The Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) provides relief to taxpayers with net operating losses (“NOLs”) and excess business losses (“EBLs”) arising in taxable years 2018 to 2020. The IRS recently issued guidance related to the new NOLs rules under the CARES Act, which are favorable to taxpayers seeking such relief.
Background – Net Operating Losses
Generally, NOLs for businesses and individuals can offset income in future or prior tax years when the company or individuals have income. The 2017 Tax Cuts and Jobs Act (“TCJA”) changed the NOL carryback and carryforward rules by disallowing all carrybacks NOLs arising in taxable years beginning after December 31, 2017, providing for an indefinite carryforward period, and limiting the use of post-2017 losses when carried forward to 80% of taxable income.
NOL Changes Under the CARES Act
The CARES Act temporarily suspends certain TCJA changes to the NOL carryover and carryback rules:
- The 80% of taxable income limit on NOL usage is suspended for taxable years beginning before January 1, 2021. NOL’s carried forward or back to taxable year beginning before January 1, 2021 will be permitted to offset 100% of taxable income.
- NOLs arising in a taxable year beginning after December 31, 2017, and before January 1, 2020, may be carried back to each of the five (5) taxable years preceding the taxable year of such loss.
- The five-year carryback will also be permitted for farming losses and NOLs for insurance companies arising in a taxable year beginning after December 31, 2017, and before January 1, 2020, which otherwise are subject to a two-year carryback rule.
- A taxpayer can elect to forgo the five-year carryback, and instead carry the loss forward.
- There are special rules with respect to REITs and life insurance companies.
This generally creates three new buckets of NOLs for most taxpayers, as follows:
Tax Planning Opportunities and Considerations
The new rules for NOLs under the CARES Act provide opportunities for taxpayers with NOLs in 2018 to 2020 taxable years to claim tax benefits of the losses by carrying back the losses to earlier years when the U.S. federal income tax rates for both corporations and individuals were higher. However, in order to maximize this opportunity, there are many factors and issues that need to be carefully considered.
Prior Year Higher Tax Rates
The highest federal income tax rate was 35% and 39.6% for taxable years before 2018 for corporations and individuals, respectively. Carrybacks of NOLs generated in 2018 to 2020 taxable years to tax years before 2018 could generate higher refunds than carryforwards of the same NOLs to taxable years when the corporate tax rate is 21% and the highest individual rate is 37% (before 2026).
Taxpayers should consider opportunities to accelerate deductions or defer income to maximize NOLs in 2020 taxable year, and if possible, to some extent in the 2019 taxable year.
One obvious planning opportunity to consider is the use of disaster loss provisions under IRC section 165(i). As a result of the declaration of COVID-19 as a nationwide emergency pursuant to section 501(b) of the Stafford Act by President Trump on March 13, 2020, taxpayers may be able to claim disaster loss deductions for 2019 (on original or amended return) or 2020.
Foreign Tax Considerations
Taxpayers should consider whether planning to maximize NOLs in tax years 2020 or 2019 may cause other potential adverse effects such as impacts on base erosion and anti-abuse tax (BEAT), foreign derived intangible income (FDII) deduction, section 163(j) disallowed interest deduction, state and local income taxes, etc.
Other Tax Attributes
Taxpayers should consider potential adverse effects of carrying back of NOLs to earlier years on certain tax attributes such as foreign tax credits, general business credits, etc., which may need to be utilized in earlier years before they expire. If the carryback is to a tax year with section 965 transition tax, additional issues must be considered to determine the best alternative.
For example, the refund of regular tax may be considered as an additional overpayment of tax for the transition tax year and be held back by the IRS for the application against future installments of the transition tax. The IRS’s most recent guidance allows taxpayers to elect to exclude transition tax year from the carryback period (see below).
The effect of carryback of 2018 to 2020 taxable years NOLs on prior-year corporate alternative minimum tax (AMT) is currently unclear. Since TCJA repealed AMT for corporations for taxable years beginning after December 31, 2017, it is not clear whether the carryback would create AMT in those years since there are no AMT NOLs after 2017 for the carryback. However, if the carryback does result in AMT, the CARES Act provides new rules for accelerated refunds of AMT credits in 2018 or 2019.
IRS Guidance Related to the New NOL Carryback Rules
Revenue Procedure 2020-23, provides guidance by allowing eligible partnerships to file amended partnership returns using a Form 1065 and issuing amended Schedules K-1 to each of its partners.
In Revenue Procedure 2020-24, the IRS provides procedures for:
- waiving the carryback period in the case of an NOL arising in a taxable year beginning after December 31, 2017, and before January 1, 2020;
- disregarding certain amounts of foreign income subject to transition tax that would normally have been included as income during the five-year carryback period; and
- waiving a carryback period, reducing a carryback period, or revoking an election to waive a carryback period for a taxable year that began before January 1, 2018, and ended after December 31, 2017.
In Notice 2020-26, the IRS granted a six-month extension of time to file Form 1139 (corporations) or Form 1045 (individuals, trusts, and estates), with respect to the carryback of an NOL that arose in any taxable year that began during calendar year 2018 and that ended on or before June 30, 2019. Form 1139 or Form 1045 allows a taxpayer to obtain a quick tentative tax refund based on an NOL carryback, which normally is required to be filed within 12 months of the close of the taxable year in which the NOL arose.
Without the extension relief provided in Notice 2020-26, a taxpayer would normally have until December 31, 2019, to file Form 1139 or Form 1045 to claim refund for an NOL arising in a calendar 2018 tax year. Now, the same taxpayer will have until June 30, 2020, to file Form 1139 or Form 1045.
To expedite processing of these refund claims, the IRS is accepting these forms via facsimile. Temporary procedures regarding this change in protocol can be found here.
Background – Excess Business Losses (EBL)
TCJA added section 461(l) disallowing the deduction of EBL for the taxable year of a taxpayer, other than a corporation, beginning after December 31, 2017, and before January 1, 2026. An EBL for the taxable year is the excess of a taxpayer's aggregate deductions attributable to the taxpayer's trades or businesses, over aggregate gross income or gain of the taxpayer plus $250,000 ($500,000 with a joint return) (as adjusted for inflation).
EBL Changes Under the CARES Act
The CARES Act provides some relief to individual taxpayers with EBLs by changing the effective date of disallowance of EBL to taxable year beginning after December 31, 2020 (instead of December 31, 2017). The EBL disallowance rule is suspended for taxable years starting after December 31, 2017, and before December 31, 2020 (2018 to 2020 taxable years). Taxpayers who filed returns with an EBL disallowance in 2018 or 2019 can file an amended return to claim a refund.
Despite the relaxation of the EBL rules noted above, Congress decided to include some bad news. For tax year 2021 and beyond, wages will not be considered business income for purposes of determining the EBL limitation. The result, for most taxpayers, will be a significant increase in the amount of limited losses.
The CARES Act provides opportunities for taxpayers with losses in 2018 to 2020 tax years to generate tax benefits. In order to maximize the cash flow from these changes, careful tax planning and modelling strategies are recommended to consider a variety of complicated tax rules and issues. If you need help modeling how you can take advantage of the new rules to maximize cash flow, call on us. In the meantime, continue to visit our COVID-19 Tax Resource Center for up-to-date information on how the COVID-19 pandemic may affect your tax filing, payments, and planning.