To combat the COVID-19 crisis, Congress passed the Families First Coronavirus Response Act and the Coronavirus Aid, Relief, and Economic Security (CARES) Act. These efforts were designed to offer relief to business owners, but, as we know from past actions, many times a change to one provision of the tax code directly or indirectly affects another provision.
Two areas are particularly viewed by lawmakers as flexible or easily amendable to respond to crises: net operating losses (NOL) and depreciation.
Net Operating Losses
Just over two years ago, the Tax Cuts and Jobs Act (TCJA) considerably changed the treatment of NOL. It generally eliminated the carryback option and limited the amount of NOL that may be used in the carryforward year to 80% of the taxpayer’s taxable income. But it did allow for an indefinite carryforward rather than a limit of 20 years.
Under the CARES Act, the NOL deduction under Internal Revenue Code (IRC) Section 172 was amended so that NOL arising in a tax year beginning after Dec. 31, 2017, and before Jan. 1, 2021, may now be carried back five years. The rule limiting the amount of loss to 80% of taxable income in the carryback or carryforward year has also been suspended for losses incurred in 2019 and 2020. The CARES Act allows for an extension of time to waive the five-year carryback until the first year ending after March 27, 2020. This allows for calendar taxpayers to decide by the extended due date of the Dec. 31, 2020, return to determine if it is more beneficial to take advantage of the five-year carryback or to carry forward any NOL. When taxpayers file their 2020 tax return, they will be required to carry back any NOL or file an irrevocable election to not carry back; Revenue Procedure (Rev. Proc.) 2020-24 provides for procedures on making the election to not use the carryback option. Taxpayers should be informed that the election, once made, is irrevocable. For years beginning after 2020, the previous rules under the TCJA are reinstated.
Refund requests for NOL carrybacks must use the applicable forms: Form 1045 for individuals, estates, and trusts, and Form 1139 for C corporations. These forms are required to be filed within 12 months of the year-end of the loss year. Thus, any calendar-year taxpayer who does incur an NOL in 2019 should file the applicable form. To assist taxpayers who incurred an NOL during any taxable year that began during calendar year 2018 and ended on or before June 30, 2019, an additional six-month extension to file Form 1045 or Form 1139 is available.1 A calendar-year taxpayer incurring an NOL for the year ending Dec. 31, 2018, would normally be required to file Form 1045 or Form 1139 by Dec. 31, 2019; this notice extends the filing date until June 30, 2020. On April 13, 2020, the IRS released an updated FAQ on NOLs to provide immediate assistance to taxpayers filing NOL carrybacks. The IRS provided a fax number dedicated to NOL filings under the CARES Act, stating that this is a temporary number until service centers are operational. Additionally, there is a limit of 100 pages for returns being faxed. Refund applications that did not meet the criteria will be processed after the IRS resumes normal operations.
Corporate taxpayers may benefit greatly by deciding to carry back any NOL, considering that the maximum corporate tax rate before the TCJA was 35%. When determining whether to carry back any NOL, however, tax preparers need to carefully review the effect it will have on the regular tax and the alternative minimum tax (AMT), and consider that the AMT was eliminated for corporate taxpayers after Dec. 31, 2017. Among the other items that need to be considered would be adjustments to the Section 179 deduction, effects on a consolidated tax return, and any other credits or deductions affected by taxable income.
Taxpayers with foreign operations that have Section 965 repatriation income have further complications with refund claims. While Rev. Proc. 2020-24 allows taxpayers to elect to exclude all Section 965 years from the carryback period for an NOL arising in a taxable year beginning in 2018, 2019, or 2020, Section 965(h) potentially prohibits a taxpayer from receiving a refund until all transition tax has been paid.
The TCJA included the new Section 461(l), disallowing the deduction of excess business losses by noncorporate taxpayers for years beginning after Dec. 31, 2017, and ending before Jan. 1, 2026. Excess business losses are the excess of the taxpayer’s aggregate trade or business deductions for the tax year over the sum of the taxpayer’s gross trade or business income plus a threshold amount. Under the TCJA, the excess losses are treated as part of a taxpayer’s NOL carryover.
The CARES Act amended Section 461(l), postponing the limitation on losses for the years beginning in 2018 through 2020. Taxpayers who had a loss subject to the limitation for 2018 or 2019 should likely file an amended return to take advantage of this change, but it is unclear whether they can report any previously limited amount as an NOL carryforward because the provision technically does not exist now for 2018 or 2019. Therefore, it would be prudent to wait for further guidance on amending for purposes of Section 461(l).
As noted above, the TCJA repealed the corporate AMT and allowed corporations to recover any refundable AMT credits in tax years beginning in 2018 through 2021. The CARES Act amended IRC Section 53(e) to allow for a recovery of 100% of the AMT credits in the tax year beginning in 2019, or to allow taxpayers to make an election to recover 100% of the credit in 2018. Taxpayers electing to recover the credit for 2018 are to file for a tentative refund by Dec. 31, 2020. However, should a taxpayer have an NOL carryback, it is possible that the credit may be revised if the NOL carryback is now allowed.
