Deducting losses in the CARES Act’s window

The Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, was signed into law by President Donald Trump on March 27, 2020. The purpose of this legislation, according to its version introduced in the Senate as S. 3548, is “[t]o provide emergency assistance and health care response to individuals, families, and businesses affected by the 2020 coronavirus pandemic.” With the closures of many businesses, the federal government enacted this legislation primarily to provide much-needed funds to many individuals who would lose their employment during the lockdown and to many businesses affected as well.

Some of the highlights of the CARES Act for businesses include deferring payment on the employer’s portion of the payroll tax, providing a refundable employee retention credit for employers whose businesses were suspended due to the COVID-19 lockdown, and creating the Paycheck Protection Program, which provides loans to help businesses keep their workers employed during the pandemic.

One important change under the CARES Act was to temporarily loosen restrictions on the net operating loss (NOL) deduction under Sec. 172, which creates an opportunity for some businesses to get an infusion of cash by filing an application for a tentative carryback adjustment under Sec. 6411. It is reasonable to believe that with little to no revenue coming in for months, many businesses across the nation will sustain losses this year, thus creating an NOL. It is critical for those businesses and especially their financial advisers to be updated on the current rules surrounding the NOL deduction.

NOLs BEFORE THE CARES ACT

Sec. 172 has been through some significant changes in the last few years. Prior to the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, an NOL deduction generally could be carried back two years and forward 20 years. There were circumstances or periods prior to the TCJA in which a carryback was different (e.g., tax years ending in 2001 and 2002 had a five-year carryback under the Job Creation and Worker Assistance Act of 2002, P.L. 107-147). In addition, generally, no dollar limitations existed on the amount of the NOL that could be used in a particular year into which the NOL deduction was carried, except for the amount of taxable income. Again, there were exceptions to this statement (e.g., for an ownership change under Sec. 382 and a conversion from a C corporation to an S corporation under Sec. 1371(b)(1)). Those rules all changed with the enactment of the TCJA.

Under the TCJA, the carryback rule was eliminated for most NOLs arising in tax years ending (subsequently revised in a technical amendment to “beginning”) after Dec. 31, 2017, although farming and certain insurance losses under Secs. 172(b)(1)(B) and (C), which could be carried back five years before the TCJA, retained a two-year carryback. NOLs arising in a year beginning after 2017 could be carried forward indefinitely. From a taxpayer perspective, the elimination of the carryback rule prevents certain taxpayers from receiving a quick cash refund from previously filed returns, which is a drawback of the TCJA rules.

The TCJA also limited the amount of an NOL deduction that may be used in a given year. For tax years beginning after Dec. 31, 2017, the NOL deduction was limited for both corporate and noncorporate taxpayers to the “amount equal to the lesser of (1) the aggregate of the net operating loss carryovers to such year, plus the net operating loss carrybacks to such year, or (2) 80% of taxable income computed without regard to the deduction allowable under this section” (pre-CARES Act §172(a)).

Excess business loss limitation

For noncorporate taxpayers, pre-CARES Act Sec. 461(l)(1) limited the amount of the NOL deduction by disallowing excess business losses for tax years beginning after Dec. 31, 2017, and ending before Jan. 1, 2026. Under this rule, excess business losses were defined as the excess of (1) the taxpayer’s aggregate trade or business deductions for the tax year (determined without regard to Sec. 461(l)(1) and any deduction allowable under Sec. 172 or 199A) over (2) the sum of the taxpayer’s aggregate trade or business gross income or gain plus $250,000 or, in the case of a joint return, $500,000 (both adjusted for inflation) (pre-CARES Act Sec. 461(l)(3)). Any disallowed excess business losses were carried over as an NOL (pre-CARES Act Sec. 461(l)(2)).

Essentially, a noncorporate taxpayer’s business loss was limited to $250,000 ($500,000 for joint returns).

NOL RULE CHANGES UNDER THE CARES ACT

Carryback reinstated

Section 2303(b) of the CARES Act temporarily reinstated a carryback period for all NOLs generated in years beginning after Dec. 31, 2017, and before Jan. 1, 2021 (i.e., for tax years 2018, 2019, and 2020). The carryback period for those tax years is five years under the CARES Act (including for farming and nonlife insurance losses) (Sec. 172(b)(1)(D)). Therefore, an NOL generated in the 2018 tax year can be carried back to the 2013 tax year, assuming there was taxable income in 2013. Because the top corporate tax rate was 35% prior to its reduction by the TCJA to 21% for tax years after 2017, carrying back an NOL from 2018, 2019, or 2020 could result in a greater benefit than carrying the NOL forward.

