The past 18-month stretch has been challenging with health, social, and financial turmoil seeming to come daily. As many are looking forward to the future, they are also excited to finalize their 2020 individual federal income tax filings by October 15th and put 2020 in the rear-view window. But before any 2020 individual income tax returns are signed, careful consideration should be given on how best to maximize net operating loss (”NOL”) cash benefits. Taxpayers can also consider optimization of 2018 and 2019 NOLs as well, given the taxpayer friendly guidance issued by the IRS in Revenue Procedure 2020-24.
Many businesses have seen the creation of federal NOL’s in 2020 due to the majority of stimulus funding not being taxable, while the associated expenses were still allowed as a deduction. This tax treatment mismatch, coupled with the negative business impact of COVID in 2020, allowed for more NOLs to be reported for the 2020 taxable year than normal.
In general, NOLs created in 2018, 2019, and 2020 are required to be carried back five years and then carried forward indefinitely. So, what’s the big deal? Isn’t it better to carry back the NOL and get the cash refund now as opposed to waiting to carry the loss forward to a future taxable year? Just like everything in the tax world, it depends. With new 2022 tax legislation looming, and the potential for federal individual income tax bills to skyrocket, taking the time to forecast a future benefit of carrying forward an NOL could result in significant tax savings.
So how do individuals maximize the cash benefit of 2018, 2019, and 2020 NOLs? Two important questions need to be asked:
1. What is the owner’s individual federal income effective tax rate for the carryback years versus the expected rate in future years?
2. What is the owner’s current cash position? Is the need for cash imminent or is there an option to postpone the cash collection to maximize the benefit?
Federal Law Changes Surrounding Federal NOLs
Significant law changes on the utilization of federal NOLs were included in the Tax Cuts and Jobs Act (TCJA) passed in December of 2017, and further modified with the passage of the CARES act in March of 2020. Prior to the TCJA, the general rule provided that a federal NOL could be carried back to the 2 previous taxable years and carried forward to the next 20 taxable years. When the NOL was carried back or forward, it could offset 100% of the reported taxable income.
As part of the TCJA, the NOL rules were modified for any loss arising in taxable years after December 31, 2017. NOLs generated after that date could be carried forward indefinitely, but the carryback was eliminated. In addition, when the losses were carried forward, they could only offset up to 80% of taxable income in that year.
But then came COVID, and with businesses struggling, there was a rush to provide assistance with stimulus funding and tax breaks. The CARES Act allows for NOLs arising in calendar tax years between 2018 and 2020 to be carried back to the five preceding tax years and then carried forward indefinitely. This was a welcome law change for many taxpayers, and it also introduced the longest NOL carryback period I have seen in my lifetime. However, a significant nuance concerning the five-year carryback period is that it must be carried back to the fifth year and then brought forward. In other words, you cannot pick and choose the taxable year that the NOL carryback would apply to.
Example
For example, let’s assume that Bob created an NOL of $500,000 in his pass-through business entity for the 2020 tax year. Under the CARES modification, Bob is required to carry back the loss five years and apply the loss to the 2015 tax year. In the 2015 tax year, Bob’s effective tax rate was 25%. In 2016, Bob’s effective tax rate was 35%. Bob cannot choose to apply the NOL to the 2016 tax year with the higher effective tax rate but must carry back the loss to the 2015 tax year. Therefore, assuming the entire loss was utilized in 2015, the amount of cash benefit Bob receives is only $125,000 (500,000 x 25%) as opposed to $175,000 (500,000 x 35%).
Not only must the effective tax rate be reviewed for carryback years, but the projected effective tax rate going forward should also be considered. Incorporating the House Ways and Means Committee reconciliation tax bill passed last week, Bob’s 2022 individual tax rate could increase significantly. Bob’s income tax rate may be as high as 39.6%, he may lose a part of his 199A deduction, and his income could be subject to an additional net investment income tax rate of 3.8%.
Now let’s assume Bob is also a rental real estate professional and has real estate holdings in a variety of partnerships. Assume Bob generates taxable income in a normal year, which consists of $3,000,000 of rental real estate income before the application of 199A and $100,000 of long-term capital gain income (prior to September 13, 2021). Bob’s effective tax rate between 2021 and 2022 could be drastically different if the House Ways and Means Committee reconciliation tax bill is passed.
Under the proposed bill, the top marginal individual income tax rate will increase from 37% to 39.6%, for married filing joint taxpayers with taxable income over $450,000. In addition, starting as early as September 13, 2021, the capital gains tax rate could increase from 20% to 25%. The bill also limits the amount of 199A deductions to $500,000 in the case of a joint return and expands the application of the 3.8% net investment income tax to include income derived in the ordinary course of a trade or business if the taxpayer has taxable income of at least $500,000. It is a lot to absorb, but the takeaway is that Bob’s federal income tax payments could significantly increase. In the most basic example, Bob will see his federal effective tax rate increase approximately 6%.
Budget Reconciliation Comparison
The Bonadio Group
The takeaway? Bob may want to avoid utilizing the $500,000 NOL that was created in 2020 against 2015 taxable income as the 2015 tax year only has an effective tax rate of 25%. He should instead consider carrying it forward to offset an expected 40% effective tax rate. The cash impact of electing to only carry forward the NOL could generate as much as $75,000 of additional cash savings ($200,000-$125,000).
How do I ensure my NOL is not carried back, but only carried forward?
Taxpayers are allowed to waive their entire NOL carryback period, but the election must be made by the due date (including extensions) for filing the taxpayer’s return for the tax year of the NOL for which the election is to be in effect. If such an election is made, the NOL can only be carried forward. Such an election is irrevocable and should not be made without consulting your tax advisor.
In Bob’s example, if he has an NOL related to the 2020 taxable year and does not wish to carry it back to previous years, he must attach a statement to his 2020 tax return by the extended due date of the return, October 15, 2021, waiving the carryback.
Now some taxpayers might have also created an NOL for the 2018 and 2019 tax year, that was not allowed to be carried back under the TCJA. However, the passage of the CARES act now forces taxpayers with NOLs created in 2018 and 2019 to carry them back five years. That doesn’t seem fair, does it? As a result, the IRS agreed and issued Revenue Procedure 2020-24, creating a process for taxpayers to waive the five-year carryback period for NOLs created in 2018 and 2019 as well.
Under Revenue Procedure 2020-24, an individual taxpayer may elect to waive the five-year carryback period for 2018 and 2019 NOLs if the appropriate statement is attached to the 2020 tax return, no later than the due date including extensions. A taxpayer makes the election by attaching a separate statement for each of taxable years 2018 or 2019 for which the taxpayer intends to make the election to its 2020 Federal income tax return. The statement must state that the taxpayer is electing to apply § 172(b)(3) under Rev. Proc. 2020-24 and include the taxable year for which the statement applies. Once made, the election is irrevocable.
It is extremely important for all tax professionals and taxpayers with NOLs generated in 2018, 2019, or 2020 to seriously consider whether they should elect to waive their federal NOL carryback period. While this decision cannot be done in a vacuum, and will require forecasting and modeling, the efforts could create significantly higher cash flow based on the expected trajectory of federal income tax rates over the next four years. The tax world continues to grow with complexity, and this is only one of many additional items to be reviewed before filing 2020 individual federal income tax returns.