The tax benefits realized (or lost) from corporate net operating losses (NOLs) may be significant. In fact, the financial statements of the Fortune 1000 reportedly include an estimated $200 billion in deferred income tax assets for NOL carryforwards. 1 Certain businesses, such as those in cyclical industries, may incur substantial losses in some years and then realize substantial profits in other years. An inequity would result if corporate tax were levied on profits from profitable years without considering losses from loss years.
The corporate deduction for NOLs helps ensure corporations pay tax on their average profitability over multiple tax years. However, corporate tax professionals must navigate the various federal and state tax rules and conduct careful tax planning to realize the full financial benefit of available NOLs, whether these NOLs arise organically or from an acquired entity.
This article provides a brief background on federal and state NOLs. It then discusses challenges tax professional face in managing corporate state NOLs and offers guidance on (1) maximizing the use of corporate state NOLs; (2) considering the value of corporate state NOLs in pricing merger-and-acquisition (M&A) transactions; and (3) recording an appropriate deferred tax asset and related valuation allowance for corporate state NOLs.
Federal treatment of NOLs
Sec. 172(c) defines an NOL as the excess of the deductions allowed by Chapter 1 over the gross income, computed with modifications specified in Sec. 172(d).
For NOLs arising prior to 2018, a U.S. corporation could carry back the NOLs to reduce its federal taxable income and apply for a tax refund in each of the two previous tax years by filing Form 1139, Corporation Application for Tentative Refund, or Form 1120X, Amended U.S. Corporation Income Tax Return. It could also carry forward the NOLs to reduce its federal taxable income and its related tax liability for up to 20 years. Pre-2018 NOLs related to specified liability losses were entitled to more generous carryback allowances.2 Furthermore, a corporation could elect to waive the federal NOL carryback period and only carry forward the NOL. Corporations calculate and report federal NOL carryforward amounts on Schedule K, "Other Information," of Form 1120, U.S. Corporation Income Tax Return.
Under the legislation known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, signed into law on Dec. 22, 2017, NOLs generated after Dec. 31, 2017, can offset only 80% of a corporation's taxable income in any year. With limited exceptions, NOLs generated after 2017 cannot be carried back, but they can be carried forward indefinitely.3
Varying state treatments
In addition to following regulations for federal NOLs, a corporation must also adhere to the various state NOL tax rules for each state in which the corporation has nexus. Even before enactment of the TCJA, state tax rules varied widely regarding the NOL carryback and carryforward periods, which is significant because a corporation may realize no tax benefit from an NOL after the NOL carryover period has expired.
For financial reporting purposes, a corporation recognizes adeferred tax asset on its balance sheet for the amount that existing NOL carryovers may reduce future tax liabilities. A corporation also records a valuation allowance for the estimated NOL tax benefit amount that is not expected to be utilized (for example, because of a lack of anticipated future taxable income or the expiration of an NOL carryover period).
Therefore, corporations should track both their federal and state NOLs to properly record any deferred tax asset and related valuation allowance arising from NOLs, as well as develop a plan to maximize the use of available NOLs to reduce future tax liability. In addition, corporations should consider available federal and state NOL carryovers from their own or other corporate subsidiaries targeted for merger or acquisition. While rules may limit the use of NOLs from acquired corporations (such as the limitations contained in Sec. 382), the value of a target company's available NOL(s) may be substantial and should be considered in the negotiated acquisition price.
An acquiring company should also consider whether a potential target company's state NOL carryover is from a separate filing state or a combined income state. It is important to note that a company may not use an NOL from a subsidiary operating in a separate filing state to offset income from profitable subsidiaries operating in a different separate filing state or that are part of a combined state tax filing. Twenty-five states and the District of Columbia allowed or required a combined corporate return as of 2017.4
Challenges for tax professionals in managing corporate state NOLs
While the same federal NOL corporate tax rules apply to all U.S. corporations, tax professionals employed by corporations that operate in multiple states face a considerable challenge keeping up with the various corporate state NOL rules. As noted earlier, a knowledge of applicable federal and state allowable NOL carryback and carryforward periods is important because no tax benefit is available for an NOL after its prescribed carryover period expires. Under the TCJA, corporate federal NOLs generated in tax years beginning on or after Jan. 1, 2018, generally have an unlimited carryforward period but (for tax years ending after Dec. 31, 2017) a usage limitation of 80% of taxable income. Under prior law, they had a two-year carryback period and a 20-year carryforward period.
