The Impact of Net Operating Loss Revisions in an Uncertain Environment
2020…we are a third of the way through the year, but if you ask most people it feels like it has been a year and some already. The year 2020 will be remembered to most as the year coronavirus, specifically COVID-19, changed the United States and the world forever. A pandemic struck us all—with numerous confirmed cases and deaths, the world markets crashed, and unemployment soared.
As a response, the United States Congress has passed legislative packages to assist the American people during these unprecedented times. The Coronavirus Aid, Relief and Economic Security (CARES) Act was signed into law on March 27, 2020, providing relief to individuals and business owners. Though the CARES Act included various tax provisions, this article will specifically review the changes made to the Net Operating Loss (NOL) rules that were modified by the 2017 Tax Cuts and Jobs (TCJA) Act.
Prior to the 2018 tax year and TCJA, NOLs were subject to the following limitations:
- NOLs were allowed a two-year carryback period (if not waived on the tax return that generated the loss) or carried forward for a period of twenty years to offset future taxable income. For example, if the taxpayer generated a NOL in 2017 it would first carryback to the 2015 tax year to offset any taxable income and then to the 2016 tax year. If the preceding two years did not have any taxable income, the carryback would be waived and the NOL would carryforward to offset any future taxable income for the next twenty years until it was fully utilized or expired.
With the enactment of TCJA, the following limitations were placed on NOLs:
- For tax years ending after December 31, 2017, TCJA limited the Net Operating Loss carryover deduction generated in a year ending after December 31, 2017 to 80 percent of taxable income. The two-year carryback period was eliminated for most industries, and the carryforward period was extended indefinitely from the original 20 years.
Under the CARES Act, these rules were temporarily modified through January 1, 2021 (at which point, the rules under TCJA will resume). The CARES Act modifications included:
- Any NOL arising in a tax year beginning after December 31, 2017 and before January 1, 2021 may be carried back five taxable years unless the carryback period is waived (applies to 2018, 2019, and 2020 NOLs).
- NOLS generated in tax year beginning in 2017 and ending in 2018 are eligible to be carried back two taxable ears.
- Unlimited carryforward of NOLs remain.
- NOLS carryovers and carryback to taxable years beginning before January 1, 2021 are not subject to the 80% limitation of taxable income.
Illustrating the changes from past to present laws
In 2018, a C Corporation taxpayer generates a loss of $300,000. Under the 2017 TCJA, this loss was ineligible for carryback to a prior tax year so the entire amount was carried forward indefinitely to future years. In 2019, the same taxpayer generates taxable income in the amount of $125,000. The NOL from 2018 ($300,000) is utilized to offset and reduce the income, but it is limited by the 80% limitation of taxable income. The taxpayer would be able to utilize 80% of taxable income, $100,000 ($125,000 x 80%) as an eligible loss and $200,000 ($300,000 - $100,000) of NOLs would carryforward to 2020 and future tax years. Under TCJA, this would result in $25,000 of taxable income for 2019 subject to the corporate tax rate (21%). The taxpayer would have a federal corporate income tax liability of $5,250 ($25,000 x 21%).
Under the CARES Act, utilizing the same fact pattern, the taxpayer would utilize the 2018 NOL of $125,000 to reduce the 2019 taxable income to $0, resulting in no federal corporate income tax liability for the 2019 tax year. The remaining 2018 NOLs, $175,000 ($300,000 - $125,000) would carryforward to 2020 and future tax years. In this example, we assume the taxpayer elected to forgo carryback of the NOLs to a prior year. The taxpayer has the option to waive the carryback election and utilize the NOLs in future years only, as illustrated in this example. In the next example, the taxpayer will not elect to forgo carryback and as such, utilize the NOLs in previous tax periods.
Let's use the same fact pattern and assume the taxpayer was in existence in 2016 and generated taxable income in 2016 of $300,000. Let's further assume that in 2018, the taxpayer does not elect to forgo carryback for the generated loss ($300,000). Based on general operative Net Operating Loss rules under the CARES Act, the loss would first carry back to the first year out of the past five years that had taxable income and then proceed to the following year. Assuming there was no taxable income in 2013, 2014 and 2015, the 2018 NOL would be utilized in 2016 to reduce taxable income to $0 for that period. Recall that the corporate tax rates were not modified to a flat rate of 21% until 2018, so this option would result in significant tax savings compared to utilizing the NOL in future years with a 21% corporate tax rate (2019, 2020, etc.)
Because of the changes to corporate tax rates, the modifications under the CARES Act can provide certain taxpayers with significant tax savings, as compared to the savings that would be otherwise be available under the TCJA provisions.
To illustrate this, let's again assume the same facts as above: a C-corporation taxpayer generates a $300,000 Net Operating Loss in 2018. The taxpayer had no federal taxable income in 2013, 2014, or 2015. The taxpayer had $300,000 in federal taxable income in 2016.
- Under the TCJA provisions, tax savings for this taxpayer would amount to $63,000 ($300,000 x 21%). This assumes the $300,000 NOL can be utilized in future years and the corporate tax rate remains at 21%.
Under the CARES Act provisions, tax savings for this taxpayer would amount to $100,250 by carrying back the 2018 $300,000 NOL to 2016. These savings are based on the corporate tax rate schedule in effect for the 2016 tax year ((($300,000 - $100,000) × 39%) + $22,250 = $100,250).
- For this particular taxpayer, with these specific facts, the CARES Act modifications to the Net Operating Loss provisions can result in an additional tax savings of $37,250.
The removal of restrictions and limitations related to NOLs creates opportunities for corporate taxpayers to take advantage of previously higher tax rates by carrying back losses generated in 2019 and 2020 to the five preceding tax years. The removal of the 80% taxable income limitation for 2018, 2019 and 2020 also affords corporate taxpayers the opportunity to utilize more NOLs.
However, the above simple examples do not consider interplays with AMT NOLs, 965 taxes or BEAT taxes which can make the analysis significantly complex.
Expedited Filings to Assist Taxpayers
To assist taxpayers in receiving cash as soon as possible, the IRS has rolled out expedited filings of tentative carryback adjustments (quick refund applications). Additionally, the IRS via Notice 2020-26 has granted a six-month extension of time to file the quick refund application for NOLS that arose during the calendar year 2018 and that ended on or before June 30, 2019. Thus, such taxpayers have until June 30, 2020 to file their tentative carryback.
Taxpayers should actively seek communication with their tax advisor to discuss the potential and opportunity of either filing an amended tax return or NOL carryback forms to take advantage of the provisions under the CARES Act to NOLs.
Questions? Contact your Brady Ware advisor today!