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Prior to the Tax Cuts and Jobs Act (“TCJA”), net operating losses (“NOL’s”) generated allowed taxpayers to carryback the loss two years and/or carryforward up to 20 years. In addition to the carryback and carryforward provisions, taxpayers could fully offset taxable income if not limited by the IRC section 382 limitations. However, due to the TCJA & CARES Act NOL provisions have changed including both the carryback/carryforward rules and the amount of the NOL that can be utilized against taxable income.
Summary of Changes to Carryback/Carryforward Provisions
| Pre-TCJA | The TCJA | CARES Act | |
| Carryback | 2 years | Disallowed | NOL’s incurred in 2018, 2019, and 2020 may be carried back five taxable years |
| Carryforward | 20 years | No limitation | No limitation |
| Limitation on $ NOL | No limitation unless limited by Section 382. [1] | NOL limited to 80% of taxable income starting with NOL’s generated after Jan 1, 2018 [2] | In 2018-2020, NOL deduction up to 100% of taxable income; after 2020, NOL deduction limited to 80% of taxable income. |
Furthermore, when calculating potential NOL amounts, C corporations are not allowed to take into account the new deduction for foreign-derived intangible income (“FDII”) and the global intangible low-tax income (“GILTI”) under Code Section 250. For pass-through business taxpayers, the new deduction under Sec 199A is not allowed in determining the NOL amount.
CARES Act
In response to COVID-19 the CARES Act [3] was signed into law on March 27, 2020 bringing additional changes to the net operating loss rules in order to provide additional assistance to those impacted by the virus. Below is a summary of the key changes:
A) CARES Act provides that NOL’s incurred in 2018, 2019, and 2020 may be carried back to offset taxable income earned during the five-year period prior to the year in which the NOL was incurred.
B) CARES Act also temporarily removes the taxable income limitation, therefore allowing taxpayers to offset 100% of taxable income in tax years 2018, 2019, and 2020.
TCJA Impact on Mergers & Acquisitions
Typically in a stock purchase or merger transaction, there are many transaction-related expenses that are deductible for federal income tax purposes, including:
A) Transaction-related bonuses;
B) Option cash-out payments; and
C) Portion of investment banker fees and legal fees.
Depending on timing of the transaction these deductible transaction-related expenses may cause the corporation to have an NOL for the year. Although there are typically provisions in the transaction agreement that entitle the sellers to the tax benefits of these deductions, these provisions had limited impact on transactions that closed after December 31, 2017. This is due to changes made by the TCJA which disallowed the carryback of an NOL incurred in 2018 or thereafter. For post-January 1, 2018 transactions, any NOL attributable to deductible transaction-related expenses could only be carried forward such that, absent an agreement of the buyer to pay the seller for the benefit of any pre-closing NOL’s that were utilized post-closing, the tax benefits associated with this NOL would automatically accrue to the buyer.
CARES Act Impact on Mergers & Acquisitions
The CARES Act now allows for NOL’s incurred in 2018, 2019, and 2020 to be carried back up to five taxable years. Depending on the transaction agreement, sellers may now be entitled to additional cash refunds that were not previously anticipated at the time of closing. Being able to carryback an NOL up to five years also means that some or all of the taxes that are recoverable will be in years where the corporate tax rate was 35% rather than 21%, increasing the value of the NOL.
Transactions involving the purchase and sale of partnerships and limited liability companies taxed as partnerships, S corporations, or, in most cases, subsidiaries of a larger consolidated group, as well as transactions structured for federal income tax purposes as asset purchases, typically will not be affected by the modification of the NOL rules in the CARES Act.
Planning Ahead
Impacts of the TCJA and CARES Act makes it imperative for you to understand the timing of your income and deduction as you consider various tax planning strategies. Further, as a result of the new limitation, you cannot fully rely on NOL carryforwards to eliminate your federal tax liability after 2020.
[1] Section 382 of the Internal Revenue Code generally requires a corporation to limit the amount of its income in future years that can be offset by historic losses (i.e. net operating loss carryforwards and certain built-in losses, after a corporation has undergone an ownership change).
[2] A taxpayer will only be able to utilize 80% of the NOL to offset taxable income, and the remaining will be carried forward indefinitely. However, NOL’s generated prior to January 1, 2018, are not subject to the 80% NOL limitation and retain the ability to deduct at 100%. Therefore pre-2018 losses should be tracked separately from post-2017 losses in order to correctly compute the NOL deduction.
[3] The Coronavirus Aid, Relief, and Economic Security Act, also known as the CARES Act, is a $2.2t economic stimulus bill passed by the 116th US Congress and signed into law on March 27, 2020.
Disclaimer: The information provided herein is intended solely for informational purposes and no person(s) or other third-party may rely upon it as financial, tax, or legal advice or use it for any other purposes. As a result, Royal Financial, and any affiliates, assume no responsibility whatsoever to readers, or any other persons for that matter, as a result of the information contained herein.