In addition to providing economic relief to individuals and loans to businesses struggling during the coronavirus crisis, the Coronavirus Aid, Relief, and Economic Security (CARES) Act changed some tax provisions to ensure firms survive a large decline in cash flow.
One such change is the loosening of rules governing net operating loss deductions (NOLs). The CARES Act made three changes to NOLs that improves cash flow:
- Provided a five-year carryback for losses earned in 2018, 2019, or 2020, which allows firms to modify tax returns up to five years prior to offset taxable income from those tax years.
- Suspended the NOL limit of 80 percent of taxable income. This means that firms may deduct their NOLs to eliminate all of their taxable income in a given year, instead of having to carry forward any NOL beyond 80 percent of taxable income.
- Pass-through business owners may use NOLs to offset their non-business income above the previous limit of $250,000 (single) or $500,000 (married filing jointly) for 2018, 2019, and 2020.
These changes are not perfect. There are potential consequences of carrying back NOLs under the CARES Act. Here are some of our takeaways:
Allowing NOL Carrybacks May Not Mean Quick Cash
First, the company needs to have ready losses for recent tax years to carry back. Second, NOLs interact with many other tax provisions and could cause negative adjustments in other areas that reduce the net benefit.
The Downside Potential Starts on the Domestic Side
Carrying back a loss to a pre-2018 year can result in AMT liability, requiring calculations of modified taxable income and adjustments to the NOL for AMT purposes, potentially leading to significantly reduced net benefits from the carryback.
Carrybacks will also affect consolidated NOLs for the group and will necessitate recalculation of allocations where group members have departed the group.
Contractual and Procedural Issues Can Also Create Problems
Requesting a refund for a “closed” year based on an NOL carryback will allow the IRS to review that year to the extent of the refund, effectively “reopening” the year. Cash benefits need to be weighed against risk of additional scrutiny.
Contractual agreements relating to mergers or other corporate acquisitions could foreclose utilization of carrybacks.
International Consequences Could Mean Net Negatives
NOLs carried back under the Act cannot be offset against income included under §965. NOLs carried back to a pre-transition tax year could increase the FTC carryover under §904(c) for future years, thereby increasing FTC availability in §965 transition tax year(s) and decreasing the transition tax liability.
Negative Effect on Financial Statements
Additional NOL deduction on prior years may result in permanent loss of tax credits, incentives, and other benefits in prior years, resulting in additional total tax expense. Additionally, the ability to carryback NOLs may result in a release of valuation allowance in the period of enactment.
If the NOL carryback results in new uncertainty for tax positions that had become certain with the expiration of the statute of limitations on tax audits, new UTP reserves will need to be created in the period of enactment to account for that uncertainty.
Some Positive Effects Exist
The carryback provisions in the CARES Act make no alterations to rate structures; therefore, a positive effect is the ability to use losses from a 21% rate year to offset income of a pre-TCJA 35% rate year.
Planning opportunities using tax periods and accounting methods may be available to maximize any available benefits.
State tax implications also need to be considered when carrying back NOLs in order to ensure that carrybacks are properly claimed in each applicable state and that the statute limitations does not inadvertently get extended. It is expected that many states will decouple from the 5-year carryback provision, as they did in the past when disaster relief regarding NOLs was enacted.
During this unprecedented time, Sousa & Weber remains vigilant in serving our clients and monitoring tax changes to keep you informed. We will continue to assist clients with understanding all of the implications of the CARES Act. Contact us to talk about your situation.