Clients who own businesses should know that recent years’ upheavals in tax law do more than influence how they pay in income tax. They also changed how they can deduct losses for their business.
Under 2017 tax reform, businesses could have been subject to limitations in excess business losses if their total deductions exceeded their gross income. The more-recent Coronavirus Aid, Relief, and Economic Security (CARES) Act gave a break to business owners who are willing to examine their recent tax situations.
Under CARES, net operating losses (NOLs) generated in tax years beginning after Dec. 31, 2017, and before Jan. 1 of this year may be carried back five years preceding the tax year of such loss; this carryback can be used to offset 100% of taxable income in those years. The latest relief, the American Rescue Plan Act of 2021, also extended the limitation on excess business losses through tax year 2026.
The carryback rule is automatic unless an election is made to forgo the carryback period, in which case the NOLs would be carried forward, added Steven A. Henderson, Norman, Okla.-based managing member and CPA at Harrison Henderson Public Accountants and founding member and financial advisor at Union Financial Advisors.
“Most business owners have become aware of this rule change, especially those hit hardest by the Covid crisis. They’re grateful to have an unexpected cash resource to help ... while they wait for business to return to a more normal level,” Henderson said.
Still, experts remain almost indispensable in this kind of tax planning. “The rules are very complex and have changed multiple times,” said Craig Richards, director of tax services at Fiduciary Trust International in New York. “The CARES Act and the American Rescue Plan Act have contributed to the complexity.”
The allowed deduction is adjusted annually for inflation. In 2021, the deductible excessive business loss is $262,000, or $524,000 for joint filers. For example, a single taxpayer who has a business loss of $1 million can deduct $262,000 of the loss, leaving $738,000 to be carried forward as an NOL.
“Make sure you’re factoring in the [allowed deduction]. That’s why it’s ‘excess’ losses,” said Bill Smith, Bethesda, Md.-based managing director for CBIZ MHM’s National Tax Office.
Federal Form 1045 is used to carry back 2020 losses, according to the “Tax Warriors” blog of Drucker & Scaccetti in Philadelphia. The form must be filed within one year of the NOL occurrence. The due date for filing 1045 for 2020 losses would be Dec. 31, 2021, for instance. If a client misses the deadline to file the 1045, they must file amended tax returns for each carryback year.
By amending previous returns, taxpayers with NOLs in tax years 2018 to 2020 can carry them to earlier years—when federal income tax rates were higher—and potentially improve a past tax situation.
Before doing that, many factors must be considered, “including the likelihood that future income tax rates are going to significantly increase under President Biden’s administration and a Democrat-controlled Congress,” said James McGrory, CPA at Drucker & Scaccetti. “While it’s true that NOLs could become more economically valuable if carried forward, doing so comes with the cost of foregoing the ability to create immediate cash flow from carryback claims.”
Other factors include the effect on prior tax credits used during a carryback year; the higher corporate tax rates prior to 2018; expected business profits and taxable income going forward; the likely increase in future marginal tax rates for individuals and corporations; and how a taxpayer’s state treats NOLs.
“Assumptions required to analyze this issue can make it hard to know what to do,” Henderson said. “But if the size of the refund is significant, it generally makes sense to file the amended returns to request a refund of prior-year taxes.”