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After the Loan Programs – CARES Act Cash Flow Generating Strategies

Dan Rahill, CPA, JD, LL.M., CGMA

On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) was passed, providing $3.3 trillion in tax, grant, and loan provisions designed to provide financial aid to individuals, businesses, nonprofits, and state and local governments which have been severely impacted by COVID-19.  The Paycheck Protection Program loans and other measures have helped stabilize the economy, but economic output and employment remain far below their pre-pandemic levels. 

Beyond these loan programs and other financial measures, which primarily supported employers, there are a number of significant cash flow benefits directed to businesses and individuals which to date have been greatly overlooked because most of their impact won’t be realized until the 2021 tax season.  These provisions contained in the CARES Act have the potential to greatly impact cash flow for taxpayers if planned for properly.

These tax provisions can be categorized into three buckets, (1) the carryback of losses to generate tax refunds and hence, liquidity, (2) relaxed limitations on deductibility of losses, and (3) increased deductions.  These categories are all interrelated:  increased deductions can generate greater losses, the limitations on those losses are relaxed to potentially produce even larger losses, and a greater amount losses can be carried back five years, producing significant new cash flow to taxpayers in the form of tax refunds.

This article provides an overview of those provisions contained in the Act.

Bucket 1 – Net Operating Losses and Carrybacks

Under the CARES Act, net operating losses (NOLs) arising in tax years beginning after December 31, 2017, and before January 1, 2021 (for example, NOLs incurred in 2018, 2019, or 2020 by a calendar-year taxpayer) may be carried back to each of the five tax years preceding the tax year of such loss. Previously, since the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA), NOLs generally could not be carried back; they could only be carried forward indefinitely. Further, under the TCJA, NOLs could only be used to offset 80% of taxable income. The CARES Act temporarily removes the 80% limitation, reinstating it for tax years beginning after 2020. Special carryback rules are provided for taxpayers such as real estate investment trusts (REITs) and life insurance companies.

In addition, taxpayers are allowed to use an NOL from a tax year with a lower corporate tax rate such as 2020, where the federal corporate tax rate is 21%, to offset taxable income that was subject to a higher corporate tax rate in an earlier tax year, such as 2015, where the corporate tax rate is 35%.  This provides taxpayers with the unique opportunity to use deductions that are generated in the lower 21% tax bracket years of 2018, 2019 or 2020, and to use them to offset income in the higher 35% tax bracket years of 2013 to 2017.

A taxpayer can still waive the carryback and elect to carry NOLs forward to subsequent tax years in certain situations where that may be more beneficial.  Taxpayers such as international corporations will want to consider how other tax attributes such as foreign tax credits or the TJCA transition tax on repatriated income will be impacted by an NOL carryback and plan accordingly.  Taxpayers that were a party to an M&A transaction may also need to consider contractual limitations affecting their ability to carry back, or carry over, an NOL.

Loss Carryback Example

Facts: A calendar year corporate taxpayer has taxable income in years 2014 through 2018 of $100,000, and an NOL of 150,000 in 2019.  It also expects a $1 million NOL in 2020 because of COVID-19 related business disruption.  Assume no election to forego the NOL carryback.

2019 NOL carryback benefit:  the $150,000 2019 NOL can be carried back 5 years to offset all of 2014’s $100,000 of income, as well as $50,000 of 2015’s income.  Because 2014 and 2015 had a corporate tax rate of 35%, the business work receive a $52,500 tax refund. 

