Enhanced NOL Carrybacks and Refunds Can Generate Cash During Pandemic

The IRS has now released several items of guidance clarifying the options available to taxpayers for utilizing net operating losses (NOLs) to generate current cash flow during the COVID-19 pandemic. As highlighted in a previous entry in the Gibbons COVID-19 client alert series, Section 2303 of the CARES Act provides for, except to the extent waived, an enhanced five-year carryback of NOLs arising in 2018, 2019, and 2020. It also suspends the 80 percent of taxable income limitation with respect to NOLs arising prior to 2021, allowing taxpayers to better make use of the tax losses they have incurred. Revenue Procedure 2020-24, in coordination with Notice 2020-26, provides guidance to taxpayers who want to either file tentative carryback adjustment applications or elect out of the new NOL carryback rules.

Critically, because of higher applicable tax rates in effect prior to 2018, the five-year carryback offers taxpayers a great way to arbitrage those rate differentials. For C corporations, with a current maximum rate of 21 percent, as opposed to the prior maximum rate of 35 percent, this advantage, if available, should not be overlooked.

Tentative Refunds of NOL Carrybacks

Taxpayers are permitted under IRC Section 6411 to file applications for tentative carryback adjustments of their tax liability for prior tax years that are reduced by NOL carrybacks. A taxpayer carries back NOLs to each of the five taxable years preceding the year in which the NOL arises, applying the NOLs first to the earliest tax year in the carryback period, and then carrying forward unused amounts of NOLs to each following taxable year. Corporations file Form 1139, while other taxpayers use Form 1045. Normally, such an application must be filed within 12 months of the end of the taxable year in which the NOL arose, and the IRS undertakes a limited examination prior to issuing a refund or credit within 90 days of the filing of the application.

Special rule for 2018 NOLs with June 30 deadline: Notice 2020-26 provides for a six-month extension, allowing taxpayers to make applications for tentative refunds of NOLs arising in 2018 no later than 18 months after the end of the tax years in which the NOLs arose. For calendar year taxpayers, the filing deadline for NOLs arising in 2018 would thus be the fast-approaching date of June 30, 2020. Taxpayers must add the phrase “Notice 2020-26, Extension of Time to File Application for Tentative Carryback Adjustment” to the top of Form 1139 or 1045, as applicable. In part, because the IRS expects delays processing the significant number of NOL carryback refund claims it anticipates receiving, it has temporarily requested taxpayers to file by fax, rather than by mail, until further notice.

Elections to Waive the NOL Carryback

Taxpayers who prefer to waive the carryback period for NOLs arising in 2018 or 2019 must make the election no later than the due date, including extensions, of their federal income tax return for the first taxable year ending after March 27, 2020. For most business taxpayers, this will be September 15, 2021, the extended due date of the return for 2020 calendar year taxpayers. The election is made by attaching a separate statement for each year (2018 or 2019) for which the taxpayer intends to make the election. The election to waive the NOL carryback period is irrevocable.

Election to Exclude Transition Tax Years

For taxpayers with foreign subsidiaries or operations that were subject to the 2017 Tax Act’s Section 965 transition tax, consistent with the fact that NOLs cannot be used to offset such inclusions, Revenue Procedure 2020-24 provides an option to exclude all Section 965 income inclusion years from the carryback of NOLs arising in taxable years beginning in 2018, 2019, and 2020. For the 2018 and 2019 tax years, this election must be made no later than the due date, including extensions, for filing the taxpayer’s federal income tax return for the first tax year ending after March 27, 2020. For NOLs arising in a tax year beginning in 2020, this election must be made by no later than the due date, including extensions, for filing the taxpayer’s federal income tax return for the taxable year in which the NOL arose. The taxpayer makes the election by attaching a statement to its federal income tax return. If the election is not made, and an NOL would otherwise be carried back to a taxable year with a Section 965 inclusion, the CARES Act includes a provision that treats the taxpayer as if it had made an election under IRC Section 965(n) to not apply the NOL against the Section 965 inclusion.

Analysis of Potential Areas for Concern and Consideration

There are several items that should be considered before deciding to carry NOLs back to prior taxable years.

Reopening of statute of limitations: Carrying back NOLs to an earlier taxable year and requesting a refund for an otherwise closed taxable year (due to the statute of limitations) will effectively reopen the year and allow the IRS to review and potentially audit that year to the extent of the anticipated refund. If the IRS determines that a tentative refund was issued in error, the IRS has a special streamlined assessment procedure to correct such an error, similar in speed to the expedited review of the original refund application. Taxpayers are required to first pay the assessments and then file refund claims in Tax Court. This could impact taxpayers when they are still struggling and ill-prepared to deal with IRS assessments. The assessment also creates a federal tax lien on all of a taxpayer’s assets and could trigger default provisions in debt instruments or other agreements. In the worst circumstances, taxpayers could be forced to file for bankruptcy protection to forestall collection procedures.

Interaction of pre-2018 NOLs with AMT and other tax provisions: Any corporate NOLs carried back to pre-2018 tax years will interact with the corporate alternative minimum tax (AMT) tax determination, which would require new calculations of modified taxable income and corresponding adjustments to NOLs for AMT purposes, which in turn could reduce the benefit of carrybacks to those earlier years.

NOL carrybacks might also cause recalculation of allocations of income and deductions within a consolidated group where members have departed the group, which could impact the availability of separate return loss year (SRLY) NOLs. Carrybacks could also impact the use of tax credits, incentives, and other benefits in earlier years, possibly decreasing any anticipated tax refund. NOL carrybacks could also impact financial statements, by affecting reserves for uncertain tax positions and deferred tax accounts. Finally, transactional documents associated with recent company M&A transactions may have clauses limiting the ability to carry back NOLs to taxable years prior to the transactions.

Additional Ways to Use NOLs for Current Relief

There are other ways taxpayers can benefit from NOLs to obtain current relief. If a corporation’s tax liability for the immediately preceding year would be reduced or eliminated by NOLs generated in the current year, the corporation can file a Form 1138, Extension of Time for Payment of Taxes by a Corporation Expecting a Net Operating Loss Carryback, to receive an extension of time to pay its taxes for the preceding year based on its anticipated NOL carryback. Somewhat similarly, if a corporate taxpayer has NOLs this year and, as a result, has overpaid estimated taxes for this year, it can get a quick refund by filing Form 4466, Corporation Application for Quick Refund of Overpayment of Estimated Tax.

For more information on the tax provisions of the CARES Act that may help your business with cash flow issues during the current coronavirus crisis, some of which are time-sensitive, please contact Peter Ulrich. The Gibbons Tax Team is well-positioned to assist with these and other tax related matters you may now face.