The Coronavirus Aid, Relief and Economic Security (CARES) Act, enacted on March 27, 2020, provides relief to corporate and non-corporate taxpayers by expanding the permitted use of net operating losses (“NOLs”).
While prior to January 1, 2018 a calendar year taxpayer could carry back NOLs two years and carry them forward 20 years, the Tax Cuts and Jobs Act (“TCJA”) altered the NOL regime by prohibiting NOL carrybacks for NOLs arising in taxable years beginning on or after January 1, 2018 and limiting NOL deductions in such years to 80 percent of taxable income while permitting carryforwards indefinitely ).
Now, under the CARES Act, an NOL arising in taxable years beginning after December 31, 2017 and before January 1, 2021 (i.e., 2018, 2019, 2020 calendar years) may be carried back to each of the five taxable years preceding the taxable year in which the NOL arose (and may still be carried forward indefinitely). Additionally, the 80% limitation on the use of NOLs will not apply to tax years beginning before January 1, 2021. As a result, NOLs may be used to offset 100% of taxable income in a calendar year taxpayer’s 2018, 2019 and 2020 tax years. The use of NOLs in those years had been previously limited.
The NOL carryback is automatic unless a timely election is made to waive it. Each election is irrevocable and applies only to a particular taxable year’s NOL (a separate election to forego carrybacks would be required to be made for each of 2018, 2019, 2020 if intending to avoid carrying back the NOLs arising from each such year). If an election to waive the carryback for a particular taxable year’s NOL is not made, that NOL will be carried back to the earliest year within the carryback period where there is taxable income.
A Few Considerations for Determining Whether to Carry Back NOLs
Applying NOLs to pre-2018 taxable years when corporate tax rates were higher (35%) will be of greater value than the use of NOLs in years when the corporate tax rate is lower (currently 21%). However, taxpayers should keep in mind that applying NOL carrybacks and thus reducing taxable income in the applicable prior years may reduce certain deductions that were claimed in those previous years.
Additionally, given that the carryback is for a five-year period, there is a possibility that one or more years to which the NOL is carried back is otherwise closed from IRS audit due to the statute of limitations. Certain taxpayers may be hesitant to afford the IRS the opportunity to contest issues that relate to the tentative refund in such closed years.
Potential Impact on M&A Negotiations
The introduction of a new 5-year carry-back and the elimination of the 80% rule may alter current negotiations of acquisition agreements and open the possibility of amendments to recently signed transactions. Prior to the TCJA, the right to benefit from the carryback of losses was often negotiated between a seller and a buyer. Post TCJA agreements often do not address the carryback of losses since carrybacks were no longer allowed.
For example, it is likely that in recently signed transactions NOLs existing at closing were valued only for the use of such NOLs carried forward (and limited to 80% of taxable income). Now NOLs can fully reduce income in certain years and NOLs that can be carried back to pre-tax rate change years are more valuable.
Parties to acquisition agreements that do not account for the carryback of losses may wish to enter into post-closing agreements to allocate the refunds that could be available due to the extended carryback period. Agreement that are being negotiated should address the carryback of losses. In particular the parties may desire to allow for a carryback rather than limit the NOL to carryforwards, and allocate the refund amounts between the parties.
The negotiations regarding NOLs are, of course, deal-specific. For instance, a refund would only be available for the target corporation to the extent that there was taxable income to offset during the five-year carryback period.
Multinational Corporations that own Controlled Foreign Corporations.
Taxpayers that had to pay the one-time Section 965 “transition tax,” related to earnings and profits of their controlled foreign subsidiaries, will generally not be allowed to use an NOL carryback to offset the transition tax. The carryback of an NOL to a year in which a transition tax is paid will not offset the income that gave rise to that tax. In the alternative taxpayers can elect to exclude any year in which they paid the transition tax from the NOL carryback. Given the lower tax rate for the transition tax, this rule is generally beneficial to taxpayers.
REITs are not permitted to carry back an NOL arising in a taxable year in which the entity was a REIT (a “REIT Year”). Additionally, if an NOL arises in a non-REIT year, it may not be carried back to any prior taxable year which is a REIT Year.
The TCJA limited the amount of “net business loss” an individual may apply in a year to $250,000 (and $500,000 for taxpayers filing jointly). Any loss that was so disallowed was converted into a NOL and was subject to the restrictive NOL rules.
The CARES Act temporarily suspends the loss limitation rules under Code Section 461(l) for 2020 and retroactively to January 1, 2018. Therefore, non-corporate taxpayers with business losses arising in 2018, 2019, and 2020 may apply the five-year carryback without regard to the Section 461(l) loss limitation rules.
According to the FAQ section on the IRS website, a taxpayer’s election to forego carrybacks for NOLs arising in a taxable year beginning in 2018 or 2019 must be made by the due date (including extensions of time) for filing the return for the taxpayer’s first taxable year ending after March 27, 2020. Thus, a calendar year taxpayer must elect for either 2018 or 2019 NOLs by the extended due date for their 2020 return. Notice 2020-26 grants a six-month extension of time for taxpayers to apply for a tentative refund from the carryback of an NOL that arose in a taxable year that began during calendar year 2018 and that ended on or before June 30, 2019. This extension of time is limited to requesting a tentative refund to carry back an NOL and does not extend the time to carry back any other item.