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Taxes: Taxpayer Relief from Net Operating Loss Changes

By J. William Harden, Ph.D., CPA, ChFC, and David R. Upton, Ph.D.
October 1, 2021

The CARES Act modifies the carryback rule for net operating losses and makes them fully deductible as they were before the Tax Cuts and Jobs Act.

 

One of the major tax benefits of the Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020 (P.L. 116-136) was the modification of the net operating loss rules. In particular, it brings back the temporary ability to carry back losses from certain years and makes net operating losses potentially fully deductible for tax years beginning in 2018, 2019, and 2020.

 

Previously, the Tax Cuts and Jobs Act (TCJA) of 2017 (P.L. 115-97) had eliminated the ability of most taxpayers to carry back net operating losses from years beginning in 2018.

 

While exceptions were made for some farm and insurance companies, most taxpayers would only have been allowed to use net operating losses in future years. A net operating loss generated after this change would, however, have an unlimited carryforward. Before this change, most taxpayers could carry back a net operating loss to the two prior tax years and then carry forward any remaining net operating losses for 20 years.

 

THE CARES ACT

 

The CARES Act has modified the carryback rule for net operating losses generated in tax years that begin in 2018, 2019, and 2020. A net operating loss generated in these years can be carried back for five years. Those losses that aren’t used in prior years will still have the benefit of an unlimited carryforward. The law change didn’t provide an option for taxpayers to elect a shorter carryback period if a five-year carryback isn’t preferred.

 

Thus, losses would need to go back the full five years if an election to forgo the carryback wasn’t made and there was income that could be offset in that fifth year prior.

 

This change should be quite helpful to taxpayers who had earnings drops in these years. The carryback can result in a current return of taxes when the net operating loss is applied to the earlier tax year’s income. This is in stark contrast to a carryforward that doesn’t generate a tax benefit until a future year generates income that it can offset. Additionally, the ability to utilize a net operating loss carryback may be particularly cost-effective for corporations. Since 2018, corporations have faced a flat 21% tax rate. Prior to this, they faced progressive rates in which some income might be taxed as highly as 39% on the margin.

 

For example, a corporation generates a $100,000 net operating loss in 2020 but has been highly profitable in all prior years and will be in subsequent years as well. The ability to carry back for five years will reduce 2015 corporate income by the $100,000. Assume that 2015 taxable income was originally $250,000. The reduction of $100,000 due to the carryback results in a tax refund of $39,000 due to the 39% bracket affecting this level of income.

 

Were this only allowed to go back to 2018 or only be carried forward, the tax savings would be limited to $21,000 due to the flat 21% corporate rate. Thus, the ability to carry back to pre-TCJA years has resulted in an additional $18,000 of refund.

 

FORGOING CARRYBACKS

 

Given the March 27, 2020, enactment date of the CARES Act, there was a potential timing issue with respect to choosing to forgo a carryback for years 2018 and 2019. To mitigate this, the CARES Act allowed additional time to forgo carrybacks from years 2018 or 2019. The period to make this choice was extended until the due date of the return for the first tax year that ends after the enactment date.

 

This includes the extension period of the return. Thus, a calendar year taxpayer (normal due date of April 15) who extended the return for six months would have until October 15, 2021, to make the election for 2018 and 2019. For a net operating loss generated in 2020, the election to forgo would have to be made by this date as well.

 

This occurs because, in general, a net operating loss election to forgo must be made by the due date of the return, including extensions. If the election isn’t made to forgo the carryback, the taxpayer would be expected to carry back any net operating loss generated in these years. (See Revenue Procedure 2020-24.)

 

EXTENDED TIME

 

Taxpayers usually file for net operating loss carryback benefits using the Application for Tentative Refund (Form 1045 for individuals and 1139 for corporations). These forms normally need to be filed within 12 months of the end of the year in which the net operating loss is created, which caused issues with using these forms for 2018 net operating losses.

 

The Internal Revenue Service, however, issued Notice 2020-26, which extended this time window by an additional six months for 2018 carrybacks. The benefits of a net operating loss carryback can also be claimed on an amended return (Form 1040-X for individuals and 1120-X for corporations).

 

The time limit for these forms is generally three years from the due date of the loss year. This latter method is now the only option for those who missed the tentative refund form deadlines.

 

INCOME LIMITATION

 

The CARES Act also changed the rules regarding limiting net operating loss deductions to 80% of income. The TCJA created this limit of 80% of income that could be offset in future years by net operating losses generated beginning in 2018. Thus, an entity that had in a future year income of $100,000 before any net operating loss deduction and significant net operating loss carryforwards from years after 2017 would only be able to offset $80,000 of that income even if larger net operating loss carryforwards existed.

 

The CARES Act eliminated this 80% limitation for tax years that begin in 2018, 2019, and 2020. The limitation is reinstated for tax years that begin after 2020 and would apply to any carryovers that were generated beginning in 2018 or later.

 

For net operating loss carryforwards that were generated in years prior to 2018, the 80% limitation still wouldn’t apply. So, the effect of the CARES Act is to allow 2018, 2019, and 2020 net operating losses to be able to 100% offset income, but only in 2018, 2019, and 2020.

 

After 2020, the 80% limit is applied for net operating losses from 2018 onward as per the TCJA. Net operating losses from before 2017 can fully offset income in future years, either before or after the TCJA or CARES Act.

 

While it’s always preferable to avoid losses, for those businesses that incurred losses in recent years, the CARES Act’s changes to the net operating loss rules provide some welcome relief.

 

© 2021 A.P. Curatola

 

J. William Harden, Ph.D., CPA, ChFC, is an associate professor of accounting at the Bryan School of Business and Economics at the University of North Carolina Greensboro. He can be reached at jwharden@uncg.edu.
David R. Upton, Ph.D., is an associate professor of accounting at the Bryan School of Business and Economics at the University of North Carolina Greensboro. He’s also a member of IMA’s Piedmont Triad NC Chapter. David can be reached at drupton@uncg.edu.
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