Will refunds from losses become a lifeline for struggling businesses?

Authored by Patrick Balthazor

It should come as no surprise that the year 2020 will be a tough one for many taxpayers. A large number of businesses are struggling, particularly in certain sectors. The restaurant and hospitality industries have been particularly hard hit, and they are not alone. Many will show tax losses for 2020. While the losses are not favorable, they may provide somewhat of a lifeline to struggling entities. The ability to use these losses against taxable income from prior years or to offset income in future years may provide businesses with much-needed cash.

The Coronavirus Aid, Relief, and Economic Security (CARES) Act, which was enacted in March 2020, provided stimulus measures to aid businesses that generate net operating losses. These losses may then be utilized to produce tax refunds via carrybacks of the losses to earlier tax years or to offset income in later tax years. Some of the more significant provisions in the CARES Act that can assist in creating refunds include:

• The temporary increase under section 163(j) in the percentage limitation on business interest deductions to 50% of adjusted taxable income (ATI) from 30% of ATI. This provision is discussed in more detail in this letter.
• The effective date for the provision that caps business losses for noncorporate taxpayers to $250,000 annually ($500,000 for joint filers) has been pushed back to taxable years beginning in 2021. This allows taxpayers to utilize the loss in the current year without the cap or to increase a net operating loss that may be carried back to prior tax years.
• For taxable years beginning before Jan. 1, 2021, the provision under the Tax Cuts and Jobs Act that limited the use of net operating losses to 80% of taxable income is not applicable. Thus, losses incurred and used in tax years before 2021 can offset 100% of taxable income. In addition, net operating losses for taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2021, are allowed to be carried back to each of the five preceding taxable years. An election may be made to carry the losses forward.

The prospect of carrying back the loss may seem attractive for taxpayers that have net operating losses in tax years 2018 through 2020. The taxpayer will likely receive the refund quicker if the loss is carried back as opposed to carrying it forward to future tax years. Some taxpayers (especially corporations) may have been in a higher tax bracket in prior years. However, the decision to carry the loss back versus electing to carry it forward should be based on a careful modeling of the consequences. Many factors, including the alternative minimum tax for individuals, repatriation income under section 965 and foreign tax credits must be considered. The application of these factors may result in a carryback refund at a much lower effective tax rate than if an election were made to carry the loss forward. As many practitioners have said: model, model, model. A lack of modeling may result in an inefficient use of the net operating loss.

It should be noted that many states may not conform to the federal changes in the CARES Act. In some cases, federal conformity is automatic, but many states may require action by the legislature. Given the pandemic, some legislative bodies may not be in session. This complicates the situation for state purposes when taxpayers do not know if the state will allow some of the favorable changes made by the CARES Act. Modeling becomes much more difficult when it is uncertain how the states will react.

Form 4466

Corporate taxpayers may also want to consider filing Form 4466 to obtain a refund of overpayments. This form can provide a quick refund of estimated taxes when a corporation has overpaid its tax. It may only be used by corporations that have an overpayment of at least 10% of their liability and at least $500. The form is filed after the end of the tax year and before the due date of the return (including extensions). While the filing of Form 4466 is not necessarily limited to corporations that have net operating losses, it is most often used in these situations. In many cases, corporations do not file their returns until many months following the end of their tax year. They may have made estimated payments during the year, but now they are finding they overpaid for the year. Filing Form 4466 before filing the federal income tax return will accelerate the tax refund as the IRS is required to act on the Form 4466 within 45 days after its filing.

For more information on this topic, contact our team.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.