On March 27, 2020, President Trump signed into law the Coronavirus Aid, Relief, and Economic Security Act (H.R. 748) (“CARES Act”). This $2.2 trillion package is U.S. Congress’s third stimulus plan in response to the COVID-19 pandemic, following an $8.3 billion public health funding bill on March 6 and the $100 billion Families First Coronavirus Response Act (H.R. 6201) on March 19. In addition to providing healthcare support and general economic relief to businesses and workers affected by the coronavirus, the CARES Act provides tax relief to both corporate and noncorporate taxpayers by adding a five-year carryback period and temporarily repealing the 80% limitation for net operating losses (“NOLs”) arising in 2018, 2019 and 2020.
Overview of NOL Legislation
Prior to the Tax Cuts and Jobs Act (“TCJA”), an NOL could be carried back two years and carried forward 20 years to offset taxable income on a dollar-for-dollar basis in those years. For NOLs arising in taxable years beginning after December 31, 2017, the TCJA limited the NOL deduction in any post-TCJA year to 80% of taxable income. It also repealed the two-year carryback for post-TCJA NOLs. These NOLs can only be carried forward, although the 20-year limitation for carryforwards was changed to an indefinite period.
The CARES Act repeals the 80% income limitation for NOL carryovers that can be deducted in tax years beginning before January 1, 2021. It also provides that for any taxable year beginning after December 31, 2020, the 80% limitation on taxable income equals 80% of the excess of taxable income over the amount of pre-TCJA NOLs carried to such year, clarifying an interpretive issue that had arisen under the TCJA text. For that purpose, taxable income is calculated without regard to the NOL deduction under section 172, the deduction for qualified business income under section 199A, and the deduction for foreign-derived intangible income (“FDII”) and global intangible low-taxed income (“GILTI”) under section 250.
For example, assume taxpayer has taxable income of $100 in 2020, a pre-TCJA NOL of $60, and a 2019 NOL of $50. With the repeal of the 80% income limitation, taxpayer can fully offset the $100 of 2020 taxable income with the $60 pre-TCJA NOL and $40 of the 2019 NOL. However, if instead the $100 of taxable income is earned in 2021, taxpayer’s deduction of its post-TCJA NOLs is limited to $32, which is 80% of $40 ($100 taxable income - $60 Pre-TCJA NOLs). Thus, taxpayer’s taxable income in 2021 would be $8 rather than $0.
The CARES Act also provides that NOLs arising in a taxable year beginning after December 31, 2017 and before January 1, 2021 shall be treated as a carryback to each of the 5 preceding taxable years unless the taxpayer elects to forego the carryback. Thus, NOLs arising in 2018, 2019 and 2020 could be carried back as far as 2013, 2014, and 2015, respectively. This carryback right can be extremely valuable as the maximum corporate tax rate applicable to tax years ending before 2018 was 35%, much higher than the current 21%.
In general, the NOL carryback provision operates on a “all or nothing” basis, that is, taxpayers may not choose to carryback NOLs to only particular years within the carryback period. Unless an election is made to forego the entire carryback, an NOL arising in a taxable year beginning in 2018, 2019 or 2020 must be carried back to the earliest year within the carryback period in which there is taxable income, then to the next earliest year, and so on. There is one exception to the “all or nothing” rule: if one or more years in the carryback period reflects section 965 income (each, a “section 965 year”), the taxpayer may elect to exclude all section 965 years from the carryback period.
On the other hand, the decision of whether to carry back NOLs arising in 2018, 2019 or 2020 is made on a year-by-year basis. Specifically, a separate election to forego carrybacks may be made for each of 2018, 2019 and 2020 without binding the taxpayer as to any other year.
