2020 has been a year like no other; a pandemic, the most active hurricane season, a record setting election turnout, and a myriad of tax law changes. Lawmakers responded quickly in March once the pandemic set in and the lockdowns occurred. Legislation, most notably the CARES Act, was passed to help taxpayers during this unprecedent time. And as part of the CARES Act, rules for the net operating loss (NOL) deduction changed once again to provide much needed cash flow to taxpayers feeling the economic effects of the pandemic.
So, what is an NOL? An NOL is the amount by which a taxpayer’s business deductions exceed his or her business gross income. Therefore, if a taxpayer, including an individual, has net business losses they can have an NOL. Individuals can generate business activity through flow-through ownership of businesses such as S corporations and partnerships. They can also conduct a business individually and report that activity on their individual return on Schedule C (often referred to as a sole proprietor). In years before 2018, these losses could be carried back or forward to offset taxable income in other years.
Effective beginning with the 2018 tax year, the Taxpayer Cuts and Job Act (TCJA) modified the then current rules regarding NOLS and the use of these deductions. The TCJA removed the NOL carryback provisions, which allowed taxpayers to amend prior year returns (or claim a refund on Form 1045 or 1139). The taxpayer could use their NOL deduction against income earned in the prior two years, reducing tax in those years, and increasing cash flow to the taxpayer. The TCJA also imposed an 80 percent taxable income limit on the use of the NOL rather than the 100 percent which was the previous law. In other words, the NOL could only reduce up to 80 percent of taxable income in any year it is carried forward.
CARES Act Changes:
As soon as we adjusted to the TCJA rules, CARES made some new changes. This Act reinstated the NOL carryback provisions allowing taxpayers that have NOLs that arise in a tax year beginning after December 31, 2017, and before January 1, 2021, to carryback the loss to each of the five tax years preceding the tax year of loss. This change expanded the number of years previously allowed before the TCJA from 2 to 5. Carrying these losses back to earlier years can also result in a higher tax refund than carrying these losses forward since the highest individual tax rate was 39.6 percent compared to the current 37 percent. Keep in mind, these provisions also apply to C corporations, which can also result in a higher refund since tax rates were as high as 35 percent rather than the current 21 percent flat rate.
The CARES Act also removed the 80 percent taxable income limit imposed by the TCJA for tax years 2018, 2019, and 2020 to allow taxpayers a larger deduction and more cash flow to combat the pandemic’s economic effects. Specifically, for tax years beginning before 2021, taxpayers can take an NOL deduction equal to 100 percent of taxable income.
Another change to loss deduction rules is the elimination of the section 461 disallowance of excess business loss for noncorporate taxpayer which was originally enacted in the TCJA. This rule removed the excess business loss limitation for tax years 2018, 2019, and 2020, which further restricted the ability to take business losses.
As is often the case, tax law changes are never simple, and the 2020 changes are no different. The IRS has issued guidance regarding the new NOL rules including how the Alternative Minimum Tax is impacted with the carryback provisions. These rules are very complicated, and a tax advisor should be consulted. Individuals and business owners should plan carefully for 2020 to maximize the losses if losses are being incurred since these losses can result in immediate tax savings and refunds. Reach out to our experts today to learn more and further discuss your specific situation.
The information and advice we are providing for this matter relates to COVID-19 legislative relief measures. Because legislative efforts are still ongoing, we expect that there may be additional guidance and clarification from regulators that could modify some of the advice and information provided to you, after the conclusion of our engagement. We, therefore, make no warranties, expressed or implied, on the services provided hereunder.