How to leverage net operating loss rules to create cash flow

As the COVID-19 pandemic continues to challenge businesses, now more than ever, cash remains a vital commodity and the IRS might be a source of liquidity.

Taxpayers can potentially retrieve tax deposits made for 2019 under current rules and, with changes made in the Coronavirus Aid, Relief, and Economic Security (CARES) Act (HR 748), they can potentially obtain a refund of taxes paid in earlier periods. The IRS issued Notice 2020-26 and Revenue Procedure 2020-24 on April 9, 2020, that clarify the process for making a refund claim. Below, we discuss how.

Benefits of using a quick refund before July 15 for 2019 tax deposits

The IRS recently extended the period for claiming a refund of estimated taxes. If a corporation with a calendar tax year has estimated tax deposits on file with the IRS, they should consider filing Form 4466 before the extended July 15 deadline if such for deposits significantly exceed the expected liability for 2019. A benefit to using this approach is to speed up the refund process and to avoid a review of a refund claim by the Joint Committee on Taxation for large refund claims ($5 million for corporate taxpayers).

Refund claims under the CARES act

The act restores the five-year net operating loss (NOL) carryback for losses arising in any taxable year beginning after 2017 and before 2021. This means companies that had a net operating loss for 2018 can immediately request a refund by filing Form 1139 to apply the loss, carrying forward any amount not used. The act also allows 100% offset of taxable income, suspending the 80% limitation that was in place under the tax reform law in passed in 2017, commonly referred to as the Tax Cuts and Job Act (TCJA). To further assist in making refund claims, the IRS has implemented temporary procedures that allow taxpayers to fax in rather than mail refund claims.

Care should be taken if any ownership changes have occurred during the three years leading up to a loss year as the amount of loss that can be used may be limited — this is a critical piece that many aren’t aware of. The rules are complex so please consult your tax advisor.

Determining if you should carry net operating losses back or forward

The act allows a taxpayer to decide to carry the loss back or to carry it forward, an election that can be made for each separate tax year in 2018, 2019, and 2020. Most companies will benefit by choosing to carry the loss back because the TCJA lowered the corporate tax rate to 21% from 35%, beginning in 2018. This means that instead of receiving $21 of benefit for every $100 of loss carried forward a corporation could receive $35 with a carryback — a permanent difference.

Other considerations

Given this rate differential, consider whether there’s an opportunity to reduce your taxable income through favorable accounting methods. While accounting methods generally create timing differences that may be of less interest to some taxpayers, corporations in particular could obtain significant cash-flow benefit and a permanent difference due to the restoration of the loss carryback rules. Changes to depreciable property, including repairs and improvements, could create substantial cash savings and other favorable accounting methods should be considered depending on the particular facts and circumstances.  The retroactive technical correction for qualified improvement property (QIP), reverting from 39-year property to 15-year property that is eligible for bonus depreciation, to assets placed in service in 2018, taxpayers with substantial QIP in 2018 can obtain significant benefits by either amending their 2018 return or requesting an accounting method change and recording a catch-up adjustment.

In addition, other tax attributes may be impacted by the carrying back of net operating losses and should be considered as part of the decision to carry back losses such as:

• The impact on alternative minimum taxes and any resulting alternative minimum tax that could result or impact an alternative minimum tax credit
• The impact on foreign tax credits since net operating losses are considered prior to utilizing foreign tax credits
• For corporations subject to the global intangible low-taxed income (GILTI) inclusion (introduced under TCJA as a new category of foreign income), there may be a significant reduction or elimination of any cash refund
• Corporations with an inclusion under IRC Section 965 (the income inclusion for foreign earnings introduced under TCJA) won’t be able to offset this income with the net operating loss carryback

While the decision to carry losses back to earlier years when income tax rates were higher may seem straightforward, the interaction with other income tax provisions and impact on other tax attributes may complicate the decision. Modeling will be necessary in many instances to fully understand the impacts and determine the amount of refund the will be available.