For example, assume a calendar year corporate taxpayer has an NOL in 2019 and expects another NOL in 2020, but had taxable income in years 2014 through 2018. If there is no election to forego carrybacks for 2019, the 2019 NOL will be carried back to 2014, then to 2015, and so on depending on taxable income. Any portion of the 2019 NOL carried back to 2018 would not be subject to the 80% income limitation. If taxpayer’s 2017 year reflects section 965 income, taxpayer could elect to exclude 2017 from the carryback, in which case the 2019 NOL would be carried back to 2014, 2015, 2016 and 2018, but not 2017. The taxpayer could decide to forego carrybacks for the 2020 NOL, and carry it forward only, or allow it to be carried back in the same manner as the 2019 NOL. The 2020 NOL would be subject to the 80% limitation if carried forward, but not if it is carried back.
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 the 2020 return, which would be October 15, 2021. A taxpayer’s election to forego carrybacks for NOLs arising in a taxable year beginning in 2020 must be made by the due date (including extensions of time) for filing the return for that year. It is expected that the Internal Revenue Service (IRS) will soon issue procedural guidance on how to either request refunds for NOL carrybacks or elect to forego carrybacks, similar to guidance issued for the 2009 five-year NOL carryback legislation (Rev. Proc. 2009-52).
Favorable Technical Correction
The CARES Act resolves, by retroactive technical correction, the TCJA-related issue of whether a fiscal year beginning before January 1, 2018 and ending after December 31, 2017 (a “straddle year”) was subject to TCJA’s repeal of NOL carrybacks. The TCJA’s statutory effective date language provided that the repeal of NOL carrybacks applied to taxable years ending after December 31, 2017, but the Committee Report indicated the effective date for both the 80% limitation and the carryback repeal was taxable years beginning after December 31, 2017. In clarifying that the repeal of NOL carrybacks applies only to taxable years beginning after December 31, 2017, the CARES Act provides that for a period of 120 days from March 27, 2020, taxpayers may request a tentative refund under section 6411 for an NOL carryback from a straddle year to a prior year, pursuant to the pre-TCJA two-year carryback rule, even though the normal deadline for making that request would have been during 2019.
NOL Carryback Does Not Offset Section 965 Income Inclusion
The CARES Act provides that if an NOL is carried back to a year in which the TCJA transition tax under section 965 applied, the taxpayer will be treated as having made an election under section 965(n). Thus, in the example above, the carryback of the 2019 NOL to 2018 would force a section 965(n) election. This means that the 2019 NOL will not be applied to reduce 2018 taxable income that is attributable to the mandatory repatriation income inclusion under section 965. Generally this provision is good news for taxpayers because section 965 income was taxed at favorable rates, thus preserving the ability to use the NOL carryback against highly taxed income.
Special Rules for REITs and Insurance Companies
REITs are not allowed to carry back an NOL for a REIT year to any preceding taxable year. If an NOL arises in a non-REIT year, it may not be carried back to a preceding taxable year that is a REIT year.
The TCJA retained the two-year carryback and 2-year carryforward period for insurance companies other than life insurance companies (e.g., a property and casualty insurance company). It also repealed the operations loss deduction for life insurance companies, but permitted them to claim an NOL deduction under the same rules as other taxpayers. The CARES Act extended the five-year carryback to non-life insurance companies. It also provided that if a life insurance company carries back an NOL arising in 2018, 2019 or 2020 to a year beginning before January 1, 2018, the NOL carryback shall be treated in the same manner as an operations loss carryback under the rules existing before the TCJA.
Considerations in Seeking Refund from NOL Carryback
A taxpayer’s decision to carry back NOLs arising in 2018, 2019 or 2020, as well as the manner in which that decision is implemented, require the balancing of several considerations, including the need for immediate liquidity and concern about IRS challenges in prior years, among other things:
- No refund until return of year of NOL is filed. The time necessary to monetize an NOL carryback will depend on whether the NOL arises in 2018, 2019 or 2020. For 2018 NOLs, presumably the 2018 return has already been filed. Taxpayers may request a refund for the year to which the 2018 NOL is carried back by either filing an amended return (Form 1120X for corporate taxpayers, Form 1040X for individual taxpayers) for the earlier carryback year or filing a request for a tentative refund (Form 1139 for corporate taxpayers, Form 1045 for individual taxpayers). For 2019 and 2020 NOLs, the return (Form 1120 for corporations, Form 1040 for individuals) must be filed before a refund may be requested for the carryback year by filing either Form 1120X or Form 1139 for corporations (or either Form 1040 or Form 1045 for individuals). Thus, taxpayers with 2019 NOLs should try to file their 2019 returns as soon as possible. Taxpayers expecting 2020 NOLs cannot file a 2020 return, obviously, until after the 2020 tax year closes. Forcing a short taxable year for 2020 to accelerate an NOL carryback through some kind of transaction might be ideal, but it may not be possible or practicable to do so.
