The Tax Cuts and Jobs Act (TCJA) has officially been in place for two years now. It lowered the corporate income tax rate from 35% to 21% and provided a 20% deduction for qualified business income (QBI). However, the law also instituted new changes regarding net-operating loss (NOL) carryback and carryforward rules. As a result, the new regulations may lessen the full effects of the rate reduction or the deduction for taxpayers with NOLs.
It is critical to understand the new rules both federally and at the state level in order to optimize your tax strategies for the future.
What is an NOL?
For income tax purposes, a net-operating loss is the result when a company’s allowable deductions exceed its taxable income within a tax period. In this term, “operating” is key as these losses must arise from the business’s regular operations. Generally, the company can use the NOL to offset their tax payments in other tax periods.
Note that the government does not allow NOL tax breaks for pass-through entities, such as sole proprietorships, partnerships and S corporations. However, their owners may apply the NOL on their personal income tax returns. Conversely, the IRS taxes C corporations at the corporate level; therefore, they apply their losses on their corporate income tax returns.
What were the NOL rules prior to the TCJA?
Prior to the TCJA taxpayers generally had the opportunity to carry an NOL backwards up to two tax years and forward up to 20 tax years to offset taxable income.
Also, there was no taxable income limit to usage of losses. Special extended carrybacks existed for NOLs attributable to specified liability losses and certain casualty and disaster losses. Among these special carryback policies was a five-year carryback for NOLs attributable to designated farming activities. There were also limitations on the carryback of certain excess interest losses attributable to corporate equity reduction transactions and NOLs of real estate investment trusts (REITs).
What changes did the TCJA have on NOL rules?
Modifications to the treatment of NOLs is nothing new. First enacted in 1918 as a temporary war-related measure, the NOL carryback and carryforward rules have since undergone a number of adjustments throughout the century.
Since their inception, carrybacks and carryforwards have been allowed, expanded and removed from the tax code numerous times.
Carryover and carryback provisions
The amendments to Internal Revenue Code (IRC) 172 pertaining to NOLs now disallow the carryback of NOLs but allow for the indefinite carryforward of those NOLs. Pursuant to Section 172(e)(2) of the statute, the amended carryback and carryover rules apply to any NOL arising in a taxable year ending after December 31, 2017.
The disallowance of NOL carrybacks is unsurprising, as it has been a part of the House and Senate plans. Its effective date may be surprising, however, particularly for fiscal year corporations reporting an NOL for a tax year that includes December 31, 2017 and ends after December 31, 2017.
For example, under a plain reading of the statute, a corporate taxpayer projecting an NOL for a fiscal year ending March 31, 2018 appears subject to the NOL carryback disallowance because the year ends after December 31, 2017.
NOL income limitation
In addition to the carryover and carryback changes, the government introduces a limitation on the amount of NOLs that a corporation may deduct in a single tax year under Section 172(a) equal to the lesser of the available NOL carryover or 80% of a taxpayer’s pre-NOL deduction taxable income.
The latter is known as the 80-percent limitation. Interestingly, this limitation applies only to losses arising in tax years beginning after December 31, 2017. As a result, taxpayers with historic NOLs may see a silver lining around the cloud of this limitation, because for NOLs generated in tax years ending before January 1, 2018, the historic rules appear applicable.
Summary
Under the TCJA, the amendments to Section 172 regarding NOLs are the following:
- Limit the NOL deduction up to 80% of taxable income in the carryforward year;
- Disallow NOL carrybacks; and
- Allow for the indefinite carryforward of NOLs
Like many tax changes made by the TCJA, the amended NOL provisions appear to have winners and losers. Barring a change, fiscal year taxpayers with years ending after December 31, 2017 that incur an NOL appear unable to carryback that loss. On the other hand, it appears that NOLs incurred in years beginning prior to January 1, 2018 avoid the 80% income limitation and remain fully available, barring other limitations, to offset the taxable income.
Are there exceptions to the NOL carryback rules?
Despite the general repeal of special extended carryback provisions, they continue to exist in some form for specified farming and insurance company losses.
Farming
Previously, NOL rules permitted a five-year carryback allowance for farming losses. However, the TCJA shortens this period to two years.
Additionally, if an NOL contains both farming and non-farming losses, the new rules dictate that they must receive separate treatment. In these instances, the taxpayer must account for the carryforward years after the non-farm loss.
In other words, the taxpayer must apply the non-farm loss, subject to the 80% limitation, to taxable income and then follow this by applying the farm loss.
Insurance Companies
For an insurance company as defined in Section 816(a), other than a life insurance company, the NOL for any tax year can be:
- Carried back to each of the two tax years preceding the tax year of the loss, and
- Carried forward to each of the 20 tax years following the tax year of the loss.
The 80% limitation on taxable income does not apply to NOLs of property and casualty insurance companies. Life insurance companies must now claim NOLs using the post-2018 treatment.
What are the effects of the new NOL rules?
Between the repeal of NOL carrybacks and the newly imposed 80% limitation rule, taxpayers are left deferring more the loss recognition to future years. Generally, this results in an increase of the present value of total federal income taxes owed.
Taking into account the time value of money, companies with intermittent loss years and start-ups with initial years of losses may fare less well than under the previous rules, all other factors being equal.
What are the NOL rules in California?
On July 1, 2019, California enacted Assembly Bill No. 91 (A.B. 91) as part of the budget package for the fiscal year 2020. Called the “Loophole Closure and Small Business and Working Families Tax Relief Act of 2019,” A.B. 91 affects both California personal income and corporate tax.
The bill selectively conforms to certain federal provisions from the TCJA. However, A.B. 91 does not conform to, or decouple from, several of the more significant federal tax reform provisions impacting business and individual taxpayers.
As mentioned above, the TJCA generally repealed the two-year carryback and special carryback provisions while extending the carryforward period (subject to certain limitations) for taxable years ending after December 31, 2017. Prior to A.B. 91, California’s PIT Laws and CT Laws allowed taxpayers to carryback NOLs attributable to taxable years beginning on or after January 1, 2013 to the preceding two taxable years.
A.B. 91 changes this rule by disallowing NOL carrybacks (with limited exceptions) for taxable years beginning after December 31, 2018. The state still permits a two-year carryback for NOLs attributable to taxable years beginning on or after January 1, 2013 and before January 1, 2019.
How can Hayashi Wayland Help?
Now more than ever you should consult a tax adviser when applying NOL deduction and carryover rules. And we are here to help. Hayashi Wayland offers a robust State and Local Tax practice with the ability to guide you through the changing rules, especially in California.
If you have any questions on the new amendments, please reach out to us. We are ready to help!