Last year, the coronavirus pandemic pushed thousands of businesses to the edge. Some of the worst-hit industries included the travel, tourism, and hospitality industry, with most businesses reporting massive losses in revenue. In response to the economic stresses brought about by the pandemic, the government initiated a massive and complex stimulus package through the CARES act to keep the economy alive. One of the most noteworthy, pro-business provisions that never received the attention it deserved is the tax refund on business losses.
The CARES Act was enacted in March 2020 to provide robust measures to help struggling businesses that generated net operating losses (NOL). This provision allowed any small or large business to carryback or carryover any net operating loss, temporary suspending limitations in 2017's Tax Cuts and Jobs Act (TCJA). This means that businesses that had more tax deductions than taxable income in 2018, 2019, or 2020 can now carry back these losses and get tax refunds or carry forward these losses to offset their income tax liabilities in later years.
In this article, we'll break down the nuances of net operating losses and how individuals, businesses, taxable trusts, and estates can leverage these tax provisions to monetize their business losses, improve their investments and grow their economic efficiencies.
What Is Net Operating Loss (NOL)
A net operating loss occurs when a company's allowable deductions exceed the gross income in that year. Ideally, to get the NOL, the tax deductions are subtracted from the taxable income. These losses can be carried forward and backward to gain tax liability advantages.
NOLs are an important part of the tax code since they help mitigate discrepancies when a company's business cycle does not align cleanly with the tax year. This mostly happens during the nascent stages of many startups when they are not yet profitable. It is also a common phenomenon in cyclical industries such as mining and farming where corporations generate huge profits in one period and incur losses in the next.
Example: If in tax year 1, business XYZ has $70,000 of gross income and $100,000 of tax deductions, then the business has an NOL of $30,000 during that loss year. Because this business has no taxable income, it will not be paying any taxes during this year. They can then carry these losses forward or backward to gain huge tax advantages against their taxable income liabilities.
The most common causes of NOL include:
- Operational losses in a business
- Natural disasters
- Property damages
- Business expenses
- Product liability claims
- Rental property expenses
- Moving costs
A net operating loss is not necessarily bad news! First, if your business experiences an NOL in one year, you will not owe the government any taxes for that period. Consequently, you can leverage that loss to offset your tax liabilities in consequent tax years. This is called a net operating loss carryforward. A business can also use net operating loss carrybacks to monetize their losses by getting immediate refunds from the previous taxes paid.
Ideally, the NOL carrybacks and carryforwards are some forms of tax relief by the IRS that help smooth out the tax burden for businesses that experience income volatility from one year to another. A business may have made large tax payments in one tax year, then incur huge operation losses in the following year. With NOL deductions, such a business can smooth out these year-to-year income volatilities.
Net Operating Loss Carryback
After a loss year, a business can carry back the loss to the previous two years to gain immediate tax rebates on tax paid during that period. This 2-year time frame is referred to as the carryback period. However, in some special circumstances such as after experiencing NOL after theft or casualty, you may carry back your losses for 3 years.
NOL carrybacks are requested using an amendment return Form 1040X. You can however expedite the refund by filing an Application for Tentative Refund using Form 1045. This provision was however removed after the 2017 Tax Cuts and Jobs Act. We will come to this in a minute.
Net Operating Loss Carryforward
Next, if a company chooses not to carry back their losses or cannot carry back the losses due to previous years' NOLs (this is common with startups), it can elect to carry it forward to minimize their future tax liabilities. NOL can be carried forward for up to 20 years when it loses value or until their NOL carryforward is zero.
This is a complex process that requires tax experts to create a schedule to track these cumulative losses. Ideally, the NOL schedule ensures that these losses are drawn down in the order in which they were created, ensuring that each loss has a 20-year validity period.
