Net Operating Losses
Last updated on Jan. 26, 2023
The purpose of the net operating loss deduction is to relieve inequities caused by the determination of the income tax based on an annual accounting period. The net operating loss deduction effectively averages a taxpayer’s income and losses over a period of years, thereby reducing the tax disparity that would otherwise exist between businesses with stable incomes and businesses with fluctuating incomes.
How is net operating loss calculated?
An individual’s net operating loss is equal to the taxpayer’s deductions less gross income, modified as follows:
- the NOL deduction is disallowed for an NOL carryback or carryover from another tax year
- the deduction of business and nonbusiness capital losses is limited to the amount of capital gains
- the deduction of nonbusiness deductions is limited to the amount of nonbusiness income
- the exclusion for capital gains from small business stock under IRC §1202 is not allowed
- the deduction for qualified business income is disallowed
A corporation’s net operating loss (NOL) is equal to the corporation’s deductions less gross income, modified as follows:
- the NOL deduction is disallowed for an NOL carryback or carryover from another tax year;
- the dividends-received deductions under IRC §243 and IRC §245 are computed without regard to the aggregate limitations that normally limit these deductions; and
- the deduction for foreign-derived intangible income is disallowed
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Which taxpayers are allowed to deduct net operating losses?
- C corporations
- estates and trusts
- exempt organizations with unrelated business taxable income
- participants in a common trust fund
- insurance companies
- personal holding companies, under certain circumstances
- S corporations
- regulated investment companies
- corporations subject to the accumulated earnings tax
- common trust funds
Bloomberg Tax surveyed tax professionals at public and private corporations with at least $500 million in annual revenue to explore the impact that Covid-19 has had and continues to have on corporate tax departments.
How did the CARES Act affect NOLs for corporations?
Prior to the CARES Act, NOLs arising in years after 2017 were not allowed to carry back, had an unlimited carryforward period, and were limited to 80% of taxable income. The CARES Act retroactively modified and expanded those rules. Under the CARES Act, NOLs arising in years beginning 2018 through 2020 may be carried back five years and the 80% NOL deduction limit is temporarily lifted for NOL carryforwards to years beginning before January 1, 2021.
Under a long-standing provision, IRC §172(b)(3), a corporation can elect to waive this five-year carryback. A corporation making an election under section 172(b)(3) can still take advantage of the temporary changes to the 80% limitation rules and offset 100% of taxable income with NOL carryforwards that would otherwise be subject to the limitation.
There are complicated interactions with other rules, particularly for multinational corporations. Those corporations that repatriated income under IRC §965 between 2016 and 2019 may not offset inclusion income under a deemed election under IRC §965(n). However, CARES provides for an election to skip IRC §965 years while still applying the NOL carryback to other years.
The impact on other tax attributes needs to be carefully considered as well. For example, general business credits (GBCs) and foreign tax credits (FTCs) may be freed up by the NOL carryback and may now carry back or forward to other years. The alternative minimum tax (AMT) may also come into play, not only with a minimum tax but with the limitation for general business credits as well.
The separate return year rules come back into play with consolidated return groups. NOLs may need to be allocated to a departing consolidated return member.
These new rules provide many planning opportunities to provide an infusion of cash to cash-strapped businesses, but it is critical to evaluate all the possible scenarios to avoid any unintended negative consequences.
Did the Covid-Related Tax Relief Act further impact NOLs?
The Covid-Related Tax Relief Act allows farmers who elected a two-year NOL carryback before the CARES Act to elect to retain that two-year carryback rather than claim the five-year carryback provided in the CARES Act. It also allows farmers who previously waived an election to carry back an NOL to revoke the waiver. This provision applies retroactively as if included in the CARES Act.
The CARES Act contains changes to NOLs, business interest expense deductions, and refundable minimum tax credit (MTC), which give rise to a significant carryback claim opportunity.
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