Example 1: Corporation X incurs a $100,000 tax loss in 2018. In addition, Corporation X had taxable income over $100,000 in 2013. The present value of tax savings from the NOL carryback to 2013 would be approximately $35,000, while if Corporation X carried the loss forward, the present value of the NOL would probably be less than $21,000 (21% tax rate).

Sec. 6411 allows a taxpayer to file an application for a tentative carryback adjustment of tax liability for a previous year into which the NOL can be carried. Regs. Sec. 1.6411-1(b) requires corporate taxpayers to use Form 1139, Corporation Application for Tentative Refund, and noncorporate taxpayers to use Form 1045, Application for Tentative Refund. Under Sec. 6411(a), the taxpayer has 12 months from the end of the NOL tax year to file the application. Sec. 6411(b) provides that within 90 days of filing the application, the IRS will credit, apply, or refund any overpayment.

The CARES Act also provided a special rule for carrybacks of NOLs by real estate investment trusts (REITs). For NOLs arising in 2018 through 2020, a loss in a REIT year cannot be carried back to prior years, and losses from non-REIT years cannot be carried back to REIT years (Sec. 172(b)(1)(D)(ii)).

With these new rules regarding carrybacks for the years 2018, 2019, and 2020, taxpayers must consider how they treated NOLs in those years and whether and how to revise that treatment.

Example 2: A taxpayer experienced an NOL for the 2018 tax year. Under the TCJA rules, the NOL must be carried forward. If the taxpayer had taxable income in the 2019 tax year, the 2018 NOL carryforward would probably have been used on the 2019 tax return. The taxpayer would have received a benefit from the NOL for the 2019 tax year. Therefore, depending on the circumstances, the taxpayer may wish to instead carry back the NOL by filing a superseding or amended return for the 2019 tax year and an amended return for each carryback year.

A taxpayer can elect to waive the carryback for losses arising in a tax year beginning after Dec. 31, 2017, and before Jan. 1, 2020. Rev. Proc. 2020-24 provides guidance to taxpayers wishing to waive the carryback for any loss incurred in these years. This election must be made no later than the due date, including extensions, for filing the taxpayer’s federal income tax return for the first tax year ending after March 27, 2020. A taxpayer makes this election by attaching a separate statement to the federal income tax return filed for the first tax year ending after March 27, 2020, and for each of tax year 2018 or 2019 for which the taxpayer intends to make the election. The statement must state that the taxpayer is electing to apply Sec. 172(b)(3) under Rev. Proc. 2020-24 and the tax year for which the statement applies. Once made, the election is irrevocable.

Rev. Proc. 2020-24 also provides guidance regarding an election to exclude Sec. 965 years from the carryback. In short, Sec. 965 requires certain U.S. shareholders of controlled foreign corporations (CFCs) to pay a transition tax on their pro rata share of undistributed earnings (post-1986) of the CFC. A taxpayer may wish to exclude a Sec. 965 year from the carryback because, for example, the taxpayer wants to use foreign tax credits instead of an NOL against that income.

Under Section 4.01(2) of the revenue procedure, a taxpayer may elect under Sec. 172(b)(1)(D)(v)(I) to exclude all Sec. 965 years from the carryback period for an NOL arising in a tax year beginning in 2018, 2019, or 2020. This election, for an NOL arising in a tax year beginning in 2018 or 2019, must be made no later than the due date, including extensions, for filing the taxpayer’s federal income tax return for the first tax year ending after March 27, 2020. For an NOL arising in a tax year beginning after Dec. 31, 2019, and before Jan. 1, 2021, the election must be made no later than the due date, including extensions, for filing the taxpayer’s federal income tax return for the tax year in which the NOL arises.

Temporary suspension of the 80% rule

The TCJA’s limitation of 80% of taxable income applied to all NOLs incurred in tax years beginning after Dec. 31, 2017. The CARES Act temporarily suspends this 80% taxable income limitation, allowing an NOL carryforward to fully offset taxable income in tax years beginning before Jan. 1, 2021.

