The CARES Act: Income Tax Provisions for Businesses
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Among its many provisions designed to stimulate the economy and provide relief to businesses, the CARES Act includes several tax provisions designed to do so through the US Internal Revenue Code. These tax provisions relate to industry-specific excise taxes, payroll taxes, income taxes and credits, charitable organizations, and tax-deferred retirement savings.1
This Advisory focuses on the following income tax provisions in the CARES Act that impact businesses:
- Businesses now generally can carry back a net operating loss (NOL) generated in 2018, 2019, or 2020 for up to five years. In addition, the annual limitation on the deduction of an NOL of 80 percent of taxable income is suspended until 2021. The CARES Act also suspends the limitation for noncorporate taxpayers on the deductibility of excess business losses until 2021.
- The limitation on interest deduction, which otherwise permits businesses to deduct interest expense only up to 30 percent of adjusted taxable income, has been generally increased to 50 percent for 2019 and 2020.
- Tax credits related to the repealed corporate alternative minimum tax (AMT) now can be refunded entirely in either 2018 or 2019, instead of over four years through 2021.
- A technical error in the Tax Cuts & Jobs Act of 2017 (TCJA) has been fixed, making the cost of real property improvements eligible for immediate expensing under the "bonus" depreciation rules beginning in 2018.
We expect that most businesses will find these changes beneficial. However, as discussed in more detail below, there may be unintended tax consequences of carrying back NOLs. Legal questions also could arise from carrying back NOLs of recently acquired corporations.
Relaxation of Rules for Utilization of Business Losses
Prior to the TCJA, an NOL generally could be carried back two years and carried forward 20 years to offset taxable income without limitation. However, the TCJA generally eliminated the ability to carry back NOLs generated after 2017, and limited the deduction for those NOLs carried forward to 80 percent of taxable income in the carryforward year. The CARES Act modifies those rules by generally allowing taxpayers to carry back NOLs generated in 2018, 2019 or 2020 for up to five years. The CARES Act also increases the allowable deduction for NOLs carried back or carried forward to 100 percent of taxable income for tax years before 2021. However, in 2021, these CARES Act changes will end, and taxpayers will again be precluded from carrying back NOLs, and the deduction for post-2017 NOLs carried forward again will be limited to 80 percent of taxable income.
In short, the CARES Act permits taxpayers to fully utilize NOLs from 2018, 2019 and 2020 to obtain refunds of taxes paid in prior years and to reduce their taxes in the future. The potential impact is significant, because taxpayers can carry back an NOL generated in 2018, 2019 or 2020, when the US federal corporate income tax rate has been 21 percent, to years before 2018, when the maximum corresponding rate was 35 percent. The result is a much larger, retroactive benefit. However, even if taxpayers are able to use NOLs to eliminate their regular tax liability, they still may have an AMT liability in certain years because the deduction for NOLs generally is limited to 90 percent of AMT taxable income.
Although the new NOL rules generally will be beneficial to taxpayers, carrying back NOLs might reduce certain deductions claimed in prior years that depend on the amount of taxable income. In that case, taxpayers may not receive the maximum economic benefit from the NOL. That outcome might occur, for example, for a US corporation with non-US subsidiaries that is taxed on global intangible low-taxed income (GILTI) or subject to the base erosion and anti-abuse tax (BEAT), two international tax provisions introduced by the TCJA that generally became effective beginning in 2018.2 For example, the 50-percent deduction generally allowed against GILTI is limited to taxable income after NOLs. Thus, increasing the use of NOLs in a year where GILTI is recognized can reduce the deduction allowed against GILTI, thereby increasing the amount of taxable GILTI. Additionally, if a corporation is subject to the BEAT in a tax year, a portion of NOLs used in that year would be added back to arrive at modified taxable income, which is the tax base for BEAT, thereby increasing the BEAT liability.
Taxpayers also should consider how carrying back an NOL may affect other tax attributes, such as foreign tax credits, the utilization of which generally is based on taxable income after NOLs. Additionally, if an NOL is carried back to a tax year for which the statute of limitations for the assessment of taxes by the Internal Revenue Service (IRS) has passed, the carry back generally does not reopen such tax year to assessment of additional taxes. However, in such case the IRS is able to redetermine taxable income for such a "closed" tax year and, partially or entirely, offset the tax benefit of the carried back NOL. As such, before taking advantage of the new NOL carryback provisions in the CARES Act, taxpayers should consider the risk of IRS adjustments with respect to uncertain tax positions in closed tax years. Depending on the outcome of that analysis, it may be more advantageous for a taxpayer to waive the carry back and elect to carry forward NOLs to subsequent tax years.
