The CARES Act and Net Operating Losses
By Nathan Pliskin
April 9, 2020
The Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), enacted on March 27, 2020, has introduced taxpayer-friendly changes to the net operating loss (“NOL”) regime. The changes impact a wide-range of tax years, potentially back to tax year 2013, and ease restrictions on NOL usage to promote tax refund claims that will help inject capital into businesses during the current economic turmoil.
NOL Rules Before the CARES ACT
The rules applicable to tax years before 2018 generally allowed a taxpayer to carry back an NOL to the two years preceding the loss year or carry forward an NOL for the subsequent 20 years. Such losses were fully deductible during either the carryback or carryforward period.
The Tax Cuts and Jobs Act of 2017 (“TCJA”) instituted a new regime, beginning in tax year 2018, which eliminated NOL carrybacks and provided for indefinite NOL carryforwards. However, a taxpayer’s deduction of post-TCJA NOLs in any carryforward year was limited to 80% of (pre-NOL deduction) taxable income in such year. Pre-TCJA NOLs remained fully deductible.
The Cares Act generally makes changes to tax years starting in 2018, but allows carrybacks to tax years 2013-2017. These changes are discussed below.
Carrybacks Allowed For Tax Years 2018-2020
A. Five-Year Carryback Claim Allowed (Into 35% Corporate Rate Environment)
The CARES Act provides for an expansive carryback rule applicable to tax years beginning after December 31, 2017 and before January 1, 2021. For losses generated in these years (2018, 2019, and 2020 for a calendar year taxpayer), the CARES Act creates a new five-year carryback period. Taxpayers may now carry back these losses to the five taxable years preceding the year in which the loss was incurred. Thus, a taxpayer may potentially carry back an NOL generated in 2018 to the 2013, 2014, 2015, 2016, and 2017 tax years.
For corporate taxpayers, the allowance of an NOL carryback to pre-2018 tax years allows losses to be deducted against income taxable up to the 35% top marginal tax rate in effect pre-TCJA. Every $100 of NOL that can be carried back to a pre-2018 tax year may generate a tax refund of $35 as opposed to a $21 cash tax value when utilized in tax year 2018 or later. Thus, such pre-2018 refunds may increase the value of each NOL utilized by 67% due to the higher rate of tax applicable to the income shielded by the NOL. Corporations in immediate need of capital should consider the potential value of refund claims that may now be available.
Individuals are likewise allowed a five-year carryback period, although the rate differential is not as significant for non-corporate taxpayers. Significantly, the CARES Act has also repealed the section 461(l) excess business loss disallowance rule for tax years beginning before January 1, 2021. This rule, created by the TCJA, has been applicable to non-corporate taxpayers and limited the amount of losses deductible by individual taxpayers beginning in tax year 2018. With the temporary retroactive repeal, losses that had been limited under section 461(l) are now fully allowed and may create NOLs that could be carried back to prior years, resulting in tax refunds.
B. Waiver of Carryback
Under the general rule for NOL carrybacks, a taxpayer must either carry back the entire NOL or elect to waive the entire carryback period. Thus, taxpayers may face a complicated and significant choice between carrying NOLs back across five different years or waiving the entire carryback period.
A review of the taxpayer’s specific circumstances in each relevant tax year is warranted prior to making refund claims. A number of tax provisions are calculated based upon (post-NOL deduction) taxable income, thus taxpayers need to run the numbers before determining that it is preferable to carry back the NOLs. Additional complications can arise where a corporate taxpayer has been involved in a merger or acquisition or has been part of a consolidated corporate group. Purchase agreements executed after the TCJA may not contemplate NOL carrybacks. An NOL carryback to a tax year with a section 965 inclusion presents several complications (discussed below).
For noncorporate taxpayers, the CARES Act repealed the section 461(l) excess business loss disallowance rule for tax years beginning before January 1, 2021. The temporary repeal of section 461(l) will generate refunds for some individual taxpayers in the 2018 and 2019 tax years, reducing their existing NOL carryforward.
The election to waive the carryback period with respect to tax years 2018 and 2019 must be made by the due date (including extensions) of the taxpayer’s return for the first taxable year ending after March 27, 2020. A separate election to waive the carryback period can be made with respect to each tax year (e.g., a taxpayer may carry back 2018 NOLs but elect to waive the carryback period for 2019 NOLs). Taxpayers therefore should consider all potential ramifications of the five-year carryback periods before filing tax year 2020 income tax returns.
C. Technical Correction to Allow Fiscal Year 2018 NOL Carryback
For fiscal tax years beginning in 2017 and ending in 2018, the CARES Act provides an extended deadline to claim a refund attributable to NOLs generated in such year. A refund based upon a carryback of such fiscal year NOLs will be treated as timely filed if the refund is claimed by the 120th day after the date of enactment.
This change is a technical correction of a TCJA drafting error that unintentionally left fiscal year taxpayers unable to carry back NOLs from tax years beginning before January 1, 2018 and ending after December 31, 2017.
D. Deferral of 2019 Tax Payment When NOL Anticipated
Taxpayers may potentially gain additional liquidity by deferring payments of tax year 2019 income taxes (which have already been postponed until July 15, 2020 under Notice 2018-20).
A further deferral for corporations should be available under section 6164, which allows companies to receive an extension of time to pay tax relating to the preceding tax year if an NOL is expected for the current year. Section 6164 is an old provision, but is newly relevant in light of the CARES Act’s reintroduction of NOL carrybacks.