- Use of Form 1139 or Form 1045. The quickest way to obtain a refund from an NOL carryback is to request a tentative refund under section 6411, by filing Form 1139 or Form 1045. The IRS is required to make a limited examination of the claim and then issue a tentative refund (or credit the refund amount against an outstanding liability) by the later of 90 days after filing Form 1139 or 1045, or 90 days from the last day of the month of the due date of taxpayer’s return for the NOL year (including extensions).
- Section 6411 requires that a Form 1139 or Form 1045 be filed within 12 months of the last day of the taxable year from which the NOL arises. For a calendar year 2018 NOL, the deadline was December 31, 2019. It is expected that forthcoming IRS guidance will extend that deadline to facilitate the use of Form 1139 for 2018 NOLs, similar to guidance issued for the 2009 five-year NOL carryback legislation (Rev. Proc. 2009-52).
- The IRS has adopted the position that taxpayers who carry back to years in which they have a section 965(a) inclusion are not permitted to file a Form 1139 or Form 1045 but instead are required to file the appropriate amended return for the affected carryback tax periods. This is true whether or not a section 965(n) election is made. Unless IRS changes this position, the ability of multinational taxpayers to obtain a “quickie refund” for carryback of NOLs arising in 2018, 2019 or 2020 to a section 965 inclusion year (most likely 2017) may be hindered.
- The IRS retains the right to conduct a full audit of the claim, at which point any finalization of the refund could be subject to Joint Committee review if the refund exceeds $5 million (for corporate taxpayers). Alternatively, the IRS could deny the refund altogether by asserting an underpayment of tax against the taxpayer, including one in excess of the refund, for any issue whether or not it relates to the NOL. Basically, while a taxpayer receives the refund up front, it may have to pay it back (with interest) if it cannot defend the amount upon later IRS challenge.
- Use of Form 1120X. Obtaining a refund from an NOL carryback by filing a Form 1120X for the carryback year could take an extended amount of time. The good news is that a refund, when paid, is a final action from the IRS’s standpoint. The bad news is that the refund will not be received until after the IRS has examined the return for the NOL year and, if necessary, Joint Committee review has occurred. Just like in the Form 1139 situation, the IRS could deny the refund by asserting an underpayment of tax (including one that exceeds the refund) for either related or unrelated issues.
- Special considerations for NOL carrybacks to years under audit. If the carryback year is under IRS audit and a Form 1120X or Form 1040X is filed, the IRS examination team typically incorporates the taxpayer’s claim into the audit, and no refund is paid until after the audit of all the other issues has been completed. If the audit is contentious with a number of issues, that could be an extended amount of time. If a Form 1139 or Form 1045 is filed, the IRS examination team typically reviews the NOL carryback as part of the audit, but the taxpayer will have received the tentative refund up front.
- Special considerations for NOL carrybacks to closed years. With a five-year carryback, it is certainly possible that at least one of the years to which the NOL is carried is already closed by the statute of limitations. Some taxpayers may be reluctant to open the statute on a year in which issues were hotly contested with the IRS, only to see the IRS raise those issues again as an offset to the refund. On the other hand, taxpayers generally are not exposed to liability for unrelated issues in the carryback year beyond the risk that the refund claimed on a Form 1120X (or Form 1040X) will be offset by these issues, or the refund obtained after filing Form 1139 (or Form 1045) will have to be returned.
