Although P.L. 115-97, known as the Tax Cuts and Jobs Act (TCJA), cut the top corporate income tax rate from 35% to 21% and provided a 20% deduction for qualified passthrough and sole proprietor-ship business income (see "Mechanics of the New Sec. 199A Deduction for Qualified Business Income," page 44), the law's changes to the net-operating-loss (NOL) carryback/carry-forward rules may lessen the full effect of the rate reduction or deduction for taxpayers with NOLs arising in tax years beginning on or after Jan. 1, 2018.
NOLs BEFORE THE TCJA
The TCJA's change in treatment of NOLs is not without precedent. An operating loss carryback/carryforward deduction was first enacted in 1918 as a temporary, war-related measure. Carrybacks and/or carryforwards have been allowed, expanded, or removed from the Code numerous times. The allowance of operating loss carrybacks and carryforwards has long been seen by Congress as a means to treat more equally taxpayers with similar average incomes but different earnings cycles that span periods longer than a tax year.
An NOL generally is the amount by which a taxpayer's business deductions exceed its gross income (Sec. 172(c)), subject to certain modifications provided under Sec. 172(d). In general, prior to the TCJA, an NOL could be carried back up to two tax years and forward up to 20 tax years to offset taxable income. NOLs offset taxable income in the order of the tax years to which the NOL may be carried, although a taxpayer could elect to waive the carryback period. Special extended carryback periods were allowed for NOLs attributable to certain specified liability losses and certain casualty and disaster losses. NOLs attributable to certain farming activities were allowed a five-year carryback. Limitations were also placed on the carryback of certain excess interest losses attributable to corporate equity reduction transactions and NOLs of real estate investment trusts.
NOLs UNDER THE TCJA
Under the TCJA, the NOL deduction for a tax year is equal to the lesser of (1) the aggregate of the NOL carryovers to such year, plus the NOL carry-backs to such year, or (2) 80% of taxable income (determined without regard to the deduction) (Sec. 172(a)). Generally, NOLs can no longer be carried back but are allowed to be carried forward indefinitely (Sec. 172(b)(1)(A)). The special extended carryback provisions are generally repealed, except for certain farming and insurance company losses.
For any portion of an NOL for a tax year that is a farming loss with respect to the taxpayer, the loss is allowed a two-year carryback (Sec. 172(b)(1)(B)(i)). For this purpose, "farming loss" is defined in Sec. 172(b)(1)(B)(ii) (former Sec. 172(h)(1)) as the lesser of (1) the amount that would be the NOL for the tax year if only income and deductions attributable to farming businesses (as defined in Sec. 263A(e)(4)) are taken into account, or (2) the amount of the NOL for the tax year. Insurance companies other than life insurance companies continue to be subject to the pre-TCJA two-year carryback/20-year carryforward rules, and the 80% limitation does not apply (Secs. 172(b)(1)(C) and (f)).
In calculating the amount of the NOL, among the other adjustments required under Sec. 172(d), corporations are not allowed to take into account the new deduction for foreign-derived intangible income and global intangible low-taxed income under Sec. 250 (Sec. 172(d)(9)). Business taxpayers other than C corporations should also be aware that the new deduction under Sec. 199A for qualified business income is not allowed in determining an NOL (Sec. 172(d)(8)).
Technical problems for fiscal-year taxpayers and taxpayers with pre-2018 NOL carryforwards
The amendments incorporating the 80% limitation apply to losses arising in tax years beginning after Dec. 31, 2017. The amendments to the carryback/carryforward provisions, however, apply to NOLs arising in tax years ending after Dec. 31, 2017 (TCJA, §13302(e)). Therefore, corporations generally will be required to track NOLs arising in tax years in both periods separately. A Senate Finance Committee senior tax counsel has said the difference in effective dates is contrary to legislative intent, which was properly reflected in the conference committee report describing both provisions as effective for tax years beginning after Dec. 31, 2017 (as they also appeared in the approved Senate bill), and that technical correction legislation may be necessary (Richman, "Net Operating Loss Provision May Need Fix From Congress," 158 Tax Notes 587 (Jan. 29, 2018)).
However, unless and until a technical correction is enacted (see also "Tax Matters: AICPA Recommends TCJA Fixes," page 67), fiscal-year taxpayers with tax years beginning before Dec. 31, 2017, and ending after that date will be subject to somewhat of a hybrid of the new and old rules for that fiscal year: Generally, the 80% limitation will not apply, but NOL carrybacks will not be allowed.
In addition, for both calendar-year and fiscal-year taxpayers, an IRS official has indicated that potentially complex computations may be required to apply the 80% limitation in the case of a taxpayer utilizing NOL carryforwards from both pre-effective-date years and post-effective-date years (see Foster, "Algebraic Solution May Be Required to Settle Pre-2018 NOL Issue," 158 Tax Notes 1715 (March 19, 2018)).
Effects of the new limitations
Both the repeal of carrybacks and the 80% limitation, by deferring more of the loss recognition to future years, will generally have the effect of increasing the present value of total federal income taxes owed. Taking into account the time value of money, companies with intermittent loss years and startup companies with initial years of losses may fare less well than under previous law, all other factors being equal.
Example: Under prior law, a calendar-year C corporation with taxable income (or loss) of $400, ($500), and $100 in successive tax years would be able to carry back $400 of the $500 loss in year 2 to fully offset the $400 of taxable income in year 1, and carry forward the remaining $100 of the loss to fully offset taxable income in year 3.
Under current law, assuming each of the tax years takes place after Dec. 31, 2017, and using the same taxable income or (losses) as above, the $500 of loss in year 2 must be carried forward to year 3 and can only be utilized to the extent of 80% of taxable income, or $80. Total federal income tax paid (after taking into account the carryforward) is $84 in year 1 ($400 at 21%) and $4 in year 3 ($20 at 21%). The remaining $420 of NOL carryforward can continue to be utilized to offset taxable income in future years (subject to the 80% limitation).
INCOME TIMING NOW MORE CRUCIAL
More generally, the changes to the NOL rules put greater emphasis on taxpayers' understanding of the timing of their income and deductions when assessing expected future tax liabilities. A taxpayer can no longer rely on the NOL carryforward provisions to result in no federal tax liability in years of low taxable income relative to prior loss years.
With these changes to the NOL rules, only time will tell what effect the new rules will have. Therefore, it is important for taxpayers to understand, with the help of their tax adviser, the impact of these changes as well as the more burdensome accounting and recordkeeping that will likely accompany the new rules. Tax advisers should assist clients to optimize the potential impact, good or bad, on their cash flow.
John Owsley (John.Owsley@ey.com) is manager, international tax services, Ernst & Young LLP in Washington. John McKinley (firstname.lastname@example.org) is professor of the practice, accounting and taxation, Cornell University, Ithaca, N.Y.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.