With many businesses experiencing losses due to COVID-19, now is a good time to review the CARES Act net operating loss (NOL) rules.
The Tax Cuts and Jobs Act (TCJA) changed the rules for deducting net operating losses in 2017. Before 2017, NOLs were fully deductible and could be carried back two years and carried forward 20 years.
In 2017, TCJA changed the NOL rules by:
- limiting NOL deductions to 80% of taxable income,
- disallowing NOL carrybacks, and
- lifting the 20-year limit on NOL carryovers.
In 2020, the CARES Act temporarily – and retroactively – changed the NOL rules again.
What is an NOL?
An NOL is the excess of a business’s tax deductions for the tax year over its taxable income for that year.
Example. For tax year 1, A has $100,000 of gross income and $125,000 of tax deductions. A has an NOL of $25,000 for tax year 1.
Why do NOL deductions matter?
Not all businesses have consistent income. Some businesses experience income volatility from year to year while other business’ income is consistent year over year. NOL deductions allow businesses to smooth out any year-to-year income volatility. Without the NOL deduction businesses with volatile income are taxed more over time on the same income than business that have consistent income.
Example. Business A has a $50,000 NOL in year 1 ($0 taxable income) and $100,000 taxable income in year 2. It pays no tax in year 1 and tax of $21,000 in year 2 (assuming a 21% corporate tax rate). So, over two years, A has a $21,000 tax liability on $50,000 of income.
Business B has income of $25,000 in year 1 and in year 2 for a total of $50,000 of income. Business B pays $5,250 in tax in each year for a total tax liability of $10,500 on $50,000 of income. In this scenario, A pays twice as much tax as B ($21,000 – $10,500 = $10,500).
However, if A may deduct the year 1 NOL in year 2, using the $50,000 year 1 NOL to offset $50,000 of its $100,000 income, then A has a tax liability of $10,500 on $50,000 of income just like B.
Can NOLs generated in 2018, 2019 and 2020 be carried back?
Under the TCJA rules, businesses couldn’t carry back NOLs. Under the CARES Act, an NOL from a tax year beginning in 2018, 2019 or 2020 can be carried back five years. Taxpayers don’t have to carryback their 2018, 2019 and 2020 NOLs. They can elect to waive the carryback period and only carry these NOLs forward to future years.
Under the CARES Act, taxpayers that carryback their NOLs must use the entire five-year carry back period. For example, taxpayers can’t elect to use a two-year carryback period instead of the five-year carryback period for their 2018, 2019 and 2020 NOLs.
As it stands right now, this five-year carryback provision goes away for tax years beginning in 2021.
Does the 80%-of-income NOL limitation still apply to NOLs generated in 2018, 2019 and 2020?
NOLs generated in 2018, 2019 and 2020 are still subject to the TCJA 80%-of-income limitation if they are carried forward to a year in which the limitation applies (generally, tax years beginning after 2020).
However, NOLs generated in 2018, 2019 and 2020 are not subject to the 80%-of-income limitation if they are exhausted during the five-year carryback period or during 2018, 2019 or 2020. NOLs carried over from pre-TCJA years aren’t subject to the limitation.
Can all taxpayers take advantage of the CARES Act NOL carryback?
Generally, C corporations, individuals, estates and trusts, and tax-exempt organizations with unrelated business taxable income can take advantage of the CARES Act NOL carryback. Partnerships and S corporations may be able to take advantage of the CARES Act NOL carryback but there are different rules for passthrough entities.
On the other hand, real estate investment trusts (REITs) can’t carry back an NOL to any preceding tax year. Additionally, an NOL generated in a tax year during which the taxpayer wasn’t a REIT (non-REIT year) can’t be carried back to a year in which the taxpayer was a REIT.
The CARES Act contains an exception to this rule. The exception allows certain taxpayers with untaxed foreign earnings from certain specified corporations to exclude tax years with Code Sec. 965 income from their carryback period.
Must NOLs be carried back to the earliest year in the five-year carryback period?
Under the CARES Act, a taxpayer must carry back an NOL generated in 2018, 2019 or 2020 to the earliest year in the five-year carryback period. If the earliest year’s taxable income can’t absorb all or part of the NOL, then the taxpayer carries forward any remaining NOL to the next carryback year with taxable income (and so on) until the NOL used up.
Under the CARES Act can NOLs still be carried forward indefinitely?
Yes. Under the CARES Act, businesses can still carry forward NOLs indefinitely. Indefinite NOLs are NOLs generated in a tax year beginning after 2017. This indefinite carryforward period includes any NOLs from 2018, 2019 and 2020 that remain after they are carried back to tax years in the five-year carryback period.
Should taxpayers carryback an NOL?
Whether a taxpayer should carryback an NOL using the CARES Act rules depends on the taxpayer’s situation. Generally, using the five-year carryback will be better for C corporations because they can carry back post-TCJA NOLs to offset high tax income. Pre-TCJA income was taxed at higher rates (the TCJA reduced the highest tax rate for C corporations from 35% to 21%). Also, a carryback can generate a refund for the prior year even if that tax year is technically closed by the statute of limitations.
However, carrying back an NOL to claim a refund requires filing an amended return or tentative refund application (which can be a lot of extra accounting and compliance work), and exposes the taxpayer to audit risk for an otherwise closed year.
How do taxpayers apply an NOL carryback to get a refund?
Taxpayers have two options for applying the NOL carryback to prior years and claiming a refund. They may amend the returns for all the carryback years or file for a tentative refund claim. Filing a tentative refund claim typically results in a faster refund.
A corporate taxpayer applies for a refund by filing Form 1139, Corporation Application for Tentative Refund. Noncorporate taxpayers apply for a refund by filing Form 1045, Application for Tentative Refund.
Tentative refund claims can’t be filed before the taxpayer files the return for the tax year that generated the NOL. Generally, taxpayers must file Forms 1139 and 1045 within 12 months of the end of the tax year that generated the NOL.
The IRS has a 90-day period to conduct a limited examination or review of the application for omissions or errors and can either allow or deny the application.
Note: In April 2020, the IRS provided a temporary procedure that allows taxpayers to file Forms 1139 and 1045 with the IRS by fax. This temporary procedure expires at the end of 2020, so the fax number will no longer work as of midnight ET on December 31, 2020. Taxpayers who can’t fax file their Forms 1139 or 1045 should follow the filing instructions on the forms.
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About the Author. Deborah Petro is a Senior Editor with Thomson Reuters Checkpoint. Before joining Thomson Reuters in 2019, Deborah practiced tax law in Chicago. Deborah is a graduate of Vanderbilt University and earned her J.D. and LL.M. in Taxation from Chicago Kent College of Law.