NOLs Before the Cares Act
Before 2017, companies could fully offset their taxable income using NOL carryforwards without limitations. Cash strapped businesses would also use the 2-year NOL carrybacks to get tax rebates against taxes paid during the 2 years. If a company had insufficient taxable income within the last 2 years, then any excess losses that were impossible to offset could be carried forward, giving the business massive tax advantages in the coming tax years.
However, in 2017, a tax reform registration called the Tax Cuts and Jobs Act (TCJA) was enacted. The TCJA changed how NOLs worked in several ways, with nearly every business and individual affected. This act changed how a business could use carrybacks/carryforwards and essentially put limitations that took effect from 2018 onwards.
First, the act removed the provision for companies to carry back their losses for the preceding two tax years but an exception was placed on some farming and insurance companies. As a result, taxpayers now had only one option: to carry forward their losses and offset future tax liabilities.
Unfortunately, the Tax Cuts and Jobs Act also placed some limitations on how various businesses would utilize their NOL carryforwards. Unlike before, corporations and individuals could only carry forward their NOLs to offset 80% of their taxable income during that particular period.
What did this mean?
Well, previously C corporations could leverage the losses they experienced in their early years to build an NOL portfolio. They would then use an NOL schedule to offset significant tax liabilities once they became profitable until their losses were fully absorbed. In such cases, a company would operate without any tax liabilities, allowing it to use the profits generated to invest back to the business, grow its economic efficiencies, and expand its operations.
After the TCJA enactment, the 80% limitation took away this advantage. As a result, a C corporation would still manage to carry forward its losses until it became profitable. However, after profitability, its NOL would only cover 80% of its taxable income.
As a result, business owners would still have a tax liability on 20% of their taxable income. This took away a massive chunk of money that could be reinvested back into the business operations, placing immense pressure on new and struggling businesses that are still working with a shoestring budget.
This act also instituted other restrictions on how NOL would be calculated. Some of the excluded items are:
- Deduction for domestic production activities
- Deduction for personal exemptions
- The net operating loss deduction
- Capital losses that exceed the capital gains (from investments or sale of business assets)
- Nonbusiness deductions that exceed the nonbusiness income
- Exclusions on section 1202, mainly from the exchange of qualified small business stock or gain from the sale
- NOL deductions from other years
However, not everything about this act was bad for businesses. It had a silver lining in how long business would use their NOL carryforwards. Previously, businesses were only allowed to utilize their losses to offset their tax liabilities for up to 20 years. The passing of TCJA lifted the 20-year limit on NOL carryovers, meaning that businesses can carry over their losses for an unlimited period of time. This provision is perhaps aimed at compensating for the other changes in the act that are unfavorable for businesses.
Reinstatement of NOL Carrybacks: New Net Operating Loss Rules According to The CARES Act
The CARES Act was signed into law in March 2020 by President Trump to provide emergency assistance and the much-needed funds to individuals and businesses affected by the coronavirus pandemic. The CARES act made several provisions to cushion the economy against the ravaging global pandemic. Some of the highlights for the CARES act included:
- A $2 trillion stimulus package to mitigate the economic effects of the pandemic
- Providing a refundable employee retention credit for business affected by the stay in shelter directives
- Deferring payments on the employer's portion of the payroll tax
- Creation of the Paycheck Protection Program (PPP) that provided loans to help employers retain their employees during the pandemic
- Alternative minimum tax (AMT) acceleration
- Expanded business interest expense deductions
- Temporary suspension of TCJA, allowing special tax treatment of NOLs for taxpayers and corporations.
The temporary suspension of some of the business loss limitations put in place by the TCJA is perhaps the crown jewel of the CARES act. In a bid to support an already struggling economy, the CARES act allowed businesses to carry back the operating losses generated between December 31, 2017, and December 31, 2020. From these provisions, businesses could now apply for NOLs carrybacks for the last 5 years.
To put it in context...
