Modified Net Operating Loss Rules — Taxpayer Considerations

The Coronavirus Aid, Relief, and Economic Security Act of March 27, 2020, (“CARES Act”) amended Section 172 of the Internal Revenue Code of 1986 (the “Code”) with respect to net operating losses (“NOL”) arising in 2018, 2019 and 2020 by restoring some of the favorable provisions applicable to NOLs prior to the enactment of the Tax Cuts and Jobs Act of 2017 (“TCJA”). The modified rules were designed to assist struggling taxpayers in the wake of the COVID-19 pandemic and provide them with liquidity in the form of tax refunds and reduced income tax liability in current and future years. The Internal Revenue Service (the “IRS”) issued additional guidance implementing and clarifying some of the NOL provisions of the CARES Act. Among the recently issued guidance is the following:

• Notice 2020-26, which provides for a six-month extension of time to file an application for a tentative refund on Form 1139 (for a corporation) or Form 1045 (for other than a corporation) for taxpayers that have NOLs that arose during a taxable year beginning in 2018 and ending on or before June 30, 2019. Since, as a general rule, an application for a tentative refund request must be filed within 12 months of the close of the taxable year in which the NOL arose, this Notice provides relief for many taxpayers who were otherwise precluded from filing a tentative refund request.
• Revenue Procedure 2020-24, which provides guidance regarding election to waive NOL carryback for taxable years 2018 - 2020 and election to exclude from the carryback period any taxable year in which the taxpayer has a Section 965(a) inclusion, among other guidance.
• Revenue Procedure 2020-23, which allows eligible partnerships to file amended returns. See our e-alert Partnerships Are Eligible for Relief.
• Temporary Procedures for faxing Forms 1139 and 1045 to claim quick refunds.
• Frequently Asked Questions (“FAQs”) for taxpayers who have had Section 965 inclusions.

However, before requesting a temporary refund arising from the NOL carrybacks, taxpayers should evaluate their individual circumstances and application of the NOL rules under the current guidance, some of which considerations are discussed below.

Three NOL Regimes

As a general rule, for tax years prior to January 1, 2018, a taxpayer could deduct NOLs in its current taxable year, and in the case of any excess NOLs, carry such NOLs back two years and forward 20 years. For NOLs arising in taxable years beginning after December 31, 2017, the TCJA limited the NOL deduction to 80 percent of taxable income and disallowed any carryback of NOLs. However, a taxpayer could carry NOLs forward indefinitely.

The CARES act suspends the 80 percent limitation and allows for up to five years of carryback for NOLs arising in tax years 2018, 2019 and 2020. As a result of these changes, a taxpayer would take into account such NOLs in the earliest taxable year in the carryback period and carry forward the unused amounts to each succeeding taxable year.

Based on the foregoing, there are currently three NOL regimes:

1. Pre-2018 NOLs: NOLs that arose on or before December 31, 2017, may be carried back two years, carried forward 20 years and may be offset against 100 percent of taxable income;
2. NOLs in 2018, 2019, 2020: NOLs that arose after December 31, 2017, and before January 1, 2021, may be carried back five years, carried forward indefinitely and offset against 100 percent of taxable income for tax years before January 1, 2021, and 80 percent of taxable income for tax years on or after January 1, 2021; and
3. Post-2020 NOLs: NOLs that arise on or after January 1, 2021, may not be carried back, may be carried forward indefinitely and may be offset against 80 percent of taxable income.

Benefits of Carryback and Waivers

As a result of the higher federal income tax rates for both corporate and noncorporate taxpayers for tax years prior to January 1, 2018, (corporate rate – 35 percent; highest individual rate – 39.6 percent), taxpayers may benefit from a rate differential by carrying the NOLs back to prior years. In addition, if a taxpayer has an unpaid tax liability arising from prior years, an NOL carryback may reduce the tax liability or result in a potential refund. 

On the other hand, a taxpayer may waive the carryback period for any of the following reasons: (i) a taxpayer’s effective tax rate for prior periods is lower than the current tax rate, (ii) a taxpayer is subject to certain terms of a stock purchase agreement, which would obligate the taxpayer to waive the carryback; or (iii) a taxpayer determines that by carrying the NOLs back to prior years, it may trigger the application of Section 382 limitation.

Amended Return or Tentative Refund

If a taxpayer has NOLs arising in tax years 2018, 2019 and 2020, taxpayer may request a refund by filing an amended return on Form 1120X. However, the IRS may take a long time to review the return and issue a refund. Alternatively, a taxpayer may request a tentative refund by filing Form 1139 or Form 1045. If a taxpayer files, within 12 months of the end of the tax year, a request for a tentative refund on Form 1139 (corporate) or Form 1045 (other than corporate), under the tentative carryback adjustment procedures, the IRS will conduct a limited examination and will issue a refund within 90 days of the filing of an application.

Taxpayers should be aware of potential drawbacks associated with tentative refunds. The IRS may conduct a more intensive examination of the taxpayer that received a tentative refund, which may extend to the closed years under the statute of limitations and can make adjustments to those years not to exceed the tentative refund amount. In addition, if the IRS determines that a refund was issued in error, the IRS can issue an immediate assessment and begin collection proceedings against the taxpayer without having to issue a notice of deficiency. Thus, a taxpayer requesting a tentative refund should keep detailed and accurate documents and records for its prior years.

Business Acquisitions

In post-TCJA years, due to the lower Federal income tax rate applicable to corporations and the 80 percent limitation, NOLs became less valuable to the buyers in business acquisition transactions. Also, companies could no longer carry NOLs back to prior tax years. Thus, the terms of some purchase agreements related to NOLs may have changed in that it was no longer necessary to specify whether the target company’s losses could be carried back and who was entitled to the refunds. Pursuant to the CARES Act, buyers and sellers may want to re-evaluate the terms of their purchase agreements, determine the benefits of the carryback and negotiate on how to split the refund.

Section 965 Tax

Special considerations apply to taxpayers with untaxed foreign income. Under Section 965 of the Code, shareholders with untaxed foreign earnings are required to pay a transition tax as if such earnings have been repatriated to the United States. Pursuant to the IRS guidance, a taxpayer will not be eligible for a refund of any Section 965 tax payment unless and until the payment exceeds the entire income tax liability for Section 965, which includes all amounts to be paid in installments under Section 965(h) in future years.

Although a taxpayer is required to carryback the NOLs arising in taxable years 2018, 2019 and 2020 to the earliest year with taxable income within the five-year carryback period, under the CARES Act a taxpayer is treated as having made an election under Section 965(n) not to use NOLs to offset Section 965 income. In addition, taxpayers are allowed to file an election to either waive the entire five-year carryback period or to exclude all of section 965 years from the carryback period. Thus, taxpayers with 965 years must carefully evaluate whether a waiver of carryback year would be appropriate.

Accounting Method Changes

In addition to the modified NOL rules, the CARES Act provides other tax incentives related to business interest expense limitation, excess business interest deduction, bonus depreciation for qualified improvement property, and others. Given these tax-related benefits, some taxpayers may consider implementing an accounting method change with respect to the prior taxable years in order to create additional losses and generate additional liquidity.

If you have any questions about the information in this alert, please contact Richard Lieberman (312-627-2250 or RLieberman@dykema.com), Scott Kocienski (248-203-0868 or SKocienski@dykema.com), Michael Cumming (248-203-0740 or MCumming@dykema.com), Asel Lindsey (210-554-5298 or ALindsey@dykema.com), or your Dykema relationship attorney.

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