In one of several legislative responses to the economic downturn caused by the coronavirus pandemic, the Coronavirus Aid, Relief, and Economic Security (CARES) Act allows taxpayers to carry net operating losses (NOLs) back five tax years, presenting a current tax refund opportunity in a time when businesses need the cash most.1 Alternatively, taxpayers can choose to carry the loss forward to offset future income.2
Example 1: A is a shareholder in an S corporation manufacturing company. She generated $1 million of taxable income and paid $350,000 of federal income tax each year from 2014 through 2018. In 2019, the business experienced financial difficulties and A's personal tax return reflected a $2 million NOL. The loss carryback provisions of the CARES Act allow A to carry back the loss to offset her taxable income from 2014 and 2015, generating a $700,000 federal tax refund.
Aside from the cash flow benefits of obtaining an immediate tax refund, the loss carrybacks present an opportunity to secure permanent tax savings by using losses to offset income generated before the law known as the Tax Cuts and Jobs Act (TCJA)3 was passed, when the maximum tax rates were higher. State conformity to the NOL carryback provisions varies.
This article discusses two planning areas related to NOL carrybacks: (1) the decision whether to carry a loss forward or back and (2) planning strategies to increase the balance of the NOL carryback.
In some cases, taxpayers will have relatively low income (but not an opportunity to plan to create an NOL). In these cases, planning may focus on increasing taxable income to take advantage of graduated tax rates for individuals rather than lowering taxable income. A discussion of planning to take advantage of low tax rates is outside the scope of this article.
Determining whether to carry the NOL forward or back
In many cases, taxpayers will want to carry back a tax NOL to generate the immediate cash flow benefits, but here are three scenarios where a taxpayer may prefer to carry a loss forward.
The expected tax refund is less than the present value of the expected future tax savings
The first scenario occurs when the expected tax refund from the loss carryback is less than the present value of the expected future tax savings from the tax carryover. The income of many taxpayers was subject to higher tax rates during the carryback period versus what they are anticipating in the future, because the TCJA reduced tax rates. For example, the top federal corporate tax rate through 2017 was 35%, whereas the corporate tax rate starting in 2018 is a flat 21%. In some cases, taxpayers were subject to lower effective tax rates during the carryback period or are expecting to be subject to higher effective tax rates in the future. In comparing the cash flow benefits of a loss carryback and a loss carryover, taxpayers should also factor in the additional professional fees to prepare and file the loss carryback claim as well as the time value of money.
Example 2: B generated $100,000 per year of taxable income and paid $15,000 in federal income tax from 2013 through 2017. B incurred a $500,000 loss in 2018. If B carries the loss back for five years, he will generate a tax refund of $75,000. B expects his income will be subject to an effective 30% tax rate in the carryover period, so the $500,000 loss may reduce his future tax liability by $150,000. B may prefer to carry the loss forward.
The tax loss will be carried back to a tax year with uncertain tax positions
The IRS generally has three years from the time a return is filed to audit the tax year and adjust the tax liability reported on the return.4 However, if a taxpayer carries a loss back to a closed year, the IRS can offset the refund with other tax adjustments in the carryback year even though the statute of limitation is closed.5 Taxpayers who breathed a sigh of relief when the statute of limitation closed for a particular tax year should be cautious about carrying a loss back to that tax year.
Another party is entitled to the refund
In some cases, another party may be entitled to the refund from carrying a loss back. For example, if the taxpayer purchased a corporation from someone else, the stock purchase agreement may require the taxpayer to compensate or share with the seller any tax refund or tax benefit received from a loss carryback.
