Managing corporate state net operating losses.

• Author: Boyle, James F.

The tax benefits realized (or lost) from corporate net operating losses (NOLs) may be significant. In fact, the financial statements of the Fortune 1000 reportedly include an estimated $200 billion in deferred income tax assets for NOL carryforwards. (1) Certain businesses, such as those in cyclical industries, may incur substantial losses in some years and then realize substantial profits in other years. An inequity would result if corporate tax were levied on profits from profitable years without considering losses from loss years.

The corporate deduction for NOLs helps ensure corporations pay tax on their average profitability over multiple tax years. However, corporate tax professionals must navigate the various federal and state tax rules and conduct careful tax planning to realize the full financial benefit of available NOLs, whether these NOLs arise organically or from an acquired entity.

This article provides a brief background on federal and state NOLs. It then discusses challenges tax professional face in managing corporate state NOLs and offers guidance on (1) maximizing the use of corporate state NOLs; (2) considering the value of corporate state NOLs in pricing merger-and-acquisition (M&A) transactions; and (3) recording an appropriate deferred tax asset and related valuation allowance for corporate state NOLs.

Federal treatment of NOLs

Sec. 172(c) defines an NOL as the excess of the deductions allowed by Chapter 1 over the gross income, computed with modifications specified in Sec. 172(d).

For NOLs arising prior to 2018, a U.S. corporation could carry back the NOLs to reduce its federal taxable income and apply for a tax refund in each of the two previous tax years by filing Form 1139, Corporation Application for Tentative Refund, or Form 1120X, Amended U.S. Corporation Income Tax Return. It could also carry forward the NOLs to reduce its federal taxable income and its related tax liability for up to 20 years. Pre-2018 NOLs related to specified liability losses were entitled to more generous carryback allowances. (2) Furthermore, a corporation could elect to waive the federal NOL carryback period and only carry forward the NOL. Corporations calculate and report federal NOL carryforward amounts on Schedule K, "Other Information," of Form 1120, U.S. Corporation Income Tax Return.

Under the legislation known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, signed into law on Dec. 22, 2017, NOLs generated after Dec. 31, 2017, can offset only 80% of a corporation's taxable income in any year. With limited exceptions, NOLs generated after 2017 cannot be carried back, but they can be carried forward indefinitely. (3)

Varying state treatments

In addition to following regulations for federal NOLs, a corporation must also adhere to the various state NOL tax rules for each state in which the corporation has nexus. Even before enactment of the TCJA, state tax rules varied widely regarding the NOL carryback and carryforward periods, which is significant because a corporation may realize no tax benefit from an NOL after the NOL carryover period has expired.

For financial reporting purposes, a corporation recognizes a deferred tax asset on its balance sheet for the amount that existing NOL carryovers may reduce future tax liabilities. A corporation also records a valuation allowance for the estimated NOL tax benefit amount that is not expected to be utilized (for example, because of a lack of anticipated future taxable income or the expiration of an NOL carryover period).

Therefore, corporations should track both their federal and state NOLs to properly record any deferred tax asset and related valuation allowance arising from NOLs, as well as develop a plan to maximize the use of available NOLs to reduce future tax liability. In addition, corporations should consider available federal and state NOL carryovers from their own or other corporate subsidiaries targeted for merger or acquisition. While rules may limit the use of NOLs from acquired corporations (such as the limitations contained in Sec. 382), the value of a target company's available NOL(s) may be substantial and should be considered in the negotiated acquisition price.

An acquiring company should also consider whether a potential target company's state NOL carryover is from a separate filing state or a combined income state. It is important to note that a company may not use an NOL from a subsidiary operating in a separate filing state to offset income from profitable subsidiaries operating in a different separate filing state or that are part of a combined state tax filing. Twenty-five states and the District of Columbia allowed or required a combined corporate return as of 2017 (4)

Challenges for tax professionals in managing corporate state NOLs

While the same federal NOL corporate tax rules apply to all U.S. corporations, tax professionals employed by corporations that operate in multiple states face a considerable challenge keeping up with the various corporate state NOL rules. As noted earlier, a knowledge of applicable federal and state allowable NOL carryback and carryforward periods is important because no tax benefit is available for an NOL after its prescribed carryover period expires. Under the TCJA, corporate federal NOLs generated...