- NOL carrybacks to section 965 years. Carrying back an NOL to a section 965 year (e.g., 2019 NOL carried back to 2017), and thereby creating an overpayment of tax, will likely implicate the IRS’s position that overpayments of tax, whether they arise from excess payments of estimated tax or an NOL carryback, must be applied to pay down future installments of section 965 transition tax liability. The Senate Republican version of the CARES Act released on March 19, 2020 included a retroactive technical correction to the TCJA that would have prevented the IRS from taking that position. While this provision is not included in the final version of the CARES Act, it does not mean that the IRS’s position is any less questionable from an authoritative standpoint. Taxpayers with NOL carrybacks that potentially move to a section 965 year after absorbing taxable income from earlier years might consider making a special election to exclude the section 965 year from the carryback until the IRS position is either ruled incorrect or overridden by legislation.
- Benefit of higher tax rate in pre-TCJA years. As noted above, a corporation’s NOL deduction in a post-TCJA year is worth 21 cents on the dollar, while its NOL deduction in a pre-TCJA year is worth 35 cents on the dollar (excluding the effect of state taxes and foreign tax credits). Taxpayers should consider the instant enhancement to the value of their post-TCJA NOLs, from both a cash flow and financial statement standpoint, if they choose to carry them back to a pre-TCJA year.
- Departure from consolidated group. If a corporate taxpayer with NOLs arising in 2018, 2019 or 2020 was part of another consolidated group during part of the applicable carryback period, there may be a question as to whether this taxpayer or the parent of the former group is entitled to the benefit of the NOL carryback. That may depend on whether the taxpayer agreed to forego carrybacks when it left the former group and, if not, what any tax allocation agreement says about the division of tax benefits. Going forward the parties to sales of subsidiary stock will again need to negotiate the rights to the NOL carryback as they did before the TCJA, in terms of whether post-deal NOLs may be carried back to pre-deal years and whether (or how) to share the tax benefit.
- NOL carrybacks and COD income. An incentive may exist to carry back an NOL when a taxpayer recognizes cancellation of debt income that is excluded under the insolvency or bankruptcy exceptions. If the NOL were to be carried forward, it would be reduced under the rules for excluded COD income. If, however, the NOL is carried back, no reduction would apply, thus allowing the taxpayer to potentially realize the full benefit of the loss.
- Noncorporate taxpayers. Prior to the TCJA, individual taxpayers operating businesses at a loss, either directly or through partnerships or S corporations, generally could offset nonbusiness income (e.g., wages, investment income) with the loss, subject to the passive loss rules. The TCJA added a limitation that applies after the passive loss rules, which disallows the use of a business loss in excess of $250,000, or $500,000 for joint filers (“excess business loss”) against nonbusiness income, and treats such loss as an NOL carryover to the next tax year. The CARES Act, however, repeals the excess business loss limitation for taxable years beginning before January 1, 2021. Thus, noncorporate taxpayers with business losses arising in 2018, 2019, and 2020 can enjoy the five-year carryback without regard to the excess business loss rules.
- Other Code provisions affected by taxable income limitations. Taxpayers should consider that while refunds attributable to NOL carrybacks may provide much-needed cash, they might also reduce certain deductions claimed in prior years that depend on the amount of taxable income. To that extent the value of an NOL carryback may be diminished. For example, in pre-TCJA tax years, reducing taxable income could reduce the taxpayer’s domestic production deduction under former section 199. A carryback of NOLs to a post-TCJA tax year could cause the deduction for FDII and GILTI under section 250 to exceed the taxable income for that year after being adjusted for the NOL carryback. In that case, the deduction would be reduced, having the effect of taxing some portion of the FDII and GILTI at a 21% U.S. effective tax rate rather than at a preferential U.S. effective tax rate (which is currently 10.5% for GILTI and 13.125% for FDII). To the extent U.S. tax on GILTI is being offset by foreign tax credits, a reduction in the section 250 deduction for GILTI could be even more costly (e.g., going from 0% U.S. tax to a 21% U.S. effective tax rate) since the foreign tax credits that otherwise offset GILTI will expire.
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