When it comes to making the most of your net operating loss (NOL) refund, tax planning and strategy are absolutely key. Businesses who experienced NOLs in 2018, 2019, and 2020 should consider enlisting the help of a professional to take those losses and turn them into a refund that could help provide much-needed liquidity during a time of financial crisis.
The NOL Carryback Refund Process
When looking at their potential NOL after taking the limitations into account, a taxpayer should first review the prior five to seven years of tax returns eligible for the NOL carryback. A taxpayer should only utilize the NOL carryback if there is a viable opportunity to obtain a refund. If the taxpayer does not determine that a refund is large enough to be worthwhile, the taxpayer should likely opt for a carryforward.
The taxpayer should then fill out a tax return for 2019 if they have not already done so or engage in an estimate to see if there is a potential NOL carryback to be had. If the taxpayer estimates that they could have an NOL, they should proceed to fill out the tax return.
If returns have not been filed for 2019, the taxpayer should file as soon as possible to receive an NOL refund from taxes paid in the years 2014 to 2018. With the 2018 and 2019 tax years closed, a taxpayer that has already filed for 2018 and 2019 should look into amending their returns or filing one of the applicable forms the IRS allows to receive a refund.
Unlike 2018 and 2019, the 2020 taxable year presents some planning opportunities with the remaining months. A taxpayer should project the potential NOL based on current business running normal operations versus some tax planning strategies to potentially enhance an NOL. These strategies include but are not limited to:
- accelerating business deductions and losses
- settling lawsuits
- utilizing strategies within the taxpayer’s accounting methods
For many potential 2020 NOLs, the tax returns cannot be filed until the beginning of 2021 at the earliest, so the time to act is now.
Enhancing a Net Operating Loss
The opportunity to enhance an NOL, as opposed to operating the business normally, can present itself in various ways. For instance, a business with pending lawsuits in a year that is shaping up to be a loss year should see the potential to settle these lawsuits to claim a business deduction. This settlement would close the legal matter and allow the business to take a deduction on the matter as a business expense, which would potentially increase the business’s NOL.
Another example of effective tax planning would be to make sure taxpayers with excess inventory sell at a loss before the year-end. This sale at a loss would enhance the taxpayer’s NOL in 2020.
Additional planning and strategies could include ways to avoid the at-risk and passive activity limitations. For example, if a taxpayer is not at-risk for a loan it could limit the taxpayer’s NOL. To prevent the NOL from being reduced, the taxpayer should make sure the loans attributable to the taxpayer’s trade or business are recourse loans or meet certain requirements for qualified nonrecourse loans. The taxpayer should be cognizant that being personally liable for their loan will allow them to avoid the at-risk limitation and help maximize the taxpayer’s NOL in a loss year.
Another potential strategy would be for a taxpayer who may be subject to the passive loss limitation on the taxpayer’s NOL. To avoid the passive activity loss limitation, a taxpayer must materially participate in the activity. The taxpayer or the taxpayer’s spouse would only need to satisfy one of the seven tests that can satisfy the material participation requirement. Therefore, any taxpayer that could be subject to passive loss limitation should find a way to materially participate in these remaining 2020 months.
For example, the taxpayer could dedicate 500 hours between now and the end of the year to satisfy the requirement. Additionally, a taxpayer could avoid the limitation if the taxpayer disposes of interest in the passive activity. The taxpayer is allowed a deduction of the passive activity losses in the year the taxpayers disposes of the interest in the passive activity. This deduction allows the passive losses previously not allowed to be used against passive income from that activity in the disposition year, then passive income from all passive activities, and then if there is still passive loss that remains, against other income in the disposition year. These actions would allow the taxpayer to avoid the passive loss limitation to their NOL and allow for the taxpayer to maximize the NOL carryback or carryforward.
Additionally, a taxpayer who engages in home rentals may be able to avoid the passive activity loss limitation through the rental activity exception. Rental activity is typically considered passive activity. However, if the property was used by customers for average use of seven days or less, then it may qualify for the rental activity exception. Some taxpayers who rent their homes or properties may be able to convert rentals into a short-term rental to meet this exception. Taxpayers who rent their property on sites such as Airbnb and Vrbo are the kinds of taxpayers who may qualify for this exception.