Qualified Improvement Property
The CARES Act fixed a so-called “retail glitch” so that qualified improvement property (QIP) is again eligible for bonus depreciation. To help taxpayers increase liquidity by reducing taxes, Congress has made QIP eligible for bonus depreciation retroactive to 2018.
The Protecting Americans from Tax Hikes (PATH) Act of 2015 created a definition for QIP, stating that such property was treated as a 39-year asset eligible for bonus depreciation unless such property met the definition of qualified leasehold improvement, qualified retail improvement, or qualified restaurant property.
The TCJA made QIP ineligible for bonus depreciation due to a drafting error. The TCJA sought to simplify the tax code by consolidating the different types of improvement property under a single definition. While Congress may have intended for QIP to have a 15-year recovery period, the final statute did not specifically include this recovery period; therefore, QIP placed in service after Dec. 31, 2017, was ineligible for bonus depreciation.
The CARES Act amended Section 168(e) to specifically include QIP in the definition of 15-year property.2 The definition of QIP under Section 168(e)(6) includes any improvement made by the taxpayer to an interior portion of a building that is nonresidential real property if such improvement is placed in service after the date such building was first placed in service. QIP does not include any improvement for which the expenditure is attributable to the enlargement of the building, any elevator or escalator, or the internal structural framework of the building. In addition, the definition of QIP under Section 168(e)(6)(A) was modified to only include improvements “made by the taxpayer.”
Taxpayers need to evaluate their specific situations and determine if amending prior-year returns or filing Form 3115 is the best option given all the facts and circumstances. The IRS issued Rev. Proc. 2020-25 on April 17, 2020, which provided additional guidance on correcting depreciation for QIP. Additionally, Rev. Proc. 2020-25 adds two new temporary automatic accounting method changes. The first is for QIP placed in service after Dec. 31, 2017. The second is late elections under Section 168(g)(7) for election to use ADS depreciation, Section 168(k)(7) for election out of bonus, Section 168(k)(10) for election to use 50% bonus depreciation, and Section 168(k)(5) for election to use bonus depreciation for certain plant bearing fruits and nuts.
For QIP placed in service in 2019 for tax returns not yet filed, taxpayers simply need to follow the new rules. Complexity arises in this area in the situations where taxpayers claimed depreciation deductions for QIP placed in service in 2018 or 2019, using a 39-year life, and have already filed the appropriate tax returns. In general, Rev. Proc. 2020-25 provides that taxpayers may file amended returns and must adjust depreciation for the placed-in-service year and all succeeding years. Alternatively, taxpayers may correct depreciation on QIP by filing Form 3115 with a timely filed original return under the automatic accounting method change procedures. It is important to note that if a 2019 tax return has been filed, a taxpayer can no longer correct QIP depreciation changes by filing an amended 2018 tax return, and must use the Form 3115 option. The deadline to file the amended returns is Oct. 15, 2021.
Partnerships subject to the centralized partnership audit regime (CPAR) typically cannot amend returns and must file an administrative adjustment request (AAR). The IRS provided recent guidance in Rev. Proc. 2020-23. Released April 8, 2020, it permits partnerships to file amended Forms 1065 for tax years beginning in 2018 or 2019 before Sept. 30, 2020, to provide relief to partnerships to take advantage of the CARES Act provisions. CPAR partnerships may make the changes using an AAR until Oct. 15, 2021. In the alternative, CPAR partnerships may correct depreciation on QIP by filing Form 3115 with a timely filed original return under the automatic accounting method change procedures. Note that filing an AAR might not benefit partners in an overall loss position, as the benefit of the depreciation change could be lost.
Under prior law, taxpayers who made the irrevocable real property trade or business election under Section 163(j)(7)(B) in 2018, 2019, or 2020 would have been prevented from electing bonus depreciation on QIP under the new changes. The IRS released Rev. Proc. 2020-22 on April 10, 2020, providing much needed flexibility. Taxpayers can now revoke a Section 163(j)(7)(B) real property trade or business election for the 2018, 2019, or 2020 taxable years (or file a late election) by filing an amended federal income tax return, amended Form 1065, or an AAR, as applicable. The general deadline for withdrawing the election is Oct. 15, 2021. As noted above, CPAR partnerships have a deadline of Sept. 30, 2020, for 2018 and 2019 amended returns. Keep in mind such revocations could affect taxable income based on the Section 163(j) limit and additional depreciation, as well as the amount of qualified business income for Section 199A purposes.
Taxpayers should consider the changes to the NOL and depreciation rules in concert, as both could present a dramatic effect on taxpayer refunds and cash flow for business owners. It is recommended that taxpayers not rush to filing amended returns or accounting method changes. Treasury and IRS are continuing to issue guidance on many tax and relief areas, possibly revising some of the information in this article. Due to the fast-moving environment, tax practitioners and business advisers need to be alert for the most updated information.
1 Notice 2020-26
2 P.L. 116-136, Section 2307; IRC Section 168(e)(3)(E)
Edward A. Kollar, CPA, EA, CSEP, is firm director with Baker Tilly Virchow Krause LLP in Wilkes-Barre. He can be reached at email@example.com.
Tim Cotter, CPA, JD, is a senior manager with Baker Tilly Virchow Krause. He can be reached at firstname.lastname@example.org.