How the CARES Act Provides Businesses a Five-Year Carryback for Net Operating Losses

Updated 10/16/2020 at 2:56pm ET — Added information on faxing Forms 1045 & 1139 to the IRS.

Under the CARES Act, for tax years 2019 and 2020, businesses are now able to utilize NOLs generated in prior years to offset 100% of taxable income. For tax years 2021 and after, the previously enacted 80% taxable income limitation rules will be reinstated with additional provisions that exclude from taxable income deductions under sections 199A and 250.

Businesses and the individuals who own pass through entities that incur NOLs in tax years 2018, 2019, or 2020 can carryback those losses to offset taxable income for a period of five years preceding the year in which the loss was generated. It is important to note that NOLs that are carried back to years in which the business was subject to the section 965 transition tax, the business will be treated as having made the election under section 965(n), which allows for the preservation of NOLs. Additionally, businesses can elect to exclude from the carryback period any years in which the section 965 transition tax applied.

Section 965 Transition Tax

The CARES Act prevents taxpayers from offsetting section 965 income using NOL carrybacks. For years in which carryback NOLs are applied, taxpayers will be treated as having made the 965(n) election to not use NOLs to offset section 965 income.

It is also important to note that if a taxpayer elected to pay the section 965 transition tax using the installment method, it is possible that the IRS will use overpayments resulting from NOL carrybacks to satisfy future installment payments of the section 965 tax. Unless the IRS position on this is overridden by legislation, taxpayers may want to consider making the special election to forego NOL carrybacks to years in which they were subject to section 965.

Foregoing the Carryback

Unless an election is made to forego the carryback, net operating losses generated in 2018, 2019, and 2020 must be carried back to the earliest year within the carryback period in which there was taxable income. The CARES Act offers one exception to this, providing taxpayers with the ability to make an irrevocable election to exclude from the carryback period any years in which section 965 income was reported. Elections to forego NOL carrybacks generated on 2018 or 2019 tax returns, 2019, or 2020 tax returns must be made by the extended due date of the 2020 return (October 15, 2021 for calendar year taxpayers) should be made on the 2020 tax return by attaching a separate statement for each year that the taxpayer intends to make the election (2018 or 2019) stating that the taxpayer is electing to apply section 172(b)(3) under Rev. Proc. 2020-24 and the taxable year for which the statement applies. Elections are to be made by the extended due date of the 2020 return (October 15, 2021 for calendar year taxpayers).

Claiming a Refund

In lieu of filing an amended return for years in which a refund is sought as a result of an NOL carryback generated in 2018, corporate taxpayers can file Form 1139/1045 to request a tentative refund. Once filed, the IRS will have 90 days to review the claim and, if approved, remit the tentative refund. Typically, these forms are due within 12 months of the last day of the taxable year in which the NOL arose (for 2018, the due date was 12/31/19), however the Act extends this period to 18 months (June 30, 2020 for calendar year filers). In order to take advantage of this extended deadline, taxpayers will need to include the following statement on the top of Form 1139/1045: “Notice 2020-26, Extension of Time to File Application for Tentative Carryback Adjustment.”

Unless the IRS changes the policy, taxpayers are unable to claim a refund using Form 1139/1045 for years in which they were subject to section 965. Instead, these taxpayers will need to file an amended tax return for the years affected.

Taxpayers also have the option to file an amended return to claim the refund. While doing so will cause delays in receiving the refund versus filing Form 1139/1045, once remitted to the taxpayer, the refund is considered final.

For years in which the taxpayer has an open IRS audit, refunds requested by filing an amended return will be reviewed by the IRS examiner as part of the audit and will not be paid until the audit has been closed. Refunds requested using Forms 1139/1045 will still be subject to review by the IRS audit team, however, the tentative refund will be remitted in advance of closure of the audit.

Alternative Minimum Tax Impact

When carrying back an NOL from a taxable year beginning after December 31, 2017 and before January 1, 2021 under the CARES Act to one of the preceding five tax years to obtain a refund, the carryback can give rise to AMT in that previous tax year. This is because the Alternative Minimum Tax was repealed as part of the TCJA of 2017, and AMT NOL’s are not generated in tax years beginning after December 31, 2017. But since authoritative guidance in the Internal Revenue Code indicates that a taxpayer is required to consider an AMT NOL when calculating Alternative Minimum Taxable Income, it would seem that the appropriate action in this situation is to manually calculate an AMT NOL alongside the regular tax NOL, thereby reducing any AMT.

However, recent guidance was released by the IRS indicating that this is not the correct approach, and no AMT NOL is permitted to be calculated in taxable years beginning after December 31, 2017 and before January 1, 2021. The expectation is that any AMT generated by a regular tax NOL carryback under the CARES Act is carried forward to the next tax return to be filed by the taxpayer, at which time a refund may be claimed. The IRS added that if a carryback claim was submitted before June 1, 2020 and was not filed correctly following these guidelines, there is no need to amend the filing unless the taxpayer is contacted by the IRS. Finally, the IRS noted that if an AMT credit generated or released by the NOL carryback in one year of the five year carryback period that is also used in a subsequent year in the carryback period to reduce the taxpayer’s tax liability (which is distinct from a refundable AMT Credit), then the taxpayer may claim a tax refund for the decrease in tax from the use of the AMT Credit on the same Form 1139.

Since the recent IRS guidance appears to be in contrast with current tax law, there is an expectation that further discussion will be held which could potentially change IRS guidance in this matter. Absent any further guidance, taxpayers should follow the existing IRS directives noted above.

Additional Items for Consideration

While taking advantage of the new NOL carryback rules will provide businesses with the ability to quickly free up cash flow, special consideration should be given before carrying back NOLs to tax years that have been closed by the statute of limitations, as well as years in which the taxpayer was able to exclude cancellation of debt income.

Taxpayers will also need to consider the effect on various tax attributes in years to which NOLs are carried back, including foreign tax credits and AMT liabilities. Additionally, carrying back NOLs to pre-TCJA years may have the adverse effect of reducing the taxpayer’s domestic production deduction under section 199. In post-TCJA tax years, NOL carrybacks could also impact the taxpayer’s deductions for FDII and GILTI under section 250.

State tax implications also need to be considered when carrying back NOLs in order to ensure that carrybacks are properly claimed in each applicable state and that the statute limitations does not inadvertently get extended. It is expected that many states will decouple from the 5-year carryback provision, as they did in the past when disaster relief regarding NOLs was enacted. For pass-through entities and sole proprietors, section 2304 of the CARES Act provides modifications to section 461(l) that allows excess business losses for tax years ending before 2021. The Act also makes a technical correction to section 461(l)(2) enacted under TCJA that allows these entities to carry forward losses to offset taxable income in future years. For additional information, please see our article on the changes to IRC 461(l) here.

SC&H Group’s Tax team continues to keep a close watch on updates as they take place. If you have any questions on how these changes apply to your organization, please reach out to our team today.