The Coronavirus Aid, Relief, and Economic Security Act (the "CARES Act") (H.R. 748), which was enacted on March 27, 2020, expanded taxpayers' ability to utilize net operating losses under Internal Revenue Code (“IRC”) § 172 by temporarily permitting certain losses to be carried back up to 5 years and suspending the rule which limited net operating loss utilization to 80% of taxable income. In addition, the CARES Act repeals the excess business loss limitation under IRC § 461(l) for tax years beginning prior to January 1, 2021 (i.e., calendar years 2018, 2019, and 2020). Further detail on both changes is provided below.
Expanded Net Operating Loss Deductions
Corporate and noncorporate (i.e., individuals, trusts, and estates) taxpayers that incur losses in excess of gross income from a trade or business, subject to certain adjustments, are allowed to utilize the net loss to offset taxable income in other tax years. For noncorporate taxpayers, the trade or business activities cannot be passive. Excess losses can be quite valuable and are generally considered a tax asset for the taxpayer, provided that the taxpayer will be able to use the losses. In an effort to enhance the value of losses for taxpayers – and keep more cash from active trade or business activity in the hands of taxpayers – the CARES Act provides additional relief for businesses in two important ways. First, net operating losses that arise in a tax year beginning after December 31, 2017 and before January 1, 2021 can be carried back for up to 5 years preceding the year in which the loss was incurred. For example, a loss incurred during the 2018 tax year could be carried back to offset taxable income from the 2013 tax year. In addition, the CARES Act suspended the rule limiting NOL utilization to 80% of taxable income for tax years beginning before January 1, 2021.
To put these rules into context, some background is useful. The rules relating to net operating loss (“NOL”) utilization have been subject to significant changes in recent years. Prior to the 2017 Tax Cuts & Jobs Act (the “TCJA”), taxpayers were able to carryback a net operating loss for 2 years and carryforward the loss for up to 20 years. The TCJA amended these rules such that NOLs could no longer be carried back to prior tax years, but could be carried forward indefinitely (subject to certain exceptions, as certain farming and insurance businesses were still permitted to use the 2-year carryback). In addition, the TCJA added a new provision which provided that a taxpayer could only use net operating losses to offset up to 80% of taxable income, with the balance of any unused losses carried forward. The changes made by the TCJA were intended to generate revenue but also removed the option for businesses with current losses to carry back losses to profitable years and obtain a refund. In a loss year, the extra cash from a refund could be particularly useful, and with the CARES Act, Congress has again allowed taxpayers to obtain cash refunds from loss carrybacks.
For US persons with international operations, the changes to the NOL rules made by the CARES Act also address taxpayers that were subject to gross income inclusions under IRC § 965 on the deemed repatriation of earnings and profits from a foreign corporation (deemed to occur as of December 31, 2017 for calendar year taxpayers or the next following fiscal year for fiscal year taxpayers). If a taxpayer was subject to a deemed income inclusion, the CARES Act provides that the taxpayer is not eligible to utilize an NOL carryback to such year to offset the amount of such income. Alternatively, for any tax year for which a taxpayer has an IRC § 965 inclusion, the taxpayer may elect to exclude the IRC § 965 inclusion year from the carryback period.
For tax years beginning on or after January 1, 2021, the CARES Act generally retains the TCJA rule with several technical modifications. Taxpayers will be able to utilize losses generated in tax years beginning prior to January 1, 2018 without regard to the 80% taxable income limitation. For losses generated in taxable years beginning on or after January 1, 2018, taxpayers will be subject to an 80% taxable income limitation determined (i) after accounting for the utilization of any pre-2018 net operating losses but (ii) without regard to the 20% Qualified Business Income Deduction under IRC § 199A, or the deductions permitted under IRC § 250 that offset a portion of the taxpayer's Global Intangible Low Tax Income (often referred to as “GILTI”) or Foreign Derived Intangible Income (often referred to as “FDII”).
Changes to Excess Loss Limitations (Section 461)
Certain noncorporate taxpayers that have active trade or business losses are subject to tax rules that impose limitations associated with, but expanding on, the NOL rules. Very generally speaking, the “excess business loss limitation” rule is one that requires taxpayers other than C corporations to carry forward certain losses from business activity and treat them as part of NOLs in future years. The CARES Act repeals the excess business loss limitation under IRC § 461(l) for tax years beginning prior to January 1, 2021 (i.e., calendar years 2018, 2019, and 2020). Specifically, IRC § 461(l) is amended such that the “excess business loss” limitation rule applies for any tax year beginning only after December 31, 2020, and before January 1, 2026. Further, this provision applies on a retroactive basis (to December 31, 2017). Prior to the temporary repeal by the CARES Act, IRC § 461(l) generally precluded taxpayers from using losses generated from an active trade or business to offset more than $250,000 of non-trade or business income ($500,000 if married filing jointly). The TCJA loss limitation rule was particularly harmful to active real estate investors with real estate losses and active portfolio income.
The bill also includes certain technical corrections to IRC § 461(l). First, the IRC § 461(l) calculation now excludes items attributable to the trade or business of performing services as an employee. In addition, net operating loss deductions under IRC § 172 and qualified business income deductions under IRC § 199A are not taken into account in determining excess business losses. Most significantly, however, deductions for losses from the sale or exchange of capital assets are not taken into account in increasing a IRC § 461(l) limitation. Certain gains from the sale or exchange of capital assets, however, may continue to be taken into account in reducing a potential IRC § 461(l) limitation (note that netting with losses is required).
- Taxpayers with losses arising in 2018, 2019, or 2020 tax years now have increased flexibility in that they now have the option of carrying losses back for up to 5 years preceding the loss to obtain a refund. Revenue Procedure 2020-24 provides guidance as to certain elections or limited elections in this regard. The tax effects of a carryback election must be carefully analyzed particularly for taxpayers with international activities.
- For corporate taxpayers, this could create a significant benefit in that a corporation that is currently taxed at a 21% rate could carryback losses to years when it paid income tax at a 35% rate. Similarly, individual taxpayers may be able to carryback losses to years when they paid tax at the higher rate brackets applicable prior to the 2017 Tax Cuts and Jobs Act (although the spread in rates for individuals pre-TCJA and post-TCJA is generally smaller than for corporations).
- Taxpayers that do not have or expect to have a net operating loss during the 2018, 2019, or 2020, tax years should also consider the expanded interest rate deductions under the CARES Act. The CARES Act increased the ceiling on business interest deductions under IRC § 163(j) from 30% to 50% of adjusted taxable income, which could result in or increase a net operating loss if the taxpayer has significant depreciation or amortization losses for those years. For further detail on the expanded interest rate deductions click here.
- With regard to the changes to the Excess Loss Limitation rules, clients with significant capital gains and losses should take note of the netting effect in the version of IRC § 461 offered by the CARES Act. Taxpayers that were previously adversely impacted by the excess business loss limitation rules may be able to carry back net operating losses from trades or businesses to the 2018 tax year to offset non-trade or business income in excess of the previous $250,000/$500,000 limitation.