The CARES Act bring changes to the net operating loss rules that may impact completed and future corporate transactions.
The US Congress enacted The Coronavirus Aid, Relief, and Economic Security Act (the CARES Act) on March 27, 2020. This article describes the changes to the net operating loss (NOL) rules as a result of the CARES Act and the impact these changes may have on completed and future corporate transactions.
Amendments to NOL Usability
The CARES Act provides a temporary five-year NOL carryback for most taxpayers, which may entitle taxpayers to significant tax refunds. The Tax Cuts and Jobs Act of 2017 (TCJA) repealed the carryback of NOLs (but enabled taxpayers to carry forward NOLs indefinitely) and limited the deduction of NOLs to 80 percent of taxable income. Prior to the TCJA, taxpayers could carry back NOLs for two years and carry forward NOLs for 20 years to offset up to 100% of taxable income in each year.
The CARES Act provides that NOLs incurred in 2018, 2019, and 2020 may be carried back to offset taxable income earned during the five-year period prior to the year in which the NOL was incurred. The CARES Act also temporarily removes the taxable income limitation, therefore allowing taxpayers utilize NOLs to offset 100 percent of taxable income in tax years 2018, 2019, and 2020. This change affects taxpayers who are otherwise profitable but, as a result of the current COVID-19 crisis, will have a NOL for the current year. Those taxpayers will be able to carry back the current year NOL up to five years and recover income taxes paid in those years. Losses incurred in tax years beginning before January 1, 2018 may be carried forward to tax years beginning after December 31, 2020 without being subject to the 80% income limitation. In addition, as discussed below, the change may provide an opportunity for corporations that have been sold since January 1, 2018 – and, by reason of deductible transaction-related expenses, had an NOL for the year of the sale – to carry that NOL back as well.
Prior to TCJA
Two taxable years
NOLs incurred in 2018, 2019 and 2020 may be carried back five taxable years
Twenty taxable years
Taxable Income Limitation
NOL deduction up to 100 percent of taxable income
NOL Deduction limited to 80 percent of taxable income
In 2018-2020, NOL deduction up to 100 percent of taxable income; after 2020, NOL deduction limited to 80 percent of taxable income
Impact on Mergers and Acquisitions
In the typical sale of a corporation in a stock purchase or merger transaction, there are many transaction-related expenses that are deductible for federal income tax purposes, including transaction-related bonuses, option cash-out payments, and portions of a corporation’s investment banker fees and legal fees. Depending on when the sale closes during the year, these deductible transaction-related expenses will often cause the corporation (which might otherwise be profitable) to have an NOL for the year. Although it is not unusual for there to be provisions in the transaction agreement that entitle the sellers to the tax benefits of these deductions – by providing that any income tax refunds relating to taxable periods ending on or before the closing date will be for the sellers’ account – these provisions had limited impact on transactions that closed after December 31, 2017. This is because of, as noted above, the changes made by the TCJA that disallowed the carryback of an NOL incurred in 2018 or thereafter. For post-January 1, 2018 transactions, any NOL attributable to deductible transaction-related expenses could only be carried forward such that, absent an agreement of the buyer to pay the seller for the benefit of any pre-closing NOLs that were utilized post-closing, the tax benefits associated with this NOL would automatically accrue to the buyer.
The CARES Act now allows for the NOL in the year of the sale (assuming the sale took place in 2018, 2019 or 2020) to be carried back up to five taxable years. Depending on the provisions in the applicable transaction agreement, sellers may now be entitled to additional cash refunds that were not previously anticipated at the time of the closing. Moreover, being able to carry back an NOL up to five years also means that some or all of taxes that are recoverable will be in years when the corporate tax rate was 35 percent rather than 21 percent, thereby increasing the value of the NOL.
Transactions involving the purchase and sale of partnerships and limited liability companies taxed as partnerships, S corporations, or, in most cases, subsidiaries of a larger consolidated group, as well as transactions structured for federal income tax purposes as asset purchases, typically will not be affected by the modification of the NOL rules in the CARES Act.
Businesses and their owners should evaluate the potential benefits of carrying back any recent NOLs and review past transaction agreements to determine how any tax refunds resulting from these CARES Act provisions should be allocated between buyers and sellers.