If your business made a net operating loss between 2018, 2019, and 2020 tax years, these losses could be carried back 5 years. The act also stipulates that those taxpayers who choose to carry back their losses must do so for the entire 5-year carryback period and cannot elect to use the conventional 2-year carryback period. This provision is however not available from the beginning of this year (2021) when the TCJA limitations fall back into place.
Businesses can utilize the CARES act carryback provisions to apply for immediate tax rebates on tax income paid during this period, thereby creating an opportunity to get some extra cash infusion from the government. However, these NOL carrybacks are not permitted for real estate investment trusts (REITs). In some cases, businesses can choose to not carry back their NOLs and instead opt for NOL carryforwards. In those instances, the business must irrevocably waive the entire 5-year carryback adjustment.
The NOL carrybacks provisions offer several benefits:
- Immediate cash flow for struggling businesses that were adversely affected by the coronavirus pandemic.
- Permanent tax savings by generating liquidity from a period when the corporate tax rate was insanely high at 35% as compared to the current 21% rate.
- Expedited procedures to process all carryback claims to inject funds back into the economy as fast as possible.
- The NOL carrybacks typically offset 100% of taxable income in the carryback years, rather than the 80% of taxable income after when the CARES act provisions lapse on 31st December 2020.
The 5-year carryback is only practical for businesses that didn't exhaust their carryback rebates in the years before the TCJA enactment.
In case a taxpayer chooses to waive their 5-year carryback advantages, the CARES act eliminated the 80% limitation on taxable income, allowing businesses to carry forward their net operating losses to offset 100% of their future tax liabilities. However, this temporary suspension of the 80% limitation only applies for NOLs carryforwards up to 31st December 2020. After this year, the TCJA NOL limitations falls back into place.
How to Increase A NOL?
Taxpayers with enough taxable income due to high tax rates in the preceding carryback period can manage to generate additional cash flow benefits by actively using some by-the-book strategies to increase their NOLs, and effectively achieve permanent tax savings.
Due to the complex tax code regulations, it is important to discuss some of the strategies with a certified San Diego CPA expert before implementing some of these strategies. Here are a few strategies that can help you increase your losses and gain maximum financial benefits from NOL carrybacks and carryforwards:
Shortening the depreciable lives of assets
The CARES act allows individuals and corporations to write off certain commercial property improvements that may have been made between 2018 and 2020. Taxpayers who might have made improvements to their properties can immediately add these costs to their balance sheets as expenses, thereby increasing their net operating losses.
Also, since properties are generally considered as depreciating assets with a tax life of either 27.5 years or 39 years, you can perfume a cost segregation analysis to determine its appropriate tax life. This way, you can shorten its depreciable life, thereby accelerating its tax deductions.
You could also accelerate its deductions by performing an energy efficiency analysis (Section 179D). These accelerated deductions tentatively increase your taxable losses that could be recovered through NOL carrybacks or carryforwards.
Harvest tax losses by writing off old or uncollectible receivables
This is another tax strategy that is especially useful to accrual method taxpayers. If you have old or uncollectible accounts whose chances of collection are minimal or uncertain, you can write them off at the end of the tax year to increase your NOLs. With the consultation of your tax advisor, this proactive tax planning measure can create massive tax losses from underwater investments.
Accelerating large equipment purchases
You can increase your operating net loss by purchasing new or used equipment and placing them into service before the end of the tax year. The cost of this equipment is then placed as an expense, hence increasing the taxable losses. For taxation purposes, business property is only considered to have been placed in service only when it is ready and available for use, even if it is not actually being used.
Expedite Bonuses and Compensation Payment
IRC allows taxpayers to deduct fixed and determinable compensation for services delivered within that tax year provided the compensation is made not more than 2.5 months after that tax year.
Make early retirement contributions
Typically, pretax retirement contributions allow a business to significantly reduce their taxable income while still saving for the future. While there are some limitations on how much you can contribute towards your retirement, there are still ways you can make contributions without crossing the lines. Talk to a certified San Diego CPA for more insights.
