- Business owners incur net operating losses when their tax deductions exceed income in a given year. Generally, these losses can offset future income.
- The CARES Act allows taxpayers to carry back losses incurred in 2018, 2019 and 2020 for up to five years.
- Affected firms and business owners can use those losses to offset income from prior years, leading to a cash refund
The coronavirus has pushed thousands of businesses to the edge, but there may be a ray of hope for cash-strapped firms.
Businesses laid low by the pandemic and community lockdowns need money now, and one of the best ways to get it is by taking advantage of very favorable rule changes on the treatment of net operating losses in the CARES Act.
A company incurs NOL when its tax deductions exceed its income in a given year. Generally, taxpayers can lower their taxes by using this loss to offset income in a future year.
The CARES Act takes this a step further, allowing battered businesses to turn this year's red ink into a tax refund from prior years' income.
A provision in the legislation allows companies to carry back losses incurred in 2018, 2019 and 2020 for five years.
"There are whole areas of U.S. business where companies are incurring significant losses and [the NOL rule changes] give them access to cash that can help them survive," said Doug Bekker, CPA and a partner in the national tax office of BDO USA.
"We anticipate a lot of NOL carry-back claims in 2021 and expect a lot of early filing to get the cash back quickly," he said.
Under the CARES Act, 2018 losses can be used to offset income as far back as 2013. Losses generated this year can be deducted from taxable income going back to 2015.
The IRS has also promised to send out refund checks to business owners and companies within 90 days of a claim if they follow a quick refund process. Individuals will need to file Form 1045, while C-corporations will have to file Form 1139.
"This is the best part of the CARES Act," said CPA Robert Tobey, a tax partner with Grassi & Co. in New York and a member of the Individual and Self-employed Tax committee at the American Institute of CPAs.
"Cash flow is the biggest issue for businesses now and how often does the government offer to give you back taxes you've already paid?" he said.
The deal is particularly sweet for C-corporations — generally larger companies that are taxed as separate entities from their owners.
The Tax Cuts and Jobs Act passed in late 2017 dropped the tax rate on C corps to 21% from 35%.
Companies that can carry back losses to pre-2017 years potentially get a bigger bang for the buck.
"For larger companies like airlines, hotels or restaurant franchises who made money in those higher tax years, this is a way to try and make it through this period," said Ryan Losi, CPA and executive vice president at Piascik in Glen Allen, Virginia.
The tax arbitrage benefit is less dramatic for small-business owners who are generally structured as pass-through corporations like S-corporations and LLCs. In this case, income from the business "passes through" to the owner's personal tax return.
The Tax Cuts and Jobs Act lowered the highest marginal individual income tax rate to 37% from 39.6%, a cut that's far less drastic than the rate reduction for C-corps.
However, the potential cash infusion from loss carrybacks may help pass-throughs stay in business.
"It's my experience that most business owners need the cash now," Losi said. "If they are losing money this year, they can get back up to 40 cents on the dollar for those losses."
The NOL carry-back option is not necessarily for everyone. If a taxpayer was not in business in those earlier years or made little taxable income then, it may not be worth the effort to get a small refund.
It also reopens your tax file on the years you carry losses back to, which can raise the risk of an audit of prior returns. "You're opening up a closed year," said Tobey. "There's a risk involved in the reward."
Taxpayers can make an irrevocable election to forgo the loss carry-backs and use losses in the 2018-2020 period to offset future income. The CARES Act allows those losses to be carried forward indefinitely.
The decision gets more difficult the more complicated your tax situation, Bekker explained.
Another factor to consider is whether states will conform to the new federal rules and allow taxpayers to also get refunds of state taxes previously paid.
"They may want to help, but they're in difficult situations themselves," Losi said.
Business owners must work with their tax professionals to determine whether there's a silver lining to this year's misery.
"This is the year to stuff every expense and every bit of bad news into your 2020 tax return," Tobey said. "Cash is king now and this is a great place to find it."