As an additional example, if the corporation was a member of a consolidated group during the NOL carryback period, the refund attributable to the carryback of the loss to a consolidated year is generally paid to the former parent of the consolidated group, even if the corporation carrying back the loss is no longer a member of that group.6
Some tax preparers filed returns reflecting an NOL that included an NOL carryback waiver election statement for 2018 or 2019, even though the NOL carryback was not available for those years.7 After the passage of the CARES Act, these preparers were concerned that the NOLs for these years were required to be carried forward due to these purported elections. However, in order for the election to waive the carryback to be valid, the taxpayer needs to have been entitled to carry back the loss at the time the election was made.8 Unless the taxpayer had farming losses or was an insurance company, the taxpayer may not have been entitled to the carryback at the time the election was made, and the election is considered invalid.
In cases where an election was made that is deemed invalid, under the CARES Act NOL carryback rules, absent an election to waive the carryback, the taxpayer not only may but must carry back the loss. If the taxpayer does not want to carry back the loss, it should prepare a waiver election, which is made by attaching an election statement with its tax return for the first tax year ending after March 27, 2020 (i.e., the 2020 tax return in the case of a calendar-year taxpayer).9 A separate election statement must be attached if the loss carryback is being waived for both 2018 and 2019.
Strategies to increase the loss carryback
If a taxpayer has sufficient taxable income subject to higher tax rates during the carryback period, the taxpayer may be able to generate additional cash flow benefits and achieve permanent tax savings by proactively adopting strategies to increase its tax losses. Here are a few tax planning strategies that may allow a taxpayer to increase tax losses.
Accelerate equipment purchases
Taxpayers can generally expense the cost of new or used equipment acquired and placed in service during the year.10 Taxpayers may want to acquire and place equipment in service before the end of the tax year to increase the amount of the loss. For tax purposes, property generally is considered placed in service when it is in a condition or state of readiness and available for use whether or not it is actually used.
Analyze tax asset depreciation methods and lives
The CARES Act allows taxpayers to immediately write off the cost of certain improvements to commercial property made in 2018 and later years.11 Taxpayers who improved commercial property in 2018, 2019, or 2020 may be able to expense the costs, increasing their tax loss. In addition, taxpayers who own real estate may be able to accelerate deductions by performing a cost-segregation analysis to determine the appropriate tax life of the various real estate assets. Likewise, they may be able to accelerate deductions related to an energy-efficient building by performing a Sec. 179D analysis.
Write off old or uncollectible receivables and harvest tax losses
Accrual-method taxpayers can claim a bad debt deduction for old or uncollectible trade accounts receivable when the possibility of collection becomes remote or uncertain. Before the end of the tax year, taxpayers can analyze trade receivables and write off any specific uncollectible accounts. In addition, proactive planning measures may be available to harvest tax losses from underwater or worthless investments.12
Make retirement contributions
Pretax retirement plan contributions reduce individuals' taxable income while allowing them to set aside money for the future. The ability to make retirement contributions in a year with a business loss may be limited depending on the plan. For example, the maximum contribution for a self-employed individual to a simplified employee pension individual retirement arrangement (SEP-IRA) is 25% of net earnings from self-employment.13 If a proprietorship generates a loss for the year, the proprietor is prohibited from contributing to the SEP-IRA.
Analyze current accounting methods for opportunities
Consider the taxpayer's current methods of accounting and evaluate whether any changes are available to defer income or accelerate deductions to increase the taxpayer's loss. Here are a few common accounting methods that a taxpayer may be able to adopt:
Overall cash method of accounting: Tax reform expanded the availability of the cash method of accounting, yet some eligible businesses have remained on the accrual method.14 The cash method of accounting generally defers recognition of income relative to the accrual method because most taxpayers have more receivables than payables.
Advance payments for goods: Accrual-method taxpayers can either account for certain advance payments and include them in taxable income in the year received (the full-inclusion method) or include the payments in taxable income in the year of receipt to the extent included in revenue for financial statement purposes and include the remaining amount in income in the next tax year (the deferral method).15
Prepaid expenses: Accrual-method taxpayers can generally deduct prepaid payment liabilities, such as insurance, taxes, and warranty or maintenance service contracts, if the term covered by the prepayment does not extend beyond the earlier of 12 months after the first date on which the taxpayer realizes the right or the end of the tax year following the year of payment.16
Internally developed software: Costs of developing computer software are often capitalized, but taxpayers could elect to deduct them in full as a research expense.17
Some accounting method changes are automatic and can be explored in more detail when preparing the tax returns, but others are deemed nonautomatic and the method change must be requested before year end.
