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CARES Act Changes to NOLs By Coombs, Chad*
Signed into law on March 27, 2020, the Coronavirus Aid, Relief and Economic Security (CARES) Act provides relief to businesses, especially small businesses, to help them survive the economic crises from the coronavirus pandemic and retain employees. An important, albeit temporary, benefit is the reinstatement of net operating loss (NOL) carrybacks and elimination of the 80% limit on NOL carryforwards. The NOL carrybacks and full carryforwards under the CARES Act can produce not only valuable offsets to taxable income but also tax refunds for the receivership estate. NOL carrybacks and carryforwards are an essential part of our income tax laws as they allow the net loss incurred in one year to offset the taxable income of another. This addresses the inherent unfairness that can arise from the annual tax year, especially for businesses that are cyclical in nature. Otherwise, businesses that only break even — or even lose money — over a number of years could still pay substantial taxes in the profitable years. Prior to the Tax Cut and Jobs Act of 2017 (TCJA), which generally became effective in 2018, taxpayers could carry back an NOL up to two years to obtain a tax refund and carry forward an NOL up to twenty years to offset taxable income in those tax years. The TCJA, while touted for its tax benefits such as the reduction in the corporate tax rate from 35% to 21%, nevertheless eliminated the NOL carryback in its entirety and limited the NOL carryforward to 80% of taxable income (determined without regard to the NOL deduction itself), though the limited NOL could be carried forward indefinitely.1 The CARES Act in effect delays the TCJA changes to NOL carrybacks and carryforwards and, for tax years beginning after December 31, 2017 and before January 1, 2021, allows the carry back of an NOL up to the five years and an indefinite carryforward of the full amount of an NOL.2 For fiscal years beginning in 2017 and ending in 2018, the CARES Act permits an NOL carryback of two years.3 The new federal NOL rules therefore allow, among other things, businesses that suffer losses in 2020 due to the economic crises to carry back those losses to obtain a tax refund. But the NOL benefits under the CARES Act are only temporary as the TCJA rules apply starting in 2021. And as of this writing, California does not conform to the new federal NOL rules.4 Individuals and taxable entities such as C corporations may have an NOL. Partnerships and S corporations, as tax pass-through entities, generally cannot use an NOL. However, the partners or shareholders of those entities can use the losses that pass-through to them to determine their respective NOLs. In general, the appointment of a receiver for an entity does not change the tax nature of that entity. Thus, a receiver for a C corporation (or in possession of all or substantially all of its assets) typically continues to file C corporation returns.5 However, a receivership that constitutes a qualified settlement fund (QSF) is an additional, separate tax entity to which the receivership assets are deemed transferred. A receivership constitutes a QSF only upon the satisfaction of certain requirements, and a common example is a receivership involving a fraudulent investment scheme.6 While a QSF is generally a taxable entity, in limited circumstances, it may elect to be treated as a grantor trust which is a pass-through entity.7 For a receivership of a C corporation that is not a QSF, the receiver may be able to carry back NOLs from receivership operations to a pre-receivership tax year of the corporation to obtain a tax refund, and this may include a tax year when the corporation tax rates were higher (before the reduction the corporate tax rate in 2018 from 35% to 21% under the TCJA). Or the receiver may carry forward the full amount of the NOLs the corporation incurred through 2020 which could result in increased tax savings should the receivership operations have taxable income. A receiver should consider whether any NOLs the corporation incurred prior to the receivership are bona fide, especially for corporations with poor records and/or which were engaged in fraudulent activities. For example, the corporation may have underreported income, and even if the statute of limitations has expired on the return which generated the NOL, the use of the NOL carryforward could nevertheless be challenged and disallowed. A QSF that is a taxable entity also may have NOLs that it can carry back or carry forward. However, receivers should be aware that there are special rules for calculating both the taxable income and NOLs of a QSF.8 And a receivership of a C corporation that is a QSF cannot carry back its NOLs to the corporation or use any NOL carryforwards of the corporation. Receivers still should be on the look-out for any pre-receivership NOLs of the corporation which could produce a tax refund for the corporation and the benefit of the receivership.
The key is for receivers to be alert to the new federal
NOL rules so the receivership can benefit from the temporary tax relief and
obtain tax refunds to the extent possible.9
Receivers should therefore consult with their tax advisors early in the
receivership to help identify NOL and other tax issues and opportunities rather
than wait until the tax returns need to be prepared.
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