With this year’s economic challenges, more businesses than usual may experience losses.
However, for 2020, there are more options for business owners to offset those losses in tax filings under provisions of the CARES Act.
Net operating loss
A net operating loss (NOL) may occur during a tax year in which business deductions exceed income, resulting in negative income. Historically, taxpayers could apply this NOL deduction to prior tax returns, at least two years prior, and in some cases as many as five years. This was referred to as an NOL “carryback.” Alternatively, the taxpayer could apply the loss to future tax returns for a maximum of 20 years. This was referred to as an NOL “carryforward.” Beginning in 2018, the Tax Cuts and Jobs Act (TCJA) eliminated the provision for NOL carrybacks, forcing business owners to apply these losses going forward on tax returns.
The CARES Act makes temporary rule changes
The CARES Act , the pandemic relief bill passed earlier this year, introduced two temporary provisions that expand the rules for using NOLs for tax purposes.
1. NOLs may be carried back to previous tax years
An NOL arising in 2020 can be carried back a maximum of five years and applied to prior tax returns, temporarily lifting the restrictions imposed by the TCJA.*
2. Temporary suspension of income limits.
The CARES Act also temporarily removes the taxable income limitation to allow an NOL to fully offset income. Prior to this change, taxpayers were limited to applying an NOL against a maximum of 80% of taxable income. The 80% limitation will apply again beginning in 2021.
Overall, these two changes allow more flexibility for business owners experiencing operating losses this year.
Consult with a tax advisor before the end of the year
- Business owners with operating losses should consult with their tax advisors before the end of the year to discuss options
- Business owners seeking immediate liquidity may consider carrying back an NOL to prior tax returns. This will generally allow them to receive a refund check from the IRS once the tax filing process has been completed. Business owners need to file IRS form 1045 (for businesses such as sole proprietors taxed as flow-through entities) or form 1139 (for C corporations)
- Other business owners may wish to apply the loss against current income rather than carrying back the NOL. In this case, a Roth IRA conversion may be a good option. The NOL could be used to offset all, or a portion, of the taxable income generated from the Roth IRA conversion.
- Rules for calculating and utilizing NOLs are complicated and require expertise from a qualified tax professional. For additional information, refer to IRS publication 536, “Net Operating Losses (NOLs) for Individuals, Estates, and Trusts.”
- Also, Putnam has published an investor education piece, “Apply a net operating loss to a Roth IRA conversion.”
*Temporary modification to NOL rules applied by the CARES Act also apply to NOLs arising in 2018 and 2019.
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