Consider inventory methods
There are generally two acceptable inventory valuation methods: cost or lower-of-cost-or-market.18 Use of the lower-of-cost-or-market inventory method takes more time but may reduce the value of the taxpayer's inventory and thus accelerate deductions.
A company may be able to deduct obsolete or damaged inventory if it can no longer sell the inventory in a normal manner or at its normal price.19 The deduction for obsolete inventory is available only if the inventory is disposed of or the taxpayer establishes the reduction in its value by offering the inventory for sale to the public at a reduced price within 30 days after the inventory date. Taxpayers may want to evaluate their inventory for potential valuation-related adjustments.
The uniform capitalization rules of Sec. 263A are complex; however, opportunities exist for taxpayers to accelerate tax deductions by analyzing their capitalization methodologies. As just one example, many taxpayers have not fully explored the tax benefits of the new modified simplified production method uniform capitalization (UNICAP) calculation that was included as an option in final regulations issued in November 2018.20
Accelerate payment of bonuses or compensation amounts
Accrual-method taxpayers can generally deduct compensation for services performed in a tax year if the compensation is paid within 2½ months following the tax year in which the services were provided.21 Accrued expenses, such as accrued compensation or accrued rent, payable to a related party are generally deductible in the year of payment.22 Taxpayers should consider paying accrued bonuses or compensation in time to get the deduction in 2020.
Plan for business interest limitation
The business interest limitation generally limits the deduction for net business interest to 30% of adjusted taxable income (ATI).23 However, under Sec. 163(j)(10)(A)(i), the limitation for tax years beginning in 2019 or 2020 is based on 50% of the taxpayer's ATI for the tax year. A taxpayer may elect not to apply the 50% ATI limitation in either 2019 or 2020 and instead apply the 30% limitation.
If the deduction for business interest is limited, the suspended interest is allowed as a carryover but not as a carryback.24 In contrast, NOLs can be carried back, potentially making an NOL more valuable than suspended business interest.
In many cases there are several options available for taxpayers to compute their business interest limitation in 2020. As noted above, taxpayers may elect to apply a 30% limitation rather than a 50% limitation in calculating the limitation. They may also use the rules regarding the limitation in final business interest regulations issued in September 202025 or use the proposed business interest regulations issued in December 201826 and may elect to use 2019 ATI instead of 2020 in computing the 2020 business interest limitation.27
Accelerate payment of payroll taxes
The CARES Act defers the employer share of the 6.2% Social Security tax on wages paid from March 27, 2020, through Dec. 31, 2020, with 50% due on Dec. 31, 2021, and 50% due on Dec. 31, 2022.28 Cash-method taxpayers generally deduct payroll taxes in the year paid while accrual-method taxpayers using the recurring item exception generally deduct payroll taxes accrued during the year if paid by the earlier of the date the taxpayers file a timely return (including extensions) or 8.5 months after the close of the year.29 Accelerating the payment of deferred Social Security taxes may allow employers to deduct the taxes in 2020.
Revisit intercompany pricing
Sometimes, commonly owned entities provide goods, services, or loans to one another. If the amounts being charged by related entities do not reflect current market rates, there may be an opportunity to revisit the prices being charged. For example, a C corporation leases property from a commonly owned partnership. The lease is month-to-month, and the rate was set 10 years ago at $10,000 per month. Current market rates for the property are $20,000 per month. If the lease is renegotiated to a fair market value rental, expenses of the C corporation will increase by $10,000 per month, potentially increasing the amount of an NOL that can be carried back. Of course, the increase in rent increases the taxable income of the owners, so a holistic planning approach is appropriate.
