Tax Planning for Late-in-Life Net Operating Lossesby
The elimination of Net Opperating Loss carrybacks was introduced with the Tax Cuts and Jobs Act, which also added an 80 percent of income limitation in the deduction year. Temporary relief came in 2020 with the enactment of the Coronavirus Aid Relief and Economic Security Act.
Net operating loss (NOL) carryovers don’t expire quickly, but recent history has been one of limiting carrybacks and, ultimately, plays an important role in lessening the harshness of the annual accounting concept.
For example, the taxpayer breaking even over two years has roughly zero taxable income if the million-loss year precedes the million-in-income year. With the same figures over two years, assuming no carryback rule and the income year preceding the loss year, the taxpayer owes tax on a million in the earlier year.
There’s the contingency this taxpayer will benefit from the NOL arising in the later year, but there is delay of use and the possibility the NOL will expire unused. In a no-carryback world, one can theoretically make a million on December 31, have a million dollar loss deduction the next day, and owe tax on a million despite breaking even over two days.
The CARES Act provides that NOLs of 2018, 2019, and 2020 can be carried back five years without being subject to the 80 percent of income limitation.
“The CARES Act also temporarily removes the taxable income limitation, therefore allowing taxpayers (to) utilize NOLs to offset 100 percent of taxable income in tax years 2018, 2019, and 2020…. 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% limitation.” (“CARES Act Five-Year NOL Carryback Rules Will Have Significant Impact on M&A Transactions,” Hall, Ruiz, Zucker, Mussio, McDermott, Will & Emery, mwe.com, 3/27/20).
If loss carrybacks are large enough, a full refund of taxes in the carryback years may be possible. The rate of realization may be relatively high in these years, depending, of course, on the taxpayer’s particulars (See also IRS Publication 536 (2020), “Net Operating Losses (NOLs) for Individuals, Estates and Trusts,” p. 1).
It is possible to waive the carryback, an election that is generally irrevocable. Special beneficial rules can apply if any part of the NOL relates to farming (See Tax Cuts and Jobs Act, CARES Act, and Rev. Proc. 2021-14).
New restrictions can limit larger “excess business losses.” The excess business loss rule limits losses generally to $250,000, or $500,000 in a joint return. In a partnership and S corporation, the limits apply to each owner’s share of the entity’s loss.
The restrictions arose with the Tax Cuts and Jobs Act and were to apply to tax years beginning after 2017 and before 2026. These were temporarily suspended by the CARES Act, such that non-corporate taxpayers can deduct losses for tax years beginning in 2018, 2019, and 2020. Also keep in mind state tax considerations (See “FAQs: COVID 19- State Net Operating Loss,” BakerHostetler; bakerlaw.com, 3/24/20; https://www.bakerlaw.com/alerts/faqs-covid-19-state-net-operating-loss-nol).
The Effects of the Taxpayer’s Passing on NOLs
What happens to the NOL of the C corporation upon the death of the sole or controlling shareholder? There is no rule per se that eliminates the NOL of the C corporation even when the sole shareholder passes (See, e.g., Section 382(l)(3)(B)).
What happens to the individual’s net operating loss carryover at death? It expires in the year of death. It doesn’t necessarily expire at death in the limited sense it can be used in a joint return that includes the survivor’s income for the entire year (Rev. Rul. 74-175, 1974-1 CB 52; Regs. 1.2-1(c)). In this scenario, it would be possible for the post-death income of the surviving spouse to be offset by the NOL of the predeceasing spouse. One can get into issues of measuring the NOLs of the predeceasing spouse and surviving spouse depending on each’s ownership interest in the business (See Rose, TC Memo 1973-207; Zeeman, 395 F.2d 861 (CA-2, 1968)).
The NOL of the predeceasing member doesn’t just pass to the survivor, even if the couple has been married many years. This suggests a possibly surprising need for the tax professional to be tracing deductions and losses with a view to the generally long carryover possibilities. The same basic principle applies to the myriad other carryovers that may be present at death.
One “checklist” issue here might include accelerating income to minimize the loss of carryovers that can arise at death, or shortly thereafter. The planning would consider the step-up at death for appreciated assets. In contemplation of death planning, this may focus on sales of appreciated assets of the healthy spouse in that such assets won’t step-up at death. In community property states, on the other hand, both halves of community step-up to fair market value upon the death of the predeceasing spouse.
Ownership changes can reduce or eliminate the C corporation’s NOL. These rules are beyond our scope, but they may deal with limitations not applying when options are exercisable only upon death, disability, or mental incapacity of the owner of a loss corporation (Regs. 1.382-9(e)’(1), Temp. Reg. 1.382-2T(h)(4)(x)(D), “Limitations on Corporate Tax Attributes, An Analysis of Section 382 and Related Provisions,” Alvarez & Marsal Taxand, alvarezandmarshal.com, Lee Zimet, May 12, 2019, p. 64, 125).
Given that the C corporation’s net operating loss doesn’t just expire at the shareholder’s (or controlling shareholder’s) death, another planning consideration is whether it may be helpful to have net operating losses in the C corporation, particularly if it appears likely there may otherwise be individual NOLs that are lost upon the shareholder’s death.
Mike Pusey, CPA served as National Tax Director at Rojas & Associates. He has a BBA and Master of Science in Accounting from Texas Tech where he graduated with honors. He planned to be an accounting professor and worked a year on the Ph. D. at the University of Arizona before beginning his career at KPMG Peat Marwick, where he worked in...