The CARES Act reinstates net operating loss carrybacks. Learn how you can proactively plan to accelerate deductions and defer income to impact the amount of net operating losses you can carry back.
- Challenging times can still be ripe with opportunities, if you know where to look.
- Consider what changes you might want make for your business and yourself.
- From retirement planning to personnel decisions and inventory considerations, businesses across industry sectors could benefit from reviewing their financial and operational decisions
If you or your C corporation generated a net tax loss during 2018, 2019, or 2020, a CARES Act provision allows you or the C corporation to carry the loss back to offset taxable income during the previous five tax years. This would generate a refund of taxes paid in earlier years. In many cases, the IRS will pay those refunds within 90 days, providing immediate cash flow benefits. Alternatively, you can choose to carry the loss forward to offset future income.
Example: Abby 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 some financial difficulties and Abby’s personal tax return reflected a $2 million net operating loss (NOL). The loss carryback provisions of the new CARES Act will allow Abby to carry the loss back to offset her taxable income from 2014 and 2015, generating a $700,000 federal tax refund.
Would you like to talk with an advisor?
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 prior to passage of the Tax Cuts and Jobs Act (TCJA), when the maximum tax rates were higher. Remember that depending on where you and your business are located, the loss carrybacks may not be available for state tax purposes.
Let’s discuss a few situations where you may prefer to carry a net operating loss forward and some planning ideas on how to increase your tax losses to take advantage of the loss carryback opportunities.
Deciding whether to carry the loss forward or back
In most cases, you will want to carry a tax loss back to a prior year to generate the immediate cash flow benefits. Your tax advisor can help you decide what’s best in your situation, but here are a few examples of situations where you might prefer to carry a loss forward:
1. The tax refund you expect to recover from the loss carryback is less than the expected future tax savings associated with a carryover (taking into account the time value of money)
If you are like most taxpayers, your income was subject to higher tax rates during the carryback period than what you are anticipating in future years, due to the tax cuts brought by the TCJA. For example, the top federal corporate tax rate through 2017 was 35%, whereas the corporate tax rate starting in 2018 is a flat 21%. Note, however, that it will not always be the case a taxpayer’s tax rate will have decreased since 2017, and it is possible that new federal legislation will increase federal tax rates sometime during the future carryover period.
Example: Braden generated $100,000 per year of taxable income and paid $15,000 in federal income tax from 2013 through 2017. Braden generated a $500,000 loss in 2018. If Braden carries the loss back for five years, he will generate a tax refund of $75,000. Braden 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. In that case, Braden may prefer to carry the loss forward.
2. The tax loss will be carried back to a tax year where you or the corporation took an aggressive tax position
The IRS generally has three years from the time you file your tax return to audit the tax year and adjust the tax liability reported on the return. However, if a taxpayer carries a loss back to a particular tax year, the IRS can offset the refund with other tax adjustments in the carryback year, even if the time has exceeded the regular three-year statute of limitations period. If you took an aggressive position in a prior tax year, you may prefer to carry the tax loss forward to avoid this potential risk.
3. Another party is entitled to the refund
For example, if you purchased a corporation from someone else, the purchase agreement may require you to compensate the seller for any refund or tax benefit received from a loss carryback.
Strategies to increase the loss carryback
If you or your C corporation have sufficient taxable income subject to higher tax rates during the five-year carryback period, you may be able to generate additional cash flow and achieve permanent tax savings by proactively planning to increase the amount of your tax losses. Here are a few tax planning strategies to increase your tax losses, which could increase your tax refund. Remember, you should consult with your tax advisor prior to implementing any of these strategies.
1. Accelerate equipment purchases
You can generally expense the cost of new or used equipment purchased for your business in the year the asset is placed in service. Consider acquiring and placing equipment in service before the end of the tax year to increase the amount of the loss.
2. Analyze tax asset depreciation methods and lives
The CARES Act allows taxpayers to immediately write-off the cost of certain improvements to commercial property made in 2018 and later years. If you improved your commercial property in 2018, 2019, or 2020, there may be an opportunity to expense the costs, increasing your tax loss.
The cost of real estate is typically allocated between two asset categories for financial statement purposes: land and building. Land is not depreciable, while buildings are generally depreciable for tax purposes over either 27.5 years or 39 years.
The tax rules take a much more granular approach than the typical financial statement approach. Real estate and its components can be classified into several different categories of assets, some with a depreciable life of just five years. If you own real estate for use in your business or for investment, you may be able to accelerate deductions by performing a cost segregation analysis to determine the appropriate tax life of the various real estate assets.
Likewise, you may be able to accelerate deductions related to an energy-efficient building you own by performing a Section 179D analysis.
3. Write off old or uncollectible receivables and harvest tax losses
Accrual method taxpayers may deduct as a tax bad debt old or uncollectible trade accounts receivables when the possibility of collection becomes remote or uncertain. Before the end of the tax year, carefully analyze your trade receivables and write off any uncollectible accounts. If you have underwater investments, consult with your tax advisor to discuss strategies to generate a tax loss.
4. Make retirement contributions
You may want to consider increasing your retirement plan contributions as a way to reduce your taxable income and set aside money for your future. There are several types of retirement plans available (e.g., 401(k), IRA, etc.). Depending on the type of plan, you may have limited ability to make a deductible contribution due to business losses.
5. Work with your tax advisor to identify possible beneficial accounting method changes
An accounting method deals with the timing of taking into account an item of income or deduction for tax reporting purposes. In some instances, there are several acceptable accounting methods available (e.g., a small business can use either the cash or the accrual method of accounting). You may be able to change your accounting methods to increase your tax losses.
For example, accrual method taxpayers generally must capitalize prepaid expenses and deduct the expenses over time. For tax purposes, you may be able to accelerate the tax deduction for certain prepaid expenses into the year of payment. If you are not currently deducting prepaid expenses in the year of payment, you may be able to make a change to your current accounting method for reporting these items and accelerate the tax deduction. Your tax advisor should be familiar with available methods of accounting and can help you identify changes to increase your losses.
6. Inventory Valuation Adjustments
For tax reporting purposes, a company may be able to take a tax deduction for obsolete or damaged inventory if they can no longer sell the inventory in a normal manner or at its normal price. You can only take a tax deduction for obsolete inventory if you dispose of the inventory at a reduced price or establish a reduction in its value by offering the inventory for sale to the public at a reduced price prior to the end of the tax year.
7. Accelerate payment of bonuses or compensation amounts
For tax reporting purposes, taxpayers can generally deduct fixed and determinable compensation amounts that are related to services performed in a tax year, if the compensation is paid within 2.5 months following the tax year in which the services were provided. In some cases, compensation has to be paid by the end of the year to be deductible. Make sure you pay accrued bonuses or compensation in time to get the deduction in 2020.
How we can help
Loss carrybacks present an opportunity to improve cash flow and achieve permanent tax savings. CLA can help you evaluate whether to carry a loss back or forward, develop strategies tailored to your situation to increase your loss carrybacks, and prepare the carryback claim. We can also help you understand other tax savings opportunities that may be available through the CARES Act. Contact Us