In early April 2020, the Internal Revenue Service (IRS) released guidance on how businesses can carry back 2018, 2019 and 2020 net operating losses under the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). When a business has more tax deductions, such as operating expenses, payroll and depreciation, than its overall income, a net operating loss (called a “business loss” in this article) results. Prior to the late-March passage of the CARES Act, business losses could only be used to offset 80% of taxable income. Any losses in excess of 80% of taxable income could be carried forward and used to offset future income, but not carried back. The CARES Act now allows any type of business (corporation, partnership or sole proprietorship) with 2018, 2019 or 2020 business losses to carry back these losses for up to five years in the past. Unlike some provisions of the CARES Act, this relief is available to businesses who receive Paycheck Protection Program loans.
Under the new law, business losses can be carried back to any year within five years of the loss when the business was profitable and paid tax on business profit, resulting in a quick (according to the new guidance) tax refund from such year’s tax. The CARES Act also repeals the 80% cap on the deduction of business losses and allows taxpayers to use business losses to fully offset taxable income in whichever year they choose to use the loss.
Losses can still be carried forward. For business losses that occur in any year from 2018 to 2020, a business must decide whether to carry back the loss and claim a refund of tax paid in a prior year or to carry the loss forward. The choice can vary among the 2018 to 2020 years. For example, a 2018 loss could be carried forward, and a 2019 loss could be carried back. Companies should consider the following factors in developing a strategy to handle 2018 to 2020 business losses:
- Audit Risk: Once a tax return is filed, the IRS must generally audit the return within three years of the filing date or else the period for the IRS to audit the return is closed. A taxpayer may choose not to carry back losses to a year where the period for audit is closed if it is expected that the IRS may audit the return upon closer look.
- Has Not Filed Yet: Most taxpayers have not filed their 2019 tax returns yet, as the deadline for filing has been extended to July. A company cannot claim a 2019 business loss if the business has not (or for a partnership or sole proprietorship, its owner(s) have not) filed a tax return. If a business’s initial financials show a 2019 business loss and the business had taxable income at some point from 2014 to 2018, the business or its owner(s) will be due a refund, and filing a 2019 tax return as soon as possible can result in claiming that refund much faster.
- Corporate Rate Change: Beginning in 2018, the corporate tax rate went from a high of 35% to a flat 21% tax rate. A taxpayer with business losses between 2018 and 2020 and taxable business income from years prior to 2018 would get a better deduction if he carried back his losses to offset income taxed at the 35% rate than carried forward the loss to offset income taxed at the 21% rate. Note, however, that in carrying back losses, losses are used first on the most recent year(s) for which there is taxable income.
- Not Capital Losses: Note that only operating losses from a business and losses from the sale of business property are subject to the carrybacks described above. Capital losses on investment assets are not eligible for carryback treatment.
Please reach out to your BBH relationship team if you have any questions about optimizing business losses under the CARES Act.