Understanding the limitation on future use and carryback of NOLs
This article was updated on March 29, 2018 to reflect recent developments by the Senate Finance Committee.
The newly enacted Tax Cuts and Jobs Acts (the “Act”) provides sweeping changes to corporate tax law, including major changes to the utilization of net operating losses (NOLs) for corporate taxpayers. For NOLs, the carryover and carryback rules change and a new limitation on NOL utilization is added.
Under prior section 172, NOLs were generally eligible for a two year carryback and twenty year carryforward. Further, NOL carryovers and carrybacks could fully offset taxable income of the taxpayer if not otherwise limited under the Internal Revenue Code (e.g., section 382 limitations). Both of those rules have now changed. Application of these changes may differ from what was expected based upon the plain language of the amended statute.
Carryover and carryback provisions
The amendments to section 172 disallow the carryback of NOLs but allow for the indefinite carryforward of those NOLs. Pursuant to section 172(e)(2) of the statute, the amended carryback and carryover rules apply to any NOL arising in a taxable year ending after Dec. 31, 2017.
The disallowance of NOL carrybacks is not surprising