Individual state NOL carryforward and carryback periods varied widely even before the TCJA. As of the beginning of 2018, approximately 22 states and the District of Columbia conformed to federal law generally on a "rolling" basis, meaning that changes to the Internal Revenue Code are automatically reflected in those states' tax treatment unless their respective state legislatures enact otherwise. Thus, barring any action to the contrary by these states, state NOLs generated in tax years beginning on or after Jan. 1, 2018, may already be limited in their recognition in tax years ending after Dec. 31, 2017, and with no carryback available.
Approximately an equal number of states have "static" general conformity with the Internal Revenue Code as it existed on a specified date. These states, however, generally enact conforming legislation each year, sometimes retroactively, so they, too, may have conformed to the TCJA's treatment regarding NOLs for tax years beginning on or after Jan. 1, 2018, or will do so. Still other states conform to federal law selectively without reference to a specific date or version of the Internal Revenue Code.
Current state NOL carryback and carryforward periods are only one factor that tax professionals need to know in managing state NOLs. For example, a presentation at the 58th Tax Executives Institute (TEI) Annual New York Tax Conference in 2017 noted the following challenges in managing state NOLs:5
- States do not follow federal NOL rules;
- States differ on how to compute and use NOLs;
- State NOL rules change from year to year;
- Reporting on a group basis frequently means tracking NOLs by entity;
- Some states allow sharing of losses and some do not; and
- Most states require modifications, limitations, suspensions, or other adjustments to NOLs.
In addition, the presentation noted that the current approach to managing NOLs for most companies involves creating their own spreadsheets. However, disadvantages of using NOL spreadsheets include: (1) time and effort needed to research and incorporate changing NOL rules; (2) required skills in using Microsoft Excel; (3) the risk of broken spreadsheet links; and (4) increasing audit scrutiny of spreadsheet use. In addition, typically, few people in the company understand complex NOL spreadsheets, which makes succession planning important when these people leave the firm or retire. Because of these issues, the conference materials recommend that tax departments replace a spreadsheet approach to managing NOLs by using technology that updates state NOL rules automatically.
Clearly, it is important that tax professionals remain up to date on the various corporate state NOL rules and effectively manage NOLs to ensure that the company and its subsidiaries comply with the state NOL rules. In addition, companies should (1) maximize the use of corporate state NOLs; (2) consider the value of corporate state NOLs in pricing M&A transactions; and (3) record appropriate deferred tax assets and related valuation allowances for corporate state NOLs. A discussion of each of these items follows.
Maximize the use of corporate state NOLs
In planning to maximize the use of corporate state NOLs, corporations should increase the opportunity to share NOLs among members of a combined return.6 Furthermore, companies aware of an entity that will have losses and that is not filing a combined return should consider the possibility for filing a combined return in a loss year because current losses are generally shareable.
The TEI conference materials also advise maximizing the use of state NOLs in carryforward periods. Since no tax benefit is available from expired NOLs, it is essential that the tax professional be aware of the current allowable state carryover periods.
Tax planning for maximizing state NOL benefits should include considering (1) each state's applicable income apportionment factors (i.e., property, sales, and/or payroll) and (2) whether each state follows post-apportionment or preapportionment rules in the state NOL calculation.7 Many corporations conduct business in more than one state and thus are subject to corporate income tax in multiple states. However, to prevent paying tax on the same income to more than one state, multistate corporations are allowed to apportion their income among the states in which they have established nexus (sufficient contacts with a state to be subject to its taxes or tax collection obligations).
Historically, in accordance with the 1957 Uniform Division of Income for Tax Purposes Act,8 income apportionment among states where a corporation has nexus considered three factors relative to company totals: (1) state-located property; (2) state-resident sales; and (3) state-resident payroll. A 2017 AICPA newsletter article indicates that many states now give more weight to the sales factor: "[C]urrently only about 10 states use the original three-factor apportionment formula with equally weighted factors for most industries. About 20 states double weight the sales factor, with an increasing number of states requiring the use of single factor apportionment based on sales."9 Besides the factors used by each state to apportion income, a tax professional must consider whether each state follows post-apportionment rules (i.e., calculates the state NOL based on an apportionment percentage in the year the NOL is incurred) or preapportionment rules (i.e., calculates the state NOL based on the apportionment percentage in the year the NOL is used).
