Cash is king when it comes to net operating losses
As a nation we are in a financial crisis that is like nothing many of us have every experienced. This is compounded by the fact that Michigan is arguably one of the worst state economies in the union.
As we head into the close of 2009, many businesses are facing an accounting loss as well as a net operating loss for income tax reporting purposes. One of the fallacies for loss businesses is that they do not have to engage in any federal tax planning as they will have no tax liability in the year of the loss. However, for many loss businesses, this may not be the case given that refunds can be generated from the NOL by carrying it back to earlier tax years in which the business paid income taxes.
Generally, a business can carry back an NOL to each of the two tax years preceding the loss year, and forward to each of the 20 tax years following the loss year. However, in a year that has seen the government stimulus programs such as Cash for Clunkers, the federal government has provided two Cash for NOLs programs that may benefit loss businesses with the correct fact pattern.
Earlier in 2009, the American Recovery and Reinvestment Act provided a tax election for small businesses (those with average annual gross receipts of $15 million or less) that could only be made for the tax year either ending in 2008 or beginning in 2008 that expanded the carry-back period to three, four or five tax years for the elected tax year.
On Nov. 6, President Obama signed the Worker, Homeownership, and Business Assistance Act of 2009, which included an expansion of the ARRA NOL carry-back extension. The Act allows all taxpayers (without regard to their gross receipts) to carry back an NOL arising in either 2008 or 2009 (but not both) for three, four or five years. Like the comparable ARRA provision, a taxpayer with a fiscal year may effectively choose from among three taxable years, i.e., any taxable year beginning or ending in 2008 or 2009, as the loss year eligible for the extended carry-back period. If the loss is carried back for five taxable years, it may only offset 50 percent of the taxable income in that fifth preceding taxable year. The remaining NOL is carried forward from the fifth preceding year until it is utilized. There is no limitation on the amount of income that may be offset by an NOL in any other year.
In addition, the Act suspends the 90 percent limitation on the use of an alternative minimum tax NOL deduction attributable to carry backs for which the extended carry-back period is elected.
Small businesses that may have already filed tax returns for 2008 and made the election under the ARRA to carry back 2008 losses can now also elect to carry back 2009 losses. For those small businesses that have not yet filed their fiscal 2009 tax returns, and did not make an ARRA election for their fiscal 2008 tax return, they will need to determine which election provides the best benefit.
If opportunity exists to carry back the losses applicable to either of the two Cash for NOLs government programs, taxpayers will need to perform modeling to ensure maximization of the actual cash benefit available to the business. The modeling should take into consideration items such as special tax elections, accounting methods, the domestic production activities deduction (the section 199 deduction), various tax credits and the alternative minimum tax.
A taxpayer qualifying for the longer carry-back period needs to consider a number of items. One of the first items to be considered is whether or not the taxpayer should elect to claim bonus depreciation. By electing to claim bonus depreciation, a taxpayer is allowed an additional deduction of 50 percent of the cost of most types of tangible personal property and computer software placed in service during the tax year. An affirmative election may increase the taxpayer’s NOL, resulting in a potentially larger amount of carry-back tax refunds.
Along these same lines, the taxpayer’s advisers should examine the current accounting methods in effect to determine if there are any accounting method changes that may be available that would either defer revenue or increase current year tax deductions, thus, again potentially increasing the amount of the taxpayer’s NOL available for carry back. Depending on whether the accounting method change(s) are either automatic or non-automatic method changes, the accounting method election(s) may need to be filed by the taxpayer’s year end. Thus, the timing is a factor for consideration of this portion of the analysis. The actual election to adopt the accounting method change is made on a Form 3115 and is filed with the Internal Revenue Service.
If the taxpayer has claimed a section 199 deduction in a previous tax year in which NOLs may be carried back, then consideration must be given to the fact that a portion of the benefit reduced by the carry back may be permanently lost. In fact, if the taxable income for the year is reduced to zero in the year to which the loss is carried back, the entire section 199 benefit will be permanently lost to the taxpayer. This result occurs because the section 199 deduction is limited to taxable income for the year the section 199 deduction is claimed. As such, taxpayers must weigh the permanent loss of the deduction against the immediate cash benefit of receiving the cash refund of any prior year tax paid.
Taxpayers also need to consider the effect on their use of general business tax credits and their origination and use of alternative minimum tax credits for the affected years. Given the right fact pattern, a taxpayer may be faced with the choice of electing bonus depreciation or forgoing a bonus to monetize certain applicable Research and Development tax credits and MTC carry forwards. Other issues may arise depending on each taxpayer’s individual facts and circumstances.
The underlying composition of the NOL should also be examined to determine if there are any “specified liability losses” that would be available for a 10-year carry back. These liabilities include expenses like product liability, and these amounts that can be carried back are limited to the NOL generated for the tax year of the specified liability loss.
The above illustrates that carrying back an NOL is not as easy as just filing the correct form and waiting for your refund. Careful planning should be done in order to maximize the cash that can be generated while not limiting other tax benefits available to the taxpayer. This should be part of tax year-end planning for all taxpayers with business losses. Taxpayers will need to consult with their tax advisers to determine how best to take advantage of the tax refund/carry-back opportunities facing them
Daniel W. Fuller is a senior director with BDO Seidman LLP. The views expressed are those of the author and are not necessarily of BDO Seidman.