The American Recovery and Reinvestment Act of 2009, signed into law on Feb. 17, 2009 ( P.L. 111-5 , the “Recovery Act”) allows qualifying small business to choose a three- four- or five-year net operating loss (NOL) carryback period for certain losses instead of the usual two-year period. This article explains the details of this new provision and the planning that should be undertaken to ensure that a qualifying business chooses the carryback period that will yield maximum tax benefits for the business, taking into account the carryback itself and its tax picture for this year and previous years.
Background. A net operating loss (NOL) is the excess of business deductions (computed with certain modifications) over gross income in a particular tax year. The loss can be deducted, through an NOL carryback or carryover, in another tax year in which gross income exceeds business deductions.
In general, NOLs may be carried back two years and forward 20 years. The NOL is first carried back to the earliest tax year for which it’s allowable as a carryback or a carryover, and is then carried to the next earliest tax year. A taxpayer may elect to forego the entire carryback period for an NOL and instead carry it forward.
Different rules apply for certain types of losses. For example, a three-year carryback is allowed for an eligible loss, including an individual’s loss from casualty or theft and a farm or small business loss attributable to federally declared disasters. A five-year carryback is allowed for a farming loss, a qualified disaster loss, and certain amounts related to specified disasters.
New law. For NOLs arising in tax years ending after Dec. 31, 2007, the Recovery Act permits small businesses to elect to increase the NOL carryback period for an applicable 2008 NOL (the “applicable NOL”) from 2 years to any whole number of years which is more than 2 and less than 6. (Code Sec. 172(b)(1)(H), as amended by Act Sec. 1211(a))
Observation: In other words, an eligible business may elect a three-, four-, or five-year carryback period for the 2008 NOL, instead of the general two-year carryback period.
A small business for this purpose is a corporation or partnership that meets the gross receipts test of Code Sec. 448(c) (applied by substituting $15 million for $5 million) for the tax year in which the loss arose, or a sole proprietorship that would meet that test if the proprietorship were a corporation. This means any trade or business (including one conducted in or through a corporation, partnership, or sole proprietorship) whose average annual gross receipts (under Code Sec. 448(c), as modified) for the three-tax-year period (or shorter period of existence) ending with the tax year before the year in which the loss arose are $15 million or less.
Observation: The increased carryback period can generate a refund for a small business because it allows the taxpayer to offset income that has already been taxed. Under pre-Recovery Act law, a taxpayer couldn’t use the NOL to offset the taxable income for the fifth, fourth, and third tax years preceding the NOL year, and so couldn’t have received a refund of the tax paid on those amounts.
Illustration 1: ABC, Inc., an eligible small business, has an “applicable NOL” for 2008. It had taxable income for 2005 (and paid the applicable federal income tax), but not for 2006 or 2007. ABC elects a 3-year carryback for the NOL, and carries it back to 2005. The NOL wipes outs ABC’s 2005 taxable income, entitling it to a refund of the tax it paid on that income. Under pre-Act law, the NOL could have been carried back only 2 years, to 2006 and 2007. Because ABC had no taxable income for either year, the carryback wouldn’t have resulted in a refund. ABC would have had to wait until later years when it had taxable income to get any tax benefit from the NOL.
Recommendation: The small business should use the tentative (or “quick”) carryback procedures (under which taxpayers can recover a refund attributable to an NOL carryback before IRS processes the return filed for the year the NOL arises to expedite the recovery of the refund. That way, the taxpayer won’t have to wait until IRS processes the return for the NOL year to get the refund. Presumably, the taxpayer will have to indicate the increased carryback election on the claim form (Form 1045 for individuals, Form 1139 for corporations).
Observation: The key factor in deciding whether to elect to carry an NOL back three, four, or five tax years should be which election will result in the largest tax savings. Thus, if the NOL is more than or at least equal to the taxpayer’s combined income for the third, fourth, and fifth years before the year in which it arose, then the loss should be carried back to the fifth year so that it can be used in all three years (see Illustration (2), below). On the other hand, if the NOL is less than the combined income for those three years, the taxpayer should try to carry it back to the year(s) in which his income was taxed at the highest rate so as to get the highest refund (see Illustration (3), below). In some cases, it may be better to not make the election because the largest tax savings will come from carrying the NOL back to the second year before the year in which the NOL arose (see Illustration (4), below).
Illustration 2: Taxpayer, a calendar-year C corporation, has an NOL of $200,000 for its 2008 tax year. It had taxable income of $50,000 in 2003, $50,000 in 2004, and $100,000 in 2005. It had taxable income of $25,000 in both 2006 and 2007. Taxpayer paid federal income taxes of $7,500 on its 2003 income, $7,500 on its 2004 income, $22,250 on its 2005 income, and $3,750 on its income for both 2006 and 2007. If Taxpayer elects to carry its 2008 NOL back five years, the NOL will completely offset its income for 2003, 2004, and 2005 ($50,000 + $50,000 + $100,000 = $200,000), and it will be entitled to a refund of $37,250 (the sum of the taxes it paid for those three years).
If Taxpayer carries the NOL back only four years, it will completely offset its income for 2004, 2005, 2006, and 2007 ($50,000 + $100,000 + $25,000 + $25,000 = $200,000), and will also result in a refund of $37,250 (the sum of the taxes paid for those four years), but it will mean that the income for 2007 will not be available to offset any NOL taxpayer may possibly have in 2009.