The majority of states (36 plus the District of Columbia) calculate a state NOL using post-apportionment rules, while only 11 states calculate a state NOL using preapportionment rules.10 To maximize an NOL through apportionment, the TEI conference materials advise that companies should (e.g., through intercompany transactions) seek to (1) increase the apportionment percentage in the year incurred for post-apportionment states and (2) increase the apportionment percentage in the year used for preapportionment states.11 Corporations generally must ensure that intercompany transactions are concluded at fair market value.
Additionally, corporate tax professionals must be mindful of changes in the corporation's business activity. Business expansion or contraction in states where a corporation has an NOL carryforward can produce surprising or unexpected results.
For example, assume a corporation relocates its business operations from a state in which it has a significant NOL carryforward into a state in which it has previously not conducted business. Assume further that the corporation's income both before and after the relocation remains the same. After the relocation, the corporation may have no nexus, or significantly reduced apportionment factors, in the NOL carryforward state. Based solely on the relocation, the corporation may need to record a valuation allowance on the deferred tax asset related to the old state's NOL carryforward.
Business changes can affect state taxes even where a corporation has no NOL carryforwards. Corporations must record state deferred tax liabilities at the state tax rate at which deferred taxes are expected to reverse. Multistate energy companies and utilities typically have large deferred tax liabilities recorded on their books. These companies have built up deferred state income taxes based on historic apportionment factors and state statutory tax rates. Business changes that affect apportionment factors can change the state tax rate at which balance sheet deferred income taxes can reverse and can result in significant financial statement charges related to a revaluation of deferred income taxes.
Example: Corporation X conducts 50% of its business in State A and 50% of its business in State B. Assume State A's state tax rate is 10% and state B's tax rate is 5%. Assume that Corporation X has temporary differences on which deferred taxes are provided in the amount of $100 million and its state deferred tax liability is $7.5 million ($5 million in State A and $2.5 million in State B). For valid business reasons, Corporation X discontinues all business operations in State B. The corporation would most likely be forced to increase its state deferred tax liability from $7.5 million to $10 million, since its temporary differences would now reverse in State A, whose tax rate is 10%. This deferred tax increase would result in a charge to earnings in the year in which the change in business activity occurred.
Consider the value of corporate state NOLs in pricing M&A transactions
Future tax savings available to a corporation from acquiring or merging with another corporation that has federal and/or state NOL carryovers may be material in amount and should be carefully considered in determining and negotiating an appropriate acquisition price. Furthermore, both the acquiring company and the target company should consider available NOL carryovers.12
Federal consolidated return regulations address issues related to apportionment of a consolidated federal NOL carryforward in the event that a member that contributed to the loss leaves the consolidated group.13 These same regulations also address how a consolidated group can use an NOL carryforward of a corporation that joins the consolidated group, or an NOL that a new member generates upon joining a consolidated group. Parties to an M&A transaction need to understand how relevant state law deals with NOLs in all three situations.
In M&A transactions, tax professionals must also be aware of Sec. 382, which limits the annual use of an acquired company's NOL to the loss corporation value multiplied by the adjusted federal long-term tax-exempt rate. This limitation can be increased or decreased by complex net unrealized built-in gain or loss rules in Sec. 382. Purchasers of corporations whose tax loss carryforwards are likely to be limited by Sec. 382 may wish to structure an acquisition as an asset purchase rather than as a stock purchase or, where applicable, as a deemed asset purchase followed by a deemed liquidation of the corporation under Sec. 338. This strategy has the effect of converting an NOL carryforward into a future tax deduction on a stepped-up basis in assets.
Under the TCJA, beginning after Sept. 27, 2017, a portion of this tax basis step-up may be available for full expensing in the year of the acquisition. Many states have decoupled from federal full expensing, creating further complexity for state tax professionals. State tax decoupling can affect state taxable income as well as state apportionment factors for those states whose apportionment laws contain property as a factor. And while 35 states conform to Sec. 382, most states do not provide explicit guidance on how to apply it.14 It is critically important to understand whether relevant states allow elections under Sec. 338 and whether a federal election is binding on a state. Additionally, because of differences between federal and state plant asset depreciation rules, the federal gain upon a Sec. 338 election is likely to be markedly different than the state gain. Other tax regulations affect the use of state NOL carryovers from an acquired company, such as the separate return limitation year rules. The TEI conference materials advise proactive state tax planning regarding state NOLs from an acquired entity (1) to determine whether the state NOL carryovers may be used after the acquisition or reorganization; (2) understand the Sec. 382/separate return limitation year (SRLY) impacts; and (3) to model impacts on group filings and know carryover NOL values.15
Record an appropriate deferred tax asset and valuation allowance for corporate state NOLs
FASB Summary of Statement No. 109, Accounting for Income Taxes,16 states: "A deferred tax asset is recognized for temporary differences that will result in deductible amounts in future years and for carryforwards." Therefore, a corporation reports available future tax savings from federal and state NOL carryforwards as a deferred tax asset. The FASB Summary of Statement 109 indicates that "[a] valuation allowance is recognized if, based on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized" (emphasis in original).