Careful planning is needed
The extended NOL carryback rules from the CARES Act presented welcome relief for many taxpayers. Careful planning will allow taxpayers to increase or create tax losses that can be carried back for five years, improving cash flow and in some cases providing permanent tax savings.
1 Sec. 172(b)(1)(D), as added by Section 2303(b)(1) of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136.
2 Sec. 172(b)(3).
3 P.L. 115-97.
4 Sec. 6501(a).
5 Lewis v. Reynolds, 284 U.S. 281 (1932).
6 Regs. Sec. 1.1502-77. A split waiver election may be available to address the issue. See, e.g., REG-125716-18 (7/8/20); T.D. 9900.
7 Bea, 749 Fed. Appx. 59 (11th Cir. 2019), underscores the danger for tax preparers who include irrevocable elections without consulting with their clients. The tax preparer included an election to waive the loss carryback with the return because the taxpayer did not have any income in the carryback period. The preparer did not consult the client regarding the election. The IRS identified errors on the returns in the carryback period and issued a notice of deficiency. The taxpayer sought to offset the income adjustment using the loss carryback. The court did not allow the taxpayer to carry back the loss because the return unambiguously waived the loss carryback, even though the tax preparer included the election without consulting the client.
8 Sec. 172(b)(3). See also Plumb, 97 T.C. 632, 640 (1991) ("a taxpayer who attempts to make an election that is not legally available to him will be treated as having made no election").
9 Rev. Proc. 2020-24.
10 Sec. 168(k).
11 Section 2307(a) of the CARES Act.
12 See, e.g., Kliegman and Turkenich, "Debt Losses: Timing and Character Issues Revisited," 111 Journal of Taxation 8 (July 2009), and Kliegman and Turkenich, "Worthless Stock or Securities: Timing and Character Issues Revisited," 111 Journal of Taxation 70 (August 2009).
13 Sec. 402(h)(2).
14 Sec. 448.
15 Sec. 451(c).
16 Regs. Secs. 1.461-4(g)(5) and (6); Regs. Sec. 1.263(a)-4(f).
17 Rev. Proc. 2000-50.
18 Regs. Sec. 1.471-2(c).
19 Regs. Sec. 1.471-2(c).
20 See T.D. 9843.
21 Temp. Regs. Sec. 1.404(b)-1T, Q&A 2(b)(1).
22 Sec. 267(a)(2).
23 Sec. 163(j)(1).
24 Sec. 163(j)(2).
25 T.D. 9905.
27 Sec. 163(j)(10)(B).
28 CARES Act §2302. Employers who benefited from loan forgiveness under the Paycheck Protection Program (PPP) were not eligible to defer the deposit and payment of the employer portion of Social Security tax, but that prohibition was repealed in June. See the Paycheck Protection Program Flexibility Act of 2020, P.L. 116-142, §4.
29 Accrual-method taxpayers deduct expenses in the year (1) all events have occurred that fix the fact of the liability, (2) the amount of the liability can be determined with reasonable accuracy, and (3) economic performance has occurred (Regs. Sec. 1.461-1(a)(2)(i)). If the liability is to pay a tax, economic performance occurs as the tax is paid (Regs. Sec. 1.461-4(g)(6)(i)). Taxpayers who use the recurring item exception can generally deduct accrued expenses where economic performance occurs on or before the earlier of the date the taxpayer files a timely return for the year (including extensions) or 8.5 months after the close of the tax year (Sec. 461(h)(3) and Regs. Sec. 1.461-5(b)(1)(ii)). A discussion of the requirements to use the recurring item exception is outside the scope of this article.
|John Werlhof, CPA, is a principal inCliftonLarsonAllen LLP's National Tax Office in Roseville, Calif. Jason Flattum,CPA, MBT, is a principal in CliftonLarsonAllen LLP's NationalTax Office and Tax Tra nsaction ServicesGroup in its Minneapolis office. For more information about this article, contact firstname.lastname@example.org.