Work with an expert San Diego CPA to identify beneficial accounting methods
Accounting methods help determine the most convenient time to place in an income or a deduction. Your tax advisor can either choose to use a cash or accrual method to increase your tax losses. Some of the common accounting methods that businesses can adopt include prepaid expenses, cash method, and advance payment method.
Accelerate payment of payroll taxes
Businesses can expedite the payment of deferred social security taxes to increase their taxable income.
Combining various expense and revenue accounts to look for flexibility in what has been recorded.
When NOT to Carry Back A Loss
The decision to apply for an NOL carryback should be carefully considered for all its knock-on effects. Ideally, the CARES act tries to offer a near-term solution to corporate tax planning. With this in mind, different corporations should tread cautiously on what to do when dealing with the NOL carrybacks. Here are some circumstances where an NOL carryback may not be a preferred business move:
- If a business has an AMT liability in a carryback year, apply for the carryback may be somewhat counterintuitive.
- Multinational groups with controlled foreign corporations (CFCs) should carefully model the impacts of the NOL carrybacks against other IRC provisions
- Taxpayers with prior M&A transactions also find themselves in a corner as some of their contractual liabilities may affect their NOL carrybacks or carryovers.
- If a company has consistently generated tax losses in the previous years, they cannot claim a tax rebate through NOL carrybacks since they don't have prior income tax liabilities that they can leverage to offset the losses.
- If the tax refund from NOL carryback is less than the expected future tax savings, then a carryback may not be an ideal economic move.
- If your business took an aggressive tax position at one of the carryback years, an NOL carryback may present unnecessary potential risks.
- If you have been severely hit by the pandemic but expect higher income in the immediate future, a loss carryforward would benefit you more than a loss carryback.
- NOL carrybacks may expose major IRC compliance issues in the carryback years, exposing you or your company to significant audit risks.
How Can I Carry Back A NOL?
There are 2 alternatives for filing an NOL carryback claim. You can apply for an NOL carryback by either:
i. Amending your returns for the carryback years (Form 1040-x), or
ii. Filing a tentative refund claim which is usually faster (Form 1045)
While there are some cases where Form 1040-x is preferred for filing an amended tax return, Form 1045 is often the most preferred for an NOL carryback. Reason: it is faster to get your tax rebates when you file for a tentative refund claim using Form 1045 and are likely to get your refund within 90 days.
Unlike form 1045, form 1040-x presents a unique technicality since the amendment return is subject to IRS screening procedures before the refund is issued, which may expose major compliance issues and also cause significant delays in the issuance of the refund.
Form 1045 is supposed to be filed within a year after the loss year. This means that, if your business experienced losses during the 2020 pandemic, you are required to have filled for the NOL claims before 31st December 2021. According to IRS procedures, tentative refund claims can only be filed after a taxpayer has filed the tax returns for the loss year.
Remember: Your accounts could still be audited even after the issuance of a refund check. Additionally, your refund claim could easily be thrown out of Form 1045 has math errors or material omissions. It is therefore paramount for individuals and businesses to work with a certified tax expert to get the refund claim right.
What Next Now?
With the coronavirus pandemic, a broad swath of industry including travel, tourism, energy, manufacturing as well as the restaurant industry experienced massive slowdowns, with many reporting massive net operating losses. The CARES Act NOL provisions were enacted to cushion businesses against massive losses. By filing an NOL claim, businesses can be guaranteed a tax refund on business losses, allowing cash-strapped businesses to get some money from the government which they can use to boost the already struggling business.
Due to the complex rules and compliance issues around the US tax code, carrying back NOLs and amending previous tax returns are complicated propositions best left to the experts. At San Diego CPA, we are here to help you take advantage of 2020 CARES act provisions so you can get back some of the previously incurred tax money and shelter your future taxable income. Contact us today with any questions on the CARES act and understand what these tax changes mean for your business' tax planning.