Maximizing Tax Benefits When Planning for NOLs

May 2021

BY

Kevin Ainsworth, Partner, National Corporate Tax Leader

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Net operating losses (NOLs) are valuable assets that can reduce taxes owed during profitable years, thus generating a positive cash flow impact for the taxpayer in the year the NOL is deducted. The tax rules for deducting NOLs can vary depending on the taxpayer’s specific situation and the year the loss is incurred. Further, the amount of the benefit an NOL can provide depends on the tax rates that apply for the year or years the NOL is used.

 

Overview of NOL deductions

Following the passage of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, the treatment of federal NOLs depends on the year the loss is generated: 
  • NOLs generated in taxable years beginning in 2017 or earlier are allowed a two-year carryback and a 20-year carryforward, and are not subject to a taxable income limitation;
  • NOLs generated in taxable years beginning in 2018 through 2020 are allowed a five-year carryback, and may be carried forward indefinitely, but are limited to 80% of taxable income in any year beginning in 2021 or later; and
  • NOLs generated in 2021 or later are not allowed to be carried back, have an indefinite carryforward period and are limited to 80% of taxable income.

For more information on the temporary changes to the NOL rules imposed by the CARES Act, see BDO’s article CARES Act Impacts on Net Operating Losses: Frequently Asked Questions.
 

Efficient utilization of NOLs

Given the potential for increased tax rates proposed by the current administration, and the loss of any carryback ability beginning in 2021, taxpayers should consider how their losses will be utilized to maximize cash benefits.
 

Carryback claims for prior year NOLs

The special five-year NOL carryback allowed by the CARES Act can provide a favorable tax rate differential for taxpayers that are able to carry back post-2017 NOLs to offset income of an earlier year that was taxed at higher rates. Taxpayers can file for a “tentative” refund of NOLs originating in 2020 within 12 months from the end of the tax year (by December 31, 2021 for calendar year filers), and the IRS is generally required to issue tentative refunds within 90 days (although these refunds are currently taking longer to process). Taxpayers that have not already filed refund claims for 2018 or 2019 NOL carrybacks can still carry back the losses and claim refunds on timely filed amended returns, the due dates for which are based on the statute of limitations for the year the loss originated.

Alternatively, taxpayers can waive the five-year NOL carryback requirement if they wish to do so based on their facts and circumstances. This election for NOLs generated in 2018 and 2019 is made with the tax return for the first taxable year ending after March 27, 2020. The election for NOLs generated in 2020 is made with the timely filed 2020 federal tax return. The election to waive the NOL carryback period is irrevocable and, therefore, should be carefully considered.
 

Losses of passthrough entities

Losses of partnerships and S corporations can be deducted on the tax returns of their owners, provided sufficient “at-risk” tax basis exists at the end of the year. Once the “at-risk” basis rules are satisfied, the passive activity loss (PAL) rules need to be evaluated. A taxpayer is not subject to PAL limitations if he or she is an “active” participant in the business generating the loss, or if sufficient income exists from other passive activities. The tax rules surrounding each of these principles are highly complex and dependent on the facts and circumstances of the specific owner.

Losses that pass the above tests are then subject to the overall deduction limits for “excess business losses” (EBLs). EBLs are limited to $500,000 for joint returns and $250,000 for all other noncorporate taxpayers (these limits will be indexed for inflation). Note that the CARES Act temporarily suspended the EBL rules for three years, but the limitations are restored beginning in 2021.

Partners and shareholders of passthrough entities whose loss deductions may be limited should evaluate how to minimize the impact of the various limitations.  
  • A partner or S corporation shareholder whose projected tax basis is not expected to cover its tax losses at the end of the tax year should consider making a capital contribution or a loan to the corporation to increase their at-risk tax basis. It is important to note that not all tax basis is considered to be at-risk.
  • Combining related S corporations and partnerships into a single corporate or partnership structure can not only create a higher tax basis for owners to deduct losses, but also may allow for additional tax-free distributions and business interest expense deductions. 
  • Partners and S corporation shareholders should consider whether they will meet the requirements for active participation in the business before the end of the year to avoid application of the passive activity loss limitation.
 

Section 382 losses

Section 382 of the tax code applies a limitation on the use of NOLs and other tax attributes when a corporation undergoes an ownership change (i.e., a 50% shift in its 5% shareholder ownership within a rolling three-year period). Section 382 also applies to pre-change business interest expense and built-in losses of S corporations.
 
An ownership change may occur as a result of cumulative transactions between or among a corporation and its shareholders or may come about from an acquisition or merger of the corporation. When an ownership change occurs, complex analysis is required to compute the applicable limitation(s). Careful consideration of these provisions is needed to quantify existing limitations and to strategize how to avoid or mitigate future ownership changes.
 
Section 382 studies can provide techniques to help corporations maximize their Section 382 annual deduction. To find out more about the potential benefits of Section 382 studies, contact BDO.
 

State and local tax considerations

State and local governments have their own rules for deducting NOLs, which can vary widely among jurisdictions. Taxpayers should not automatically assume that an NOL that is deductible for federal purposes is also deductible in the same amount or in the same year for state or local purposes.
 

How BDO can help

The rules for calculating and deducting NOLs vary depending on a variety of factors. BDO tax professionals can assist with transaction structuring and other strategies to maximize NOL deductions for businesses and individuals, at both the federal and state levels. For more information, contact BDO.