Increasing liquidity has taken center stage for many businesses as the COVID-19 pandemic continues to present challenges. One opportunity to free up cash through a tax deferral is leveraging net operating losses (NOLs). However, this option requires action this year.
Understanding how to utilize these benefits through the effects of carryback claims can be complex and some allowances are quickly sunsetting.
Following is a run-down of questions related to NOLs and how to utilize them in the 2020 year-end filing while the opportunity exists.
What is a net operating loss (NOL)?
A NOL exists when a taxpayer’s allowable tax deductions for the year exceed taxable income. A NOL can generally be used to offset a taxpayer’s tax liabilities in other tax periods, commonly known as a carry-forward or carry-back.
Is there a time limit to when you can leverage a NOL?
Historically, NOLs have been available to taxpayers in a variety of ways. Recent tax reform, commonly known as the Tax Cuts and Jobs Act (TCJA), removed the NOL carryback potential. This limited taxpayers to only carrying NOLs forward that arose in 2018 and later years. However, the Coronavirus Aid, Relief, and Economic Security (CARES) Act, in March of 2020, restored NOLs to allow a five-year carryback for losses arising in any taxable year beginning after 2017 and before 2021.
These increased NOL benefits are timely to your 2020 year-end filing. Under current tax law, the availability to carry an NOL back to claim a refund from a prior year will sunset with losses generated in 2020. If an NOL is generated in 2021 or later, the losses are required to be carried forward.
Learn more about the changes in How to Leverage Net Operating Loss Rules to Create Cash Flow.
Could leveraging NOLs affect your 2020 year-end filing?
Many companies were hit hard by the COVID-19 pandemic, potentially leaving them in a loss position for 2020 that they did not anticipate at the beginning of the year. Corporations that began 2020 expecting to be in a taxable position can file for a quick refund on Form 4466 by April 15, 2021 to receive the refund of federal tax overpayments applied to 2020 or estimated tax payments previously paid in 2020, even if they plan to extend their return.
Is there a benefit to carrying a NOL back versus forward?
Taxpayers have the choice 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 of $14.
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 available refund.
Extra care should be taken if any ownership changes have occurred during the carryback period. For instance, if an ownership change occurred during the three years leading up to a loss year, it’s possible the amount of loss that can be used may be limited—this is a critical rule that many business owners aren’t aware of. The requirements for carrying back NOLs are complex, so it’s important to consult your tax advisor.
How can you create NOLs and utilize the limited-time opportunity?
There are many fixed-asset opportunities that can create significant losses and possibly create a NOL. Most of the strategies work by reducing federal and state tax liabilities. The two most common opportunities are: a cost segregation study or a fixed-asset study.
Below is an overview of each study type and how each can lead to increased cash-flow, especially when leveraging the current NOL provisions for most taxpayers.
Cost Segregation Study
These work on the premises of frontloading depreciation deductions into a taxpayer’s early years of owning real estate; segregating shorter-lived assets into buckets of five, seven, or 15 years, as opposed to the standard 27.5-year or 39-year lives. This tax deferral strategy increases current-year deductions, which can be used to offset income, or even create a net operating loss.
These studies generally can be done for both current-year or prior-year property purchases or new constructions. Basically, any acquired properties and all types of construction projects—such as ground-up construction, remodels, expansions, and tenant improvements—could make sense to have a study completed.
If the property was acquired or constructed in a previous tax-year, a taxpayer generally can catch-up the depreciation missed on prior tax returns by taking those deductions in the current year. This is done through a Form 3115 and doesn’t require amending any prior returns.
The benefits of cost segregation studies are compounded with other fixed-asset incentives that are increased through the process of quantification and qualification of shorter-lived assets, such as bonus deprecation and qualified improvement property (QIP). With bonus deprecation at 100% for acquired properties, new construction properties and QIP, cost segregation studies are becoming increasingly beneficial for most taxpayers.
Fixed Asset Study
A fixed asset study is similar to a cost segregation study; however, it’s applied in a broader scale as opposed to focusing on a single real estate asset. The benefits of a fixed asset study come from the missed opportunities for accelerating depreciation they uncover. This could be in the form of:
- Bonus depreciation or Section 179 expensing
- Commercial buildings energy-efficiency tax deductions
- Asset recovery periods
- Repairs or routine maintenance
- Qualified property classifications such as QIP, qualified leasehold improvement property (QLIP), qualified rental property (QRP), and qualified retail improvement property (QRIP)
- Assets never placed in service
- Assets that have been physically disposed or abandoned, yet are still being depreciated – commonly known as ghost assets
Often, taxpayers are unaware of the nuances and different compliance issues for tax versus generally accepted accounting principles, commonly known as GAAP. This is especially cumbersome for taxpayers who fit the following criteria:
- Have more than $25 million in fixed asset holdings
- Operate out of multiple physical locations or business units
- Work with de-centralized accounting teams
- Self-manage fixed assets for tax
With a fixed asset study, the options are two-fold:
- Take a one-time look at a taxpayer's books to identify areas to accelerate deductions on assets previously placed in service
- Provide an ongoing annual or quarterly assessment of additions and provide proper lives and methods
Both can lead to immediate tax deductions for the owners and offer the taxpayer the added benefit of tax compliance.
What’s an example that illustrates applying an NOL for losses created in 2020?
Below is an example of how the losses from tax deferral strategies can increase liquidity and free up cash for your business.
Let’s assume that a cost segregation, fixed asset, or combined study is performed applicable to the 2020 tax year that results in a $1 million NOL being generated. A carryback of this NOL would generate a refund of taxes paid in prior years. If the carryback is to years 2015–2017 and taxes were paid at the highest federal taxable rate of 35%, the NOL carryback would result in a $350,000 refund.
If no taxes were paid in years 2015–2017 and the carryback is instead to 2018 or 2019, the refund would be $210,000 on the $1 million NOL carryback, assuming this amount of tax was paid in those years.
Likewise, if the NOL is carried forward, future tax payments would be reduced by $210,000 under the current federal tax rate of 21%.
We’re Here to Help
For more information on how to utilize NOLs and other tax deferral strategies, contact your Moss Adams professional.