Corporations have historically received an extension under section 6164 by filing Form 1138, Extension of Time for Payment of Taxes by a Corporation Expecting a Net Operating Loss Carryback. The IRS has not issued any guidance on the use of Form 1138 with respect to the 2019 tax year, however we expect that corporate taxpayers will be able to take advantage of expected 2020 losses in 2019 using this provision. Using this provision will mean that corporate taxpayers will not have to pay 2019 taxes and then wait until after the end of the 2020 tax year to claim a refund.
Note, however, interest will accrue on the unpaid 2019 tax from July 15, 2020 through the due date for the tax year 2020 return. In other words, the IRS allows for the deferral of tax due, but will charge interest on amounts deferred until the due date of the loss year return. Finally, penalties will be assessed if the taxpayer fails to sufficiently estimate the anticipated NOL, resulting in an underpayment of tax.
E. Carryback Rules and the Section 965 Transition Tax
The CARES Act also created rules to prevent taxpayers from using NOL carrybacks to offset the section 965 transition tax, generally applicable with respect to the 2017 tax year. Section 965 required United States shareholders to pay a transition tax on the untaxed foreign earnings of certain foreign corporations as if those earnings had been repatriated to the United States.
Where a taxpayer carries back an NOL to a year with a section 965 inclusion, the NOL carryback will not be utilized to offset the section 965 inclusion (via a deemed section 965(n) election). Because section 965 inclusions are taxed at a discounted rate, it is generally preferable not to offset such income with NOLs. Taxpayers should also be cognizant that the carryback of NOLs to such years may impact the foreign tax credit (“FTC”) limitation computation, which will result in a change to the section 965 liability (even though it is not offset by the NOL carryback). A portion of the NOL may also be considered foreign source, which would likewise adversely affect the FTC limitation. Last, it appears that any overpayment of tax generated in such years by virtue of the NOL carryback will be applied first to reduce the overall section 965 tax liability (including amounts payable under an eight-year installment) before being refunded to the taxpayer. Accordingly, taxpayers must carefully consider the interaction between NOL carrybacks and Section 965.
Because of these issues, the CARES Act makes a further modification to the election to waive the NOL carryback period when there is a section 965 inclusion in a relevant tax year. As discussed above, such election generally waives the entire carryback period (i.e. all five years). However, there is a special rule which allows taxpayers to exclude only the section 965 inclusion year without waiving the entire five-year carryback period. This will allow taxpayers to avoid the problems with NOL carrybacks to a year with a section 965 inclusion.
F. Carryback Restrictions For REITS
The CARES Act contains special rules that govern the use of NOLs by taxpayers that are taxable as REITs. The rules prevent REITs from carrying back any REIT year NOL to a preceding year. The rule also prevents non-REIT year NOLs from being carried to any preceding REIT year.
G. Special Carryback Rules for Insurance Companies
Like other taxpayers, insurance companies are entitled to a five-year NOL carryback period under the CARES Act. The law also provides that any NOL carryback by an insurance company to a pre-2018 tax year is treated as an operations loss carryback under section 810 (before that section’s repeal by the TCJA).
Taxable Income Limitation Temporary Repeal and Modifications
A. Temporary Repeal of Taxable Income Limitation
Under the CARES Act, the limitation on the use of NOL carryforwards to 80% of (pre-NOL) taxable income has been repealed for tax years beginning before January 1, 2021. Accordingly, existing NOL carryforwards may be fully deducted against 2020 income (in the absence of other restrictions). This rule applies to prior tax years as well. Thus, taxpayers that were subject to the 80% limitation on their 2018 and 2019 income tax returns may file their return, or amend a prior return, to claim additional NOLs in excess of the repealed 80% taxable income limitation.
B. Modified Taxable Income Limitation
The limitation of NOLs to 80% of taxable income is reinstated for any tax year beginning after December 31, 2020. In addition, the CARES Act contains certain changes to this calculation, resolving some statutory ambiguity (in ways that may not be beneficial to taxpayers).
Under the CARES Act, the 80% of taxable income calculation takes place after deducting pre-TCJA NOLs (which are deductible in full). Accordingly, this reduces the amount of any post-TCJA NOL carryforward that may be deducted in any tax year (after 2020) in which a taxpayer also deducts pre-TCJA NOLs.
Conversely, the 80% of taxable income calculation does not account for the section 199A passthrough deduction or the FDII or GILTI deductions under section 250. This is because both sections 199A and 250 limit the deductions thereunder to taxable income. In some instances, this will reduce total taxable income by allowing a greater amount of post-TCJA NOLs to be deducted. In other instances, it will cause the utilization of post-TCJA NOLs to decrease the tax benefits that would otherwise be available in that year under sections 199A or 250.
Corporate Alternative Minimum Tax
The CARES Act accelerates the potential for refund claims for corporate alternative minimum tax (“AMT”) credit carryforwards from pre-TCJA tax years.
The TCJA eliminated the corporate AMT, but provided that existing corporate AMT credits can offset regular income tax liability for any year. Moreover, the TCJA allowed corporate taxpayers to claim a refund of AMT credits in taxable years beginning after December 31, 2017 in an amount equal to 50% of the excess of the minimum tax credit for the taxable year over the amount of the credit allowable for the year against regular tax liability. For tax year 2021, the 50% ratio increases to 100%, thereby allowing corporate taxpayers to claim a refund for any remaining AMT credit by the end of tax year 2021.
The CARES Act modifies the refundable AMT credit calculations created by the TCJA to accelerate the fully refundable credit from tax year 2021 to tax year 2019. Thus, taxpayers with remaining pre-TCJA AMT credits will be able to claim a refund on account of these credits in the 2019 tax year.
As a result of the interplay between the revised NOL provisions and various other provisions in the Internal Revenue Code, care must be taken before amending tax returns and/or waiving carryback provisions.
Please contact your Mazars USA LLP professional for additional information.