation prevents taxpayers from disposing of investments at a loss and deducting the net capital losses against ordinary income, while deferring their unrealized gain on other investments.
The capital loss limitation basically keeps taxpayers from positioning their portfolio to trigger net capital losses in order to deduct them against ordinary income.
Taxpayers argue that this creates barriers to the deduction of true economic losses on financial positions when they do not have current capital gains. The rules under IRC Sec. 1212 lessen this effect by allowing the taxpayer to carry back and carry forward net capital losses.
Because corporate taxpayers do not receive a lower tax rate on capital gains, and are subject to the capital loss limitation, taxpayers may look for creative workarounds, such as:
- structuring financial transactions to generate ordinary gains and losses to avoid the capital loss limitation rules; or
- for corporate taxpayers with net capital loss carryforwards, structuring transactions so as to produce capital gains which could be offset by the net capital loss carryforwards.
In any case, the capital loss limitation rules continue to restrict tax-savings strategies for corporate taxpayers.
By Tralawney Trueblood, J.D., M.B.A.