Carrying back an NOL also may have implications for state income taxes. US federal taxable income generally is the starting point for determining the taxable income in most states. Accordingly, businesses will need to determine the extent to which they will need to amend their state income tax returns for prior years to reflect changes in their US federal taxable income from carrying back NOLs. Other tax provisions in the CARES Act may require a similar analysis.
Businesses also should consider legal issues that could arise from carrying back NOLs of corporations that have been acquired in the last few years. Such carry backs could impact pre-closing and post-closing tax liabilities of the parties, and such changes in tax liabilities may not have been properly addressed in the applicable transaction documents. Additionally, under the terms of those transaction documents, an acquiror may be required to obtain the consent of the seller before carrying back NOLs to a pre-closing tax period.
Excess Business Losses: The TCJA introduced a new rule that disallows the deduction of certain excess trade or business losses by noncorporate taxpayers for tax years beginning after 2017 and ending before 2026. In particular, that TCJA provision generally limited the amount of losses that a noncorporate taxpayer can deduct related to trades or businesses to the amount of income from those businesses plus $250,000 ($500,000 for married taxpayers filing jointly). Any loss disallowed under this rule is treated as an NOL carryover to the following year.
The CARES Act suspends the application of this provision until 2021. This temporary suspension is expected to be particularly beneficial for active property owners that benefit from substantial depreciation deductions that often can exceed annual income from such property.
Expanded Deductibility of Business Interest Expense
The TCJA limited the annual deduction for business interest expense to 30 percent of adjusted taxable income (roughly equal to earnings before interest, taxes, and, prior to 2022, also before depreciation and amortization). The CARES Act relaxes this rule by increasing the limitation on deductibility of business interest to 50 percent of adjusted taxable income for 2019 and 2020. Additionally, for 2020, a taxpayer may elect to apply the limitation based on the taxpayer's adjusted taxable income for 2019, instead of taxable income for 2020 (which could be greatly reduced as a result of business disruptions from the current crisis). The additional interest expense that may be deducted may generate or increase an NOL, which, as discussed above, may result in much greater tax benefits as a result of the CARES Act.
Partnerships are eligible for the increased limitation on interest deductions only in 2020. However, in lieu of the increased limitation at the partnership level for 2019, business interest in excess of the 30-percent limitation allocated by a partnership to a partner is subject to a special rule, unless the partner elects otherwise. Under the special rule, 50 percent of such interest is deductible by the partner without respect to the adjusted taxable income limitation for the partner in 2020, and the remaining 50 percent is subject to the normal rules for excess interest allocated to a partner.
Acceleration of Refund of Corporate AMT Credits
TCJA eliminated the corporate AMT beginning in the 2018 tax year and permitted corporations to utilize their unused AMT credits, which can offset regular tax liability and are refundable, incrementally over a four-year period through 2021. The CARES Act accelerates the ability of corporations to recover those AMT credits in either 2018 or 2019, permitting companies to immediately claim a refund for such credits.
Immediate Expensing of Qualified Improvement Property
The TCJA expanded the "bonus" depreciation deduction from 50 percent to 100 percent of the cost of qualifying property for the year such property is placed in service. To qualify for bonus depreciation, property generally must have a 20-year or less depreciation recovery period and meet certain other requirements. In addition, the TCJA eliminated the concepts of "qualified leasehold improvement property," "qualified restaurant property," and "qualified retail improvement property," and replaced those concepts with one category called "qualified improvement property." Congress intended to provide a general 15-year recovery period for such property, thereby making it eligible for bonus depreciation. However, the TCJA's text failed to properly include that 15-year recovery period. As a result, qualified improvement property became subject to the 39-year recovery period for nonresidential rental property, and therefore was ineligible for bonus depreciation.
The CARES Act corrected this technical error (commonly known as the "retail glitch") by specifically designating qualified improvement property as 15-year property for depreciation purposes and making it eligible for bonus depreciation. This technical amendment is effective for property placed in service beginning in 2018. This provision is expected to have benefits broadly among many industries, particularly for those in the retail and restaurant sectors.
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We expect that most businesses will find these changes to the tax rules to be beneficial. However, in light of the rules' complexities, we recommend businesses consider the provisions' collateral tax impacts before taking advantage of them. We are available, of course, to assist clients in analyzing the impact of these rules, and we will continue to report on material developments.
© Arnold & Porter Kaye Scholer LLP 2020 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.