By: Trevor Kline
The Coronavirus Aid, Relief, and Economic Security (CARES) Act, which went into effect on March 27, 2020, has altered the current framework of business taxation to mitigate the economic hardship suffered by businesses during the coronavirus pandemic. Businesses have benefited from deferral of employer payroll tax, refundable employee retention credits for businesses affected by the COVID-19 lockdown, and the Payroll Protection Program, which have provided critical funds for payroll costs and other qualifying expenses. (Click here for our post regarding the PPP and loan forgiveness.) These policies were designed to give business owners an infusion of cash in a year where many businesses may have little to no revenue for months.
One notable change to the tax law under the CARES Act was to temporarily relax restrictions on Net Operating Loss (NOL) deductions pursuant to Sec. 172 of the Internal Revenue Code. Section 2303(b) of the CARES Act has temporarily reinstated a carryback period for all NOLs generated during the 2018, 2019, and 2020 tax years. The carryback period is five years, which means that NOLs sustained during the 2020 tax year can be carried back to offset pre-Covid19 profits from the 2015 tax year to present. The temporary re-implementation of the NOL carryback provisions will allow businesses across the nation that have suffered a loss this year to obtain payment from the federal government if they have profits to offset in previous tax years.
It is essential that business owners and financial advisers be updated on the current NOL mechanics so they can access these additional funds when applicable.
net operating losses: why do they matter?
The federal business tax regime is intended to tax a business’s average net 
income in a consistent and efficient manner over time. However, some businesses may provide goods and services in volatile industries where annual profitability can be unpredictable. The NOL deduction ensures that business owners in these enterprises are taxed on an accurate representation of their overall profits. The following examples illustrate this point:
TABLE 1: No Net Operating Loss Deduction, 21% Corporate Tax Rate
| Year 1 Net Income | Year 2 Net Income | Year 1 Tax Liability | Year 2 Tax Liability | Total Tax Paid | |
| Company A | -$500,000 | $1,000,000 | $0 | $210,000 | $210,000 |
| Company B | $250,000 | $250,000 | $52,500 | $52,500 | $105,000 |
In Table 1, Company A and Company B both have a net profit of $500,000 at the end of Year 2. Nevertheless, Company A has paid double Company B’s tax because Company A did not receive a net operating loss deduction in Year 1 to offset its income in Year 2. This tax framework penalizes Company A by ignoring its losses and imposing a higher total tax paid on the same amount of net profits.
TABLE 2: Net Operating Loss Deduction, 21% Corporate Tax Rate
| Year 1 Net Income | Year 2 Net Income | Year 1 Tax Liability | Year 2 Tax Liability | Total Tax Paid | |
| Company A | -$500,000 | $1,000,000 | $0 | $105,000 (1,000,000 -500,000) x .21 | $105,000 |
| Company B | $250,000 | $250,000 | $52,500 | $52,500 | $105,000 |
In Table 2, Company A and Company B both have a net profit at the end of Year 2. However, Company A has been granted a net operating loss deduction of $500,000 that has been carried forward and applied against its Year 2 tax liability. This results in an identical total tax paid of $105,000 for the two businesses despite their differing Year 1 and Year 2 Net income. This tax framework accounts for the varying profit volatilities of Company A and Company B and taxes their average profitability.
pre-cares act net operating loss mechanics
The Sec. 172 NOL provisions have evolved dramatically over the last five years. Prior to the 2017 Tax Cuts and Jobs Act (TCJA), NOL deductions could be carried forward twenty years and carried backward two years. Additionally, there were no dollar limitations on the amount of NOLs that could be applied to a specific year. This allowed business owners to apply their NOLs to the extent of taxable income in a given tax year.
The enactment of the TCJA changed these provisions in 3 impactful ways:
- Elimination of the loss carryback provisions for most NOLs – NOLs generated after Dec. 21, 2017 can no longer be carried back to previous tax years, except for certain farming and insurance related losses. Instead, NOLs generated after Dec. 21, 2017 are no longer subject to the twenty year carry forward limitation and can now be carried forward indefinitely.
- Imposed limitations on the amount of NOLs that may be used in a year – The TCJA limited the NOL deduction available to corporate and noncorporate taxpayers to 80% of their business’s taxable income. Any remaining NOLs must be carried forward to future tax years.
- Placed limitations on losses for pass-through business owners – The TCJA also capped losses for pass-through businesses, like LLCs, at a rate of $250,000 for single filers and $500,000 for joint filers. Business owners who actively participate in their pass-through entities could only use losses up to those limits to offset taxable income earned outside the business.
cares act changes to net operating loss mechanics
The CARES Act adjustment to NOLs could be very useful to businesses that suffered losses during the 2020 tax year due to the Coronavirus pandemic.
The CARES Act temporarily suspended the TCJA changes to net operating losses for NOLs generated in during the 2018, 2019, and 2020 tax years. The following changes were intended to give business owners additional tax benefits that could put money back in the pockets of qualifying businesses:
- Provides a five-year carryback period for NOLs arising in 2018, 2019, and 2020 – This CARES Act provision permits businesses to modify tax returns up to five years prior with NOLs from qualifying years to offset taxable income in prior years.
- Temporarily suspended the NOL deduction limit of 80% of taxable income – This CARES Act provision permits NOL deductions to offset all taxable income in a given tax year instead of requiring taxpayer to carry forward any NOLs exceeding 80% of taxable income.
- Temporarily suspended loss limitations for pass-through business owners – This CARES Act provision allows pass-through business owners to offset their non-business income beyond the $250,000 single filer and $500,000 joint filer thresholds for 2018, 2019, and 2020.
conclusion
Businesses that have NOLs from 2018 and 2019 can use the CARES Act provisions to carryback losses from those years to prior years. It is important to remember that the business must have reported taxable income within five tax years of the net operating loss to benefit from a carryback. Owners of pass-through entities also may have the opportunity to apply additional NOLs from 2018, 2019, and 2020 to offset their income from other sources.
The revival of NOL carrybacks under the CARES Act will grant business owners additional options to improve cash flow and liquidity in a pandemic-stricken economy.
Trevor Kline, at the time of this post, is a 3L Law student at the Penn State Dickinson School of Law. He is a resident of Dillsburg, Pennsylvania, and a graduate of McDaniel College. Trevor is a Site Coordinator at the Dickinson Law VITA program, an Honor Code Representative, and a Research Assistant for Professor O’Savio. He intends to pursue a career in tax law after graduation.