Example 3: Corporation X, a calendar-year entity, incurs a $300,000 NOL in 2019. Corporation X elects to waive the carryback as provided in Sec. 172(b)(3) and carries the NOL forward. Corporation X has taxable income of $250,000 in 2020. Since the NOL deduction is applied to a year beginning before Jan. 1, 2021, rather than offsetting $200,000 of Corporation X’s taxable income (80%), the NOL can be used to fully offset the $250,000 taxable income, which leaves a $50,000 NOL carryforward.

However, in the case of a tax year beginning after Dec. 31, 2020, the amount of an NOL deduction is equal to the aggregate amount of the NOLs arising in tax years beginning before Jan. 1, 2018, carried to such tax year, plus the lesser of (1) the aggregate amount of NOLs arising in tax years beginning after Dec. 31, 2017, carried to such tax year; or (2) 80% of the excess of taxable income computed without regard to the NOL deduction and the Secs. 199A (qualified business income) and 250 (foreign-derived intangible income and global intangible low-taxed income) deductions, over the amount of the NOLs carried forward from before 2018.

Example 4: Corporation X, a calendar-year entity, has a 2017 NOL carryforward of $20,000. Corporation X also has NOL carryforwards of $100,000, $50,000, and $150,000 for the tax years 2018, 2019, and 2020, respectively. Corporation X has waived the carrybacks on all the NOLs. In 2021, Corporation X has taxable income of $200,000. Corporation X applies the NOL carryforwards to the taxable income incurred in 2021.

Since Corporation X’s 2021 tax year begins after Dec. 31, 2020, the 80% rule applies. The 2017 NOL can be fully applied, leaving 2021 taxable income of $180,000 ($200,000 taxable income, less the $20,000 2017 NOL). Next, Corporation X can deduct the lesser of (1) the aggregate amount of the NOLs incurred after Dec. 31, 2017, or $300,000 ($100,000 + $50,000 + $150,000); or (2) 80% of the excess of taxable income before a Sec. 172 deduction over the 2017 NOL [($200,000 – $20,000) x 80%] = $144,000. Since $144,000 is less than the $300,000 aggregate carryovers from the years 2018, 2019, and 2020, the maximum NOL deduction is $164,000 ($20,000 from the 2017 NOL, plus $144,000).

Temporary suspension of the excess business loss limitation

Under the TCJA, noncorporate taxpayers could only deduct a maximum $250,000 of excess business losses ($500,000 for joint returns). Section 2304(a) of the CARES Act retroactively suspends this rule. Now noncorporate taxpayers can deduct excess business losses arising in 2018, 2019, and 2020. However, for any tax years beginning after Dec. 31, 2020, and before Jan. 1, 2026, excess business losses will not be allowed (Sec. 461(l)(1)(B)). Excess farm losses for certain taxpayers are allowed for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026 (Sec. 461(l)(1)(A)). Prior to the CARES Act, a taxpayer would determine excess business losses using Form 461, Limitation on Business Losses. Form 461 will not exist for the 2020 tax year but will be used again starting in the 2021 tax year.

MANAGING LOSSES TO BEST ADVANTAGE

The TCJA brought some favorable treatment for taxpayers, such as increasing the standard deduction, reducing the corporate tax rate, creating a passthrough business deduction (Sec. 199A), and doubling the child tax credit, just to name a few. However, the TCJA brought about some unfavorable changes, as well. For example, the TCJA capped the itemized deduction for state and local taxes at $10,000, eliminated personal exemptions, and discontinued the moving expense for nonmilitary taxpayers. Another unfavorable change by the TCJA was its limitations on the NOL deductions and instituting the excess business loss limitation.

The CARES Act temporarily restores the net present value of the NOL deduction by reinstating the carryback and removing the limitations on the amount of the NOL deduction. However, the time window for a taxpayer to maximize an NOL’s net present value is short. These NOL rule changes under the CARES Act only apply to tax years 2018, 2019, and 2020. Taxpayers that incur an NOL during this three-year period and their financial advisers should be aware of these rule changes in order to maximize the net present value of their NOLs.

About the author

Richard Ray, CPA, Ph.D., is an associate professor of accounting at California State University, Chico.

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.

AICPA resources

Articles

• COVID-19 News and Resources
• “Liquidity and Cash Management Strategies During a Pandemic,” The Tax Adviser, July 2020

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• “Tentative Carrybacks — Forms 1139 and 1045,” Tax Section Odyssey

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