In view of the divergent and changing corporate state NOL rules, gathering and evaluating evidence to determine whether "it is more likely than not" that state NOLs will not be realized (which would require recording a tax valuation allowance) involves knowing the current tax rules and considerable estimation and judgment. An April 24, 2017, PwC video, "Tax Valuation Allowance Fundamentals,"17 advises, "This assessment [of whether it is more likely than not that the deferred tax asset will not be realized] is subjective and requires significant judgment to evaluate all available positive and negative evidence. It's important to remember that the assessment needs to be done by jurisdiction, and judgments should be reassessed each reporting period." Furthermore, it is "difficult to avoid a valuation allowance [related to a deferred tax asset from an NOL] when there are cumulative losses in recent years."
In other words, recent losses represent negative evidence that the deferred tax asset from an NOL will be realized (and thus supports recording a valuation allowance). On the other hand, income in a carryback period and projections of future income in a carryforward period provide positive evidence that the deferred tax asset from an NOL will be realized (and thus supports not recording a valuation allowance). Effectively managing state NOLs includes not only knowing the state NOL rules and tax planning strategies to maximize the use of available state NOLs, but also gathering and evaluating positive and negative evidence for recording an appropriate deferred tax asset and related valuation allowance.
Additionally, a recent financial reporting change intended to simplify the balance sheet classification of deferred tax assets became effective in 2017 for calendar-year public companies: FASB Accounting Standards Update No. 2015-17, Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes. This final guidance "requires companies to classify all deferred tax assets and liabilities as noncurrent on the balance sheet instead of separating deferred taxes into current and noncurrent amounts."18
Practice implications for managing state NOLs
Some practical takeaways for tax professionals are:
- Maximize the use of state NOLs in carryforward periods.
- No tax benefit may be realized after NOL carryover periods expire.
- Use technology to replace a spreadsheet approach to managing NOLs.
- Share NOLs among members of a combined return.
- Where possible, file combined returns for loss entities to share current losses.
- Be aware of how changes in business operations can impact state deferred income taxes.
- Increase the apportionment percentage in the year incurred for post-apportionment states.
- Increase the apportionment percentage in the year used for preapportionment states.
- For an acquired entity with an NOL, determine if the NOL can be used, model effects on group filings, and know carryover NOL values.
- Consider both positive and negative evidence in recording an NOL deferred tax asset and related valuation allowance.
2Sec. 172(b)(1)(C), prior to amendment by the Tax Cuts and Jobs Act of 2017, P.L. 115-97.
3Secs. 172(a)(2) and (b), as amended by the TCJA.
4The states were Alaska, Arizona, California, Colorado, Connecticut, Hawaii, Idaho, Illinois, Kansas, Maine, Massachusetts, Michigan, Minnesota, Montana, Nebraska, New Hampshire, New York, North Dakota, Oregon, Rhode Island, Texas, Utah, Vermont, West Virginia, and Wisconsin, plus the District of Columbia. See Institute on Taxation and Economic Policy, "Combined Reporting of State Corporate Income Taxes: A Primer" (Feb. 24, 2017), available at itep.org.
6Id. at 6.
7Id. at 34-39.
8National Conference of Commissioners on Uniform State Laws, Uniform Division of Income for Tax Purposes Act (July 8-13, 1957).
10Bloomberg BNA, "State Net Operating Losses: Understanding the Rules & Maximizing the Benefits," pp. 12-13 (May 9, 2017).
11Id. at 35.
13Regs. Sec. 1.1502-21.
14Bloomberg BNA, "State Net Operating Losses: Understanding the Rules & Maximizing the Benefits," p. 58 (May 9, 2017).
15Id. at 57.
James F. Boyle,CPA, DBA, is Master of Accountancy program director and assistant professor of accounting at the University of Scranton, Scranton, Pa. Charles A. Lenns, CPA, J.D., is vice president of tax at Consolidated Edison in New York City and an adjunct professor of accounting at the University of Scranton. Douglas M. Boyle, CPA, DBA, CMA, is the accounting department chair and an associate professor of accounting at the University of Scranton.