A net operating loss (NOL) occurs when a taxpayer’s allowable deductions exceed their gross income for a given year. Most taxpayers can take advantage of NOL deductions, including individual taxpayers, exempt organizations, trusts, and most C corporations, to offset taxable income from other tax years. NOLs allow companies large and small to have an average effective tax rate over time that reflects their taxable income over the long term, survive the start-up years and survive economic downturns.
To illustrate these principles, suppose you read an article about a large corporation – let’s call it Fortune 50 – that pays “no taxes!” or has an effective tax rate that is “lower than a janitor!” Sensational titles are undoubtedly effective. But once you remove the smoke and mirrors from those headlines, it can only be buried in the article that the note that Fortune 50 paid significant taxes in a previous year and/or will pay important taxes in the years to come.
This article will take a step back from these sensational titles and examine how NOL deductions make these titles possible, and explore whether the NOL policy is effective or if there are better alternatives.
“Lean” and “lush” years
Tax law is designed so that a corporation’s tax rate reflects its gross taxable income over a number of years. Going back to the hypothetical Fortune 50 article, consider this example—Fortune 50 has a taxable income/loss as follows: first year: $5 billion; Second year: $6 billion; Third year: $1 billion. In its three years in business, Fortune 50 has broken even, but the headline for year three might be “Fortune 50 pays no taxes!” This may sound shocking, but if Fortune 50 makes no profit over a three-year period, then it’s no surprise that Fortune 50 owes no taxes.
Indeed, as the Supreme Court succinctly put it in Lisbon shops against Koehler“Those [NOL rules]…were enacted to mitigate the unduly harsh consequences of taxing income strictly on an annual basis. They were designed to allow a taxpayer to offset their lean years with their lush years, and hit something like an average taxable income calculated over a period longer than a year.
NOL deductions can also be useful for start-ups, especially the deferral of deductions to future years, which is currently indefinite. Startup companies that focus on creating a new product or technology may initially go through many years of investment and operation before the company’s revenue exceeds its annual expenses. Without the NOL carryover deductions, these businesses would not be able to take advantage of the deductions accumulated over the first few years before achieving stability and profitability. As the US economy is increasingly driven by companies that started as startups in the last 15-20 years – Airbnb, Tesla, Uber, etc. -, it is obvious that there are significant economic advantages in being able to defer the first losses.
NOLs also encourage businesses to maintain and/or revamp their operations during an economic downturn. When businesses face difficult times, either due to an unexpected economic cycle or due to national economic conditions such as the 2008 financial crisis or Covid-19, they can take comfort in the fact that NOLs occurring during these periods can be deferred to more profitable periods. coming. NOLs can provide some assurance that can help prevent companies from making drastic decisions to downsize operations or downsize their workforce.
Congress uses NOLs as a political tool, so the law regarding NOLs changes. For example, to help spur the economic stimulus needed in response to the dot-com crash and ensuing recession, Congress passed legislation in 2002 authorizing a five-year temporary deferral period – an extension of the window two-year carry-back then in effect. This extended deferral was available for NOLs occurring in the 2001 and 2002 tax years. Later, in response to the Great Recession beginning in 2008, Congress again created a temporary extension to the NOL deferral rule. This allowed taxpayers to choose to carry forward certain losses that occurred in 2008 and 2009 for three, four or five years.
Then, in 2018, the Tax Cuts and Jobs Act of 2017 (TCJA) made NOLs subject to a 20% haircut. This means that they can only be used to offset up to 80% of taxable income and cannot be carried forward to offset taxable income from previous years, but can be carried forward indefinitely – hereafter, the general NOL rule. Prior to 2018, NOLs could be deferred for up to two years and deferred for up to 20 years without a discount. Abandoning rollback reduces the effectiveness of NOLs in terms of their usefulness and ability to help businesses survive a downturn. Under the general NOL rule promulgated by the TCJA, struggling businesses will also no longer be able to use NOLs to obtain prompt refunds.
Presumably recognizing these NOL benefits, on March 27, 2020, as part of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), Congress retroactively amended and expanded the general NOL rule for certain years. Under the CARES Act, NOLs occurring in the years 2018 through 2020 can be carried over for five years, and the 20% NOL haircut is temporarily suspended for NOLs carried over to years beginning before 2021.
As the above illustrates, Congress has shown that it is willing and able to deviate from the general NOL rule. Yet important questions remain; for example, whether improving the NOL tool for specific purposes is as effective as having a general stable rule and whether other tax reliefs may be more effective for specific events.
By comparison, the Employee Retention Credit (ERC), also introduced by the CARES Act, is a form of stimulus providing more direct relief to struggling businesses during the pandemic. The ERC provides relief to businesses that have retained employees during the pandemic, typically by waiving them from paying 50% of certain employer taxes. By directly tying tax relief to a company’s desire to maintain operations and keep members of its workforce employed, the ERC was arguably more effective in helping companies that would otherwise have had to facing pressure to reduce their workforce as a result of the pandemic. .
NOLs can be seen as a broad instrument of financial assistance to businesses in times of economic downturn. But without a requirement to tie NOL relief to a specific business-impacting event that Congress is seeking to help, increasing the ability of all struggling taxpayers to use NOLs is nothing more than a reduction in the overall effective tax rate for companies that could be entirely unaffected by the specific event causing the downturn.
Some of these businesses should fail under the general NOL rule. We suggest more targeted stimuli, such as targeted NOL relief, and credits, such as ERCs. We also advocate for the return of the NOL deferral so that, without having to hope Congress will act, businesses know there is a safety net available. Ultimately, the goal should be to encourage reasonable entrepreneurial risk-taking.
This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Patrick M. “Rick” Cox is a partner in Nixon Peabody’s M&A and Corporate Transactions team and a member of its Tax team. Rick focuses on various tax aspects facing domestic and international businesses and brings significant experience in the areas of capital markets, reorganizations, real estate and private equity matters.
Brian Kenney is a partner in the Corporate practice of Nixon Peabody and a member of its Tax team. He advises corporate clients on tax issues relating to mergers, acquisitions, fund formation, private equity investments and other business transactions, and has extensive experience in advising clients on inbound and outbound tax issues on real estate investments. .
Myra A.Benjamin, also a partner at Nixon Peabody, is a litigator and a member of the firm’s Complex Litigation practice. She represents clients in federal and state courts in numerous commercial disputes, including tax disputes, lender liability, contract disputes, bankruptcy and creditor-debtor, fraud, commercial torts and foreclosures.
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