2020 NOL carryback benefit: $350,000 of the $1 million 2020 NOL can then be carried back, first to 2015, and then to years 2016 – 2019, in that order.  $50,000 of the 2015 income has already been offset by the 2019 NOL carryback, so $50,000 remains to be offset.  The business can also offset taxable income of $100,000 in 2016, 2017, and 2018. The unused NOL will carryforward.  This 2020 carryback will result in the following tax refund: 

YEARINCOMETAX RATEREFUND
201550,00035%17,500
2016100,00035%35,000
2017100,00035%35,000
2018100,00021%21,000
TOTAL TAX REFUND108,500

The tax returns for 2019 and 2020 must be filed before a refund may be requested.  Therefore, in early 2021, expect a significant boost to cash flow for calendar year 2020 taxpayers who incur significant losses because of the COVID-19 crisis.  These taxpayers should file their tax returns as soon as possible after their year-end so that a refund claim may be filed.  A refund may be requested by filing either a Form 1120X or Form 1139 for corporations, or Form 1040X or a Form 1045 for individuals.  Forms 1139 and 1045 are the much faster method to obtain refunds; the IRS is required to issue a tentative refund by the later of 90 days after filing form 1139 or 1045, or 90 days from the last day of the month of the due date of the taxpayer’s return for the NOL year, including extensions.  Taxpayers who file their 2020 tax returns by April 15, 2021 should therefore begin receiving their refunds by the summer of 2021. 

Bucket 2 – Relaxed Limitations on Loss Deductibility

Net Operating Loss 80% Limitation

The TCJA enacted two rules that imposed significant limitations on a taxpayer’s ability to deduct losses—one applicable to net operating losses and the other applicable to active business losses. For tax years beginning after December 31, 2017, a taxpayer became limited in its ability to deduct net operating loss carryovers by reference to 80 percent of taxable income.  Under the CARES Act, the 80 percent limitation is eliminated for net operating losses deducted in a tax year beginning before 2021   Therefore a 2020 NOL would not be subject to the 80% limitation if it is carried back; it only applies if it is carried forward.   This potentially increases the cash flow benefit of such a loss carryback. 

Excess Business Losses

Also a part of the TCJA, for tax years beginning after December 31, 2017 and ending before January 1, 2026, taxpayers other than C corporations were not allowed to deduct excess business losses.  For this purpose and with some exceptions, “excess business loss” essentially means taxpayers’ otherwise deductible trade or business losses in excess of $250,000 for single filing taxpayers, or $500,000 for married taxpayers filing jointly, adjusted for inflation. Disallowed excess business losses were carried forward and treated as a net operating loss in subsequent tax years.  

Under the CARES Act, the excess business loss limitation for non-C corporation taxpayers is retroactively eliminated for tax years beginning before 2021, potentially increasing the amounts available for loss carryback.

Bucket 3 – Increased Deductions

There are three provisions in the CARES Act that increase available deductions: the tax treatment of Qualified Improvement Property (QIP) deductions, the relaxation of the limitation on deductibility of business interest, and increased limitations on charitable deductions for both corporations and individuals.  The CARES Act changes to depreciation for qualified improvement property are further enhance by the bonus depreciation rules and cost segregation studies as discuss below. 

Qualified Improvement Property, Bonus Depreciation, and Cost Segregation

The CARES Act QIP provision enables businesses to use bonus depreciation to immediately write off costs associated with improving facilities instead of having to depreciate those improvements over the 39-year life of a commercial building. The QIP provision, which corrects an error in the TCJA often referred to as the “retail glitch,” not only increases companies’ access to cash flow by allowing them to claim the benefit retroactively to the enactment of TCJA, but also incentivizes them to continue to invest in improvements as the country recovers from the COVID-19 emergency.  Either amending 2019 tax returns for this law change if already filed, or claiming bonus depreciation now as 2019 tax returns are filed, can result in significant cash flow benefits.

QIP is defined as any improvement made by a taxpayer to an interior portion of a nonresidential building placed in service after the building was placed in service. It excludes expenditures for the enlargement of the building, elevators and escalators, or the building’s internal structural framework. QIP can include roofs, heating and air conditioning equipment, and fire protection and security equipment. In order to qualify for bonus depreciation, the QIP must be new property in the hands of the taxpayer, not used property. 

Bonus depreciation allows individuals and businesses to immediately deduct a certain percentage of their asset costs the first year they are placed in service. The TCJA made used property eligible for bonus treatment for the very first time, and it also increased the bonus percentage to 100 percent through tax year 2022. Prior to this law change, only new property was qualifying, and bonus depreciation was expected to be only 50 percent in 2019.  Any assets that are removed from the “real property” bucket and placed in the “personal property” bucket may now be eligible for bonus depreciation and can be immediately expensed in the first year.

