Improving cash flow with loss carrybacks.

• Author: Werlhof, John

In one of several legislative responses to the economic downturn caused by the Coronavirus pandemic, the Coronavirus Aid, Relief, and Economic Security (CARES) Act allows taxpayers to carry net operating losses (NOLs) back five tax years, presenting a current tax refund opportunity in a time when businesses need the cash most. (1) Alternatively, taxpayers can choose to carry the loss forward to offset future income. (2)

Example 1:A is a shareholder in an S corporation manufacturing company. She generated $1 million of taxable income and paid $350,000 of federal income tax each year from 2014 through 2018. In 2019, the business experienced financial difficulties and A's personal tax return reflected a $2 million NOL.The loss carryback provisions of the CARES Act allow A to carry back the loss to offset her taxable income from 2014 and 2015, generating a $700,000 federal tax refund. Aside from the cash flow benefits of obtaining an immediate tax refund, the loss carrybacks present an opportunity to secure permanent tax savings by using losses to offset income generated before the law known as the Tax Cuts and Jobs Act (TCJA) (3) was passed, when the maximum tax rates were higher. State conformity to the NOL carryback provisions varies.

This article discusses two planning areas related to NOL carrybacks: (1) the decision whether to carry a loss forward or back and (2) planning strategies to increase the balance of the NOL carryback.

In some cases, taxpayers will have relatively low income (but not an opportunity to plan to create an NOL). In these cases, planning may focus on increasing taxable income to take advantage of graduated tax rates for individuals rather than lowering taxable income. A discussion of planning to take advantage of low tax rates is outside the scope of this article.

Determining whether to carry the NOL forward or back

In many cases, taxpayers will want to carry back a tax NOL to generate the immediate cash flow benefits, but here are three scenarios where a taxpayer may prefer to carry a loss forward.

The expected tax refund is less than the present value of the expected future tax savings

The first scenario occurs when the expected tax refund from the loss carryback is less than the present value of the expected future tax savings from the tax carryover. The income of many taxpayers was subject to higher tax rates during the carryback period versus what they are anticipating in the future, because the TCJA reduced tax rates. For example, the top federal corporate tax rate through 2017 was 35%, whereas the corporate tax rate starting in 2018 is a flat 21%. In some cases, taxpayers were subject to lower effective tax rates during the carryback period or are expecting to be subject to higher effective tax rates in the future. In comparing the cash flow benefits of a loss carryback and a loss carryover, taxpayers should also factor in the additional professional fees to prepare and file the loss carryback claim as well as the time value of money.

Example 2: B generated $100,000 per year of taxable income and paid $15,000 in federal income tax from 2013 through 2017. B incurred a $500,000 loss in 2018. If B carries the loss back for five years, he will generate a tax refund of $75,000. B expects his income will be subject to an effective 30% tax rate in the carryover period, so the $500,000 loss may reduce his future tax liability by $150,000. B may prefer to carry the loss forward. The tax loss will be carried back to a tax year with uncertain tax positions

The IRS generally has three years from the time a return is filed to audit the tax year and adjust the tax liability reported on the return. (4) However, if a taxpayer carries a loss back to a closed year, the IRS can offset the refund with other tax adjustments in the carryback year even though the statute of limitation is closed. (5) Taxpayers who breathed a sigh of relief when the statute of limitation closed for a particular tax year should be cautious about carrying a loss back to that tax year.

Another party is entitled to the refund

In some cases, another party may be entitled to the refund from carrying a loss back. For...