The 2020 Coronavirus Aid, Relief and Economic Security Act (CARES) offered several different relief avenues for small businesses that are suffering in the wake of the COVID-19 pandemic.
Relaxing the net operating loss (NOL) deduction rules gives small business clients the option of changing their NOL deduction elections to provide liquidity, in the form of a refundable tax credit based on loss deductions taken against prior years’ income. Taking advantage of the expanded NOL relief can help many small business clients weather the current economic climate—but before making any concrete decisions, clients should fully understand how the new NOL options might impact their business as a whole.
CARES Act Relief
Prior to the 2017 tax reform legislation, net operating losses were fully deductible. They could be carried back for two tax years and carried forward 20 tax years. The 2017 tax reform legislation changed these rules so that NOLs deductions are limited to 80% of the business’ taxable income. For non-corporate taxpayers, the 2017 tax reform legislation changed the rules so that certain excess business losses must be carried forward and treated as a part of the taxpayer’s NOL in subsequent years.
The CARES Act lifted the 80% income limitation so that NOLs can offset 100% of income for 2018, 2019 and 2020. CARES also allows businesses to carry back losses for 2018, 2019 and 2020 for five years. Generally, the NOL will be carried back to the earliest possible tax year—and if it is not used up during that tax year, it is carried to the next earliest year until it is used up (or carried forward). Business owners have the option of excluding years where they had untaxed foreign earnings under IRC Section 965.
For tax years beginning prior to January 1, 2021, businesses can offset 100% of taxable income with NOL carryovers and carrybacks (rather than capping offsets at 80% of taxable income). The CARES Act also effectively delayed application of the excess business loss rule for non-corporate taxpayers until January 1, 2021.
Taxpayers can also elect to forgo the carryback provision and carry 2018 or 2019 losses forward to future years. Losses incurred in tax years beginning before 2018 may be carried forward to tax years beginning after 2020 without being subject to the 80% income limitation. However, amounts carried forward to tax years beginning on or after January 1, 2021 are once again subject to the 80% limit.
Practical Implications of NOL Carrybacks
Ideally, small business clients organized as corporations should aim to take NOL deductions in a prior year when the business was subject to the higher, pre-tax reform 35% tax rate (which has since been lowered to 21%). Under the CARES Act rules, the NOL deduction can generate a refund for the client even if the tax year in question is technically closed by the statute of limitations.
On the other hand, small business clients should understand that opening the statute of limitations period to take advantage of NOL deductions in a prior year also opens that year’s return to IRS examination. IRS guidance allows taxpayers to waive the carryback period for NOLs in 2018 and 2019
Some small business clients might prefer to waive the carryback option, whether to avoid IRS examination or to avoid becoming subject to the alternative minimum tax in that prior year. Clients entering into merger or acquisition transactions might also consider the implications of that transaction. For example, allowing the buying entity to take advantage of the NOL in a later year might make the business more attractive.
From a practical perspective, taxpayers take advantage of the NOL relief by filing Form 1139 to get a refund (the IRS has already granted a six-month extension to file this return for NOLs arising in tax years beginning in 2018 that end on or before June 30, 2019). Noncorporate taxpayers can file Form 1045 (and also take advantage of the six-month extension).
The NOL deduction rules have arguably become more complex post-CARES Act. Before making any decisions, small business owners should review the rules in detail with their advisors. It’s also important to understand how the NOL rules might also intersection with other provisions impacted by the CARES Act, including the business interest expense deduction.