If Taxpayer carries the NOL back only three years, it will completely offset its income for 2005, 2006, and 2007 ($100,000 + $25,000 + $25,000 = $150,000), and $50,000 ($200,000 − $150,000) of the loss can be carried forward to 2009. However, it will result in a refund of only $29,750 (the sum of the taxes paid in those three years).
Illustration 3: Assume the same facts as in Illustration (2), except that in 2005, Taxpayer had taxable income of $300,000 on which it paid federal income taxes of $100,250. If Taxpayer elects to carry the NOL of $200,000 back five years, it will completely offset the income of $50,000 for 2003 and 2004, and $100,000 of the income for 2005. Because the income for 2005 above $100,000 is taxed at a rate of 39%, this will result in a refund of $39,000 (39% of $200,000 [$300,000 − $100,000]) for that year and a total refund of $54,000 ($7,500 for 2003, $7,500 for 2004, and $39,000 for 2005).
However, if Taxpayer carries the NOL back only three years to 2005, it will be entitled to a refund of $78,000 (39% of $200,000, the taxable income for 2005 over $100,000).
Observation: Because in Illustration (3), the income for 2003, 2004, and 2005 will not be available to offset any NOL that might arise in 2009, there is no reason to carry the NOL back before 2005 if carrying it back to that year will result in the largest tax refund.
Illustration 4: Assume the same facts as in Illustration (2), except that Taxpayer had taxable income of $300,000 in 2006. Taxpayer will get the largest refund if it does not elect to carry the NOL back beyond two years. By carrying it back to 2006, it will get a refund of $78,000 (39% of the taxable income for 2005 over $100,000). If Taxpayer elected to carry the NOL back five years, it would get a refund of only $37,250 as shown in Illustration (2). If it carries the NOL back four years, it would get a refund of $49,250 ($7,500 for 2004, $22,250 for 2005, and $19,500 [39% of $50,000] for 2006). If it elected to carry the NOL back three years, it would get a refund of $61,250 ($22,250 for 2005 and $39,000 [39% of $100,000] for 2006).
Observation: Because in Illustration (4), the income for 2006 will not be available to offset any NOL that might arise in 2009, there is no reason to carry the NOL back before 2006 if carrying it back to that year will result in the largest tax refund.
What is an “applicable 2008 NOL”? An applicable 2008 NOL is the taxpayer’s NOL for:
- any tax year ending in 2008, or,
- at the taxpayer’s election, any tax year beginning in 2008. (Code Sec. 172(b)(1)(H)(ii)(II))
An election under Code Sec. 172(b)(1)(H), made in the manner prescribed by IRS, must be made by the due date (including extensions) for filing the taxpayer’s return for the tax year of the NOL. (Code Sec. 172(b)(1)(H)(iii)) Any such election is irrevocable. Additionally, any carryback election under Code Sec. 172(b)(1)(H) may be made only with respect to one tax year. (Code Sec. 172(b)(1)(H)(iii))
Excess interest losses. If a corporation has a corporate equity reduction transaction (a CERT, i.e., a major stock acquisition or an excess distribution) and an “excess interest loss” (i.e., interest allocable to the CERT) for a “loss limitation year,” the loss is an NOL. It’s subject to the regular NOL carryback and carryover rules, except that it can’t be carried back to a tax year before the year in which the CERT occurred. The “loss limitation year” is generally the tax year in which the CERT occurred (the “CERT year”) and each of the next two tax years.
Under the Recovery Act, if an eligible small business makes a Code Sec. 172(b)(1)(H) election to increase the carryback for an applicable 2008 NOL, then Code Sec. 172(b)(1)(E)(ii) (which defines “loss limitation year”) is applied by using the whole number that is one less than the number of years the taxpayer elected as the carryback for the NOL instead of “two.” (Code Sec. 172(b)(1)(H)(i)(II))
“Eligible losses.” Code Sec. 172(b)(1)(F) prescribes a 3-year NOL carryback for “eligible losses,” including an individual’s loss from casualty or theft and a farm or small business loss attributable to federally declared disasters. The Recovery Act provides that Code Sec. 172(b)(1)(F) doesn’t apply to an applicable 2008 NOL for which a small business taxpayer has made a Code Sec. 172(b)(1)(H) election. (Code Sec. 172(b)(1)(H)(i)())
Alternative tax net operating loss. An alternative tax net operating loss deduction (ATNOLD or ATNOL deduction) is allowed for alternative minimum tax () purposes instead of the regular NOL deduction.
Observation: The regular tax NOL deduction and the ATNOLD are governed by a single carryback period. Thus, the increased carryback elected for the 2008 NOL also applies for the ATNOLD in computing AMTI.
Transition rules. Act Sec. 1211(d)(2) provides that for a NOL from a tax year ending before Feb. 17, 2009:
- any election made under Code Sec. 172(b)(3) to waive the carryback period with respect to such loss may be revoked before Apr. 18, 2009 (the date which is 60 days after the Feb. 17, 2009 enactment date);
- any election to increase the carryback period under Code Sec. 172(b)(1)(H) is treated as timely made if made before Apr. 18, 2009; and
- any application for a tentative carryback adjustment under Code Sec. 6411(a) with respect to such loss is treated as timely filed if filed before Apr. 18, 2009.
Anti-abuse rules. Act Sec. 1211(c) gives IRS authority to issue rules necessary to prevent the abuse of the purposes of Act Sec. 1211, including anti-stuffing rules, anti-churning rules (including rules relating to sale–leasebacks), and rules similar to the rules under Code Sec. 1091 relating to losses from wash sales.
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