To further enhance cash flow, a cost segregation study is an established tax technique used to increase cash flows, reduce tax liability, and uncover missed deductions, should be considered.  The study assess an entity’s real property assets to identify the portion of those costs that can be treated as personal property. By segregating personal property from the building itself, the study will be able to reassign costs that would have been depreciated over a 39-year period to asset groups that will be depreciated at a much quicker pace, or perhaps expensed immediately as bonus depreciation.

An example: A taxpayer purchases a building worth $10 million. After performing a cost segregation study, they can reclassify 10 percent of those costs to be personal property. By assigning these assets a shorter depreciable life, they can apply bonus depreciation and write off $1 million of that $10 million purchase price in Year 1. A taxpayer with a 21 percent federal corporate tax rate would save $210,000 in taxes that first year.  If this transaction occurs in 2019 or 2020, and the taxpayer is in an NOL position, this incremental deduction may be carried back 5 years to recover taxes at an even higher 35% tax rate. 

Business Interest Deductions

Under the TCJA, business interest expense deductions are generally limited to 30% of a company’s adjusted taxable income. The CARES Act provides that the 30% limitation on business interest expense deductions is generally increased to 50% for any taxable year beginning in 2019 or 2020.  In addition, a company can generally elect to use their 2019 adjusted taxable income (which is likely higher than their 2020 adjusted taxable income) for purposes of computing the business interest expense deduction for the 2020 taxable year.  It should be noted that special rules apply to businesses taxed as partnerships.

New Charitable Above-the-Line Deduction

One significant impact of the TCJA is that fewer taxpayers are itemizing deductions than they did previously.  Many donors now opt for an increased standard deduction (and do not itemize their deductions) and therefore get zero no tax benefit for their charitable contributions

This changes under the CARES Act.  An individual can now claim an above-the-line deduction of up to $300 for donations made to qualified charitable organizations. As a result, donors may be entitled to a charitable deduction whether or not they itemize.  One caveat, the deduction isn’t available for contributions to private foundations or donor-advised funds. 

The first $300 donated in 2020 goes toward this deduction.   Therefore, itemizers will benefit from the deduction before claiming any other donations on Schedule A. Any excess is carried forward for five years.

Increased Individual Charitable Deduction Limit

Prior to the CARES Act, an individual’s annual deduction for cash contributions was limited to 60 percent of adjusted gross income (AGI).  This limit was raised from 50 percent of AGI for 2018 through 2025 by the TCJA.

The CARES Act increases this deduction limit to 100 percent of AGI for 2020.  Therefore, a taxpayer who itemizes can generally write off the full amount of his or her charitable contributions of cash or cash-equivalents in 2020. Any excess above 100 percent of AGI is carried forward for up to five years. As noted with the new $300 deduction for non-itemizers, this provision does not apply to private foundations or DAFs.

Increased Corporate Charitable Deduction Limit

The tax law also imposes limits on deductions for charitable contributions made by corporations: the annual deduction for contributions by a corporation cannot exceed 10 percent of its taxable income. Therefore, a corporation with taxable income of $10 million is limited to a deduction of $1 million. Any excess is carried forward for up to five years.

Under the CARES Act, the annual threshold for corporate deductions is increased to 25 percent of taxable income for 2020. Going back to our previous example, a corporation with taxable income of $10 million could write off up to $2.5 million.  Any excess is carried forward for up to five years.

The CARES Act contains many cash flow planning opportunities, mostly overlooked because their benefits will not be realized until mid-2021, months after 2020 tax returns are filed.  Businesses and individuals impacted by the COVID-19 should review their options with their advisors as soon as possible to achieve the optimal tax result that also gets much needed cash into their hands. 

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This information may answer some questions, but is not intended to be a comprehensive analysis of the topic. In addition, such information should not be relied upon as the only source of information; professional tax and legal advice should always be obtained.

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