The taxpayer who meets the use requirement for the exception would then need to meet the active participation requirement. The active participation element requires a taxpayer to make management decisions such as who can stay on the property. Sites like Airbnb offer the property hosts the ability to accept or decline rental offers. This decision making likely would help the taxpayer meet the active participation requirement.
A taxpayer with effective planning on the use and active participation requirements and possible conversion to short term rentals may avoid the passive activity loss limitation and recognize these rental losses, therefore helping to enhance their NOL.
Strategic Planning Based on Tax Rates
Additionally, unlike individual taxpayers who are subject to a progressive tax based on the income tax brackets, corporations (since the passage of the 2017 Act) are subject to a 21% flat tax. Corporations seeking to maximize an NOL should recognize a great opportunity to carryback NOLs into years where the corporate tax rate was higher than it is now.
Before the 2017 Act, the IRS taxed corporations at a top tax rate of 35 percent. The 2017 Act paved the way for a lower tax rate as it implemented a 21 percent tax rate. Corporations now have a golden opportunity to carryback an NOL from 2018 to 2020 back five years.
For corporations with a 2018 NOL this means utilizing the NOL against five years that were taxed at 35 percent. For a 2020 NOL, the NOL would be used against three years that were taxed at 35 percent. The NOL would be most efficiently maximized by carrying it back into those higher-taxed years instead of a carryforward on years taxed at 21 percent.
The carryback provides money and liquidity to the taxpayer as soon the year ends. The amount of taxes paid in 35 percent taxed years is likely greater, so in most cases, the access to liquidity and greater utilization makes the carryback a great option for corporations.
When considering whether to ultimately carryback or carryforward, a taxpayer should be cognizant of the effects a carryback may have on Alternative Minimum Tax years, § 965 years, and other tax provisions such as the Foreign Tax Credit or the Global Intangible Low-Taxed Income and the effect it could have on those taxable years. Adverse effects on these tax-related issues may make the decision to carryforward a better option for certain taxpayers.
Additionally, a taxpayer who took an aggressive or questionable tax position in previous years where the statute of limitations for review has passed may not want to submit those years for a second look by the IRS. For taxpayers in this position, it might make sense to carryforward. It will require weighing the benefit of cash refunds and increased liquidity versus the potential risks of opening up for IRS audits and reviews for closed tax years.
Forms For Refunds
Once it is determined there is an NOL, the taxpayer can carryback or carryforward if the NOL occurs in the years 2018 to 2020. If a taxpayer finds there to be an opportunity for a carryback the next step would be deciding which form to file.
Taxpayers have two options when it comes to the forms. They can file:
- Using a “quick refund form”
- Amending the prior year returns
Both options present some advantages and disadvantages. Individuals can either utilize forms 1040-X which is an amended return, or Form 1045 (also known as a “quick refund form” for NOL carrybacks). Trusts and estates cannot file a Form 1045 and must instead file 1041 amended returns to claim NOL carrybacks. Corporations can either file 1120-X amended returns or 1139 quick returns.
The quick returns present taxpayers with a fast-tracked option for refunds on NOL carrybacks. The IRS processes applications within 90 days after the application is filed. The deadline to file the Form 1045 is typically twelve months from the year-end that NOL was generated.
For example, a 2019 NOL Form 1139 or 1045 is due by December 31, 2020 for corporations and individuals respectively, and a 2020 NOL form would be due by December 31, 2021. A taxpayer should note that under these rules a 2018 NOL that uses Form 1139 or 1045 would have been due on December 31, 2019. However, the IRS has granted an extension of this deadline to June 30, 2020 for 2018 NOLs.
For taxpayers not wanting to utilize the quick return form, the amended returns give the taxpayer more time to amend and carryback an NOL. A taxpayer has three years from the due date of the initial return to file the amended return. One drawback is that the taxpayer would have to amend the tax return for every year in the allotted carryback period as the 1040-X only amends the year selected on the form. In contrast, the quick return form applies to all years in the carryback period.
In terms of quickness and efficiency, Form 1139 or 1045, depending on the taxpayer, provides this in comparison to the amended return option. Each taxpayer may have different goals or time constraints so both options should be taken into account depending on the needs of each unique taxpayer.