A Review of Net Operating Loss Tax Provisions in the CARES Act and Next Steps for Phase 4 Relief

In addition to providing economic relief to individuals and loans to businesses struggling during the coronavirus crisis, the Coronavirus Aid, Relief, and Economic Security (CARES) Act changed several taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. provisions to increase liquidity to ensure firms survive a large decline in cash flow.

Among other tax changes, the CARES Act loosened rules governing net operating loss deductions (NOLs). These modifications provided much-needed relief for businesses, and there is an opportunity to build upon them in upcoming “Phase 4” economic relief legislation.

Why Net Operating Loss Deductions Matter

The goal of business income taxation is to tax a firm’s net income, ideally in a consistent manner over time. However, some businesses and industries may have more volatile profitability than others, which may lead to inconsistent tax treatment over time without an NOL deduction. For example, imagine a firm in a volatile industry that has a $50,000 loss in year one and makes $100,000 in net income in year two. A second firm makes an even $25,000 in both years, so both firms have the same combined net income over those two years ($50,000).

Without an NOL deduction, firm one pays a higher effective tax rate than firm two: a 21 percent tax on $100,000 in net income for year two despite only a $50,000 net over the past two years. This penalizes firm one for having more volatile profits than the second firm (see Table 1).

Table 1. Effective Tax Rate for Two Firms without a Net Operating Loss Deduction (21% Tax Rate)

	Year One Net Income	Year Two Net Income	Tax Liability for Year One	Tax Liability for Year Two	Combined Effective Tax Rate
Firm One	($50,000)	$100,000	$0	$21,000	42%
Firm Two	$25,000	$25,000	$5,250	$5,250	21%
Source: Tax Foundation calculations

When firm one takes an NOL deduction, this equalizes the effective tax rate on net income over both years with firm two (Table 2). To do so, firm one “carries over” the loss from year one ($50,000) and deducts it from its net income in year two ($100,000 – $50,000) when calculating tax liability for the second year (see Table 2). This ensures that the tax code is targeting a firm’s average profitability over time, regardless of how volatile a firm’s income is from one year to the next.

Table 2. Effective Tax Rate for Two Firms with a Net Operating Loss Deduction (21% Tax Rate)

	Year One Net Income	Year Two Net Income	Tax Liability for Year One	Tax Liability for Year Two	Combined Effective Tax Rate
Firm One	($50,000)	$100,000	$0	$10,500 ($100,000 – $50000) * 21%	21%
Firm Two	$25,000	$25,000	$5,250	$5,250	21%
Source: Tax Foundation calculations

The tax code imposes rules on how firms may take NOL deductions. The Tax Cuts and Jobs Act (TCJA) of 2017, for example, changed limits related to NOL carrybacks and carryforwards. Under the TCJA, firms were allowed to carry forward losses for an unlimited number of years, but carrybacks were disallowed. This prevented firms from taking losses realized in one year and modifying a previous year’s tax return to deduct the loss from previous income, which under prior law firms were allowed to do up for up to two previous tax years.

The TCJA also limited how much taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. can be offset using an NOL deduction in each tax year. Firms could only deduct up to 80 percent of their taxable income, and had to carry forward any NOL beyond that limit to future tax years. Additionally, the TCJA placed limits on losses for pass-through businessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates. es, set at $250,000 for single filers and $500,000 for joint filers. Active business owners of pass-through firms could only use losses up to those limits to offset taxable income earned outside of the business.

Review of Net Operating Loss Provisions in the CARES Act

The CARES Act made three changes to NOLs that improves cash flow for struggling businesses:

• Provided a five-year carryback for losses earned in 2018, 2019, or 2020, which allows firms to modify tax returns up to five years prior to offset taxable income from those tax years.
• Suspended the NOL limit of 80 percent of taxable income. This means that firms may deduct their NOLs to eliminate all of their taxable income in a given year, instead of having to carry forward any NOL beyond 80 percent of taxable income.
• Pass-through business owners may use NOLs to offset their non-business income above the previous limit of $250,000 (single) or $500,000 (married filing jointly) for 2018, 2019, and 2020.

While these provisions improved liquidity for businesses with losses on the books from 2018 to 2020, these changes are not perfect.

The TCJA lowered individual income and corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. rates. The carryback provisions allow firms to deduct losses from tax years with these lower rates (e.g., 21 percent corporate income tax) and apply them to tax years prior to 2018 (35 percent corporate income tax), increasing the benefit to those firms compared to firms that cannot use losses to deduct income from those tax years. Ideally, firms would be able to deduct losses from years with similar or equivalent tax rates to prevent arbitrage opportunities and maintain fairness in the tax code.

A less compelling criticism of these changes surrounds the treatment of pass-through losses. Some have argued that this change benefits wealthy business owners by allowing them more opportunities to use business losses to offset non-business income above the previous limits, such as capital gains. However, capital gains income is taxed at the 20 percent preferential rate, which would not be a good use of NOL deductions that could offset the top ordinary income tax rate of 37 percent. Allowing pass-through business owners to offset non-business income is economically similar to providing additional NOL carrybacks and is not a tax preference.

Changes to pass-through NOL rules ensure that pass-through firms and C corporations are treated symmetrically in the tax code. Additionally, passive investors in passthrough firms, such as real estate investors, are rightly limited or prevented from taking NOL deductions to offset their non-business income.

Monetizing Net Operating Loss Deductions and Other Tax Assets in Phase 4 Relief Legislation

While the NOL deduction changes in the CARES Act provided liquidity for firms with taxable income to offset in previous years, businesses that have not posted profits in the applicable years will not get relief. Startups, for example, may not have earned profits since they opened for business. Other businesses may not have existed during the applicable tax years and would not have profits to offset with current losses.

One option policymakers should consider in upcoming “Phase 4” relief legislation is accelerating tax assets, such as NOL deduction carryforwards or R&D tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. s, that are currently on firms’ books. For example, if a firm has $50,000 in NOL carryforwards, it could get that carryforward advanced by the IRS now. This would reduce the carryforward that firms could use to offset future taxable income, and would provide liquidity to firms that have not earned enough in profits over the past five years.

While most of the cost of this proposal would be the result of timing effects (e.g., firms taking a deduction now instead of when earning profit in the future), there would be a cost to the federal government. Firms that accelerate their tax assets now may end up going out of business before earning future profits, depriving the government of revenue. Some of this could be offset if the acceleration of tax assets had an interest charge built into it, though this may make the provision more complex. This is a trade-off policymakers should consider when evaluating this option.

Another consideration in the design of this option is whether to cap the acceleration of tax assets for large firms. Some large firms have earned a large volume of NOL deductions or other tax assets on their books, and these firms may not need the additional liquidity as much as smaller firms do. If policymakers settle on a firm size limit, however, they should be mindful of sharp cutoffs, as this would create spikes in firms’ marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. s.

Conclusion

Contrary to some of the rhetoric surrounding the changes to NOL deductions in the CARES Act, the provisions are a step forward for providing firms liquidity in a time of crisis and constrained cash flow. NOL deductions are a key component of a sound tax code.

While arbitrage opportunities should be minimized, policymakers should explore ways for firms to leverage their tax assets, including NOL deductions, in the next round of economic relief legislation. The goal is not to provide a windfall to firms nor to cut long-run taxes, but to ensure firms without past profits can survive through an unprecedented economic crisis. Reforming NOL rules is a smart way to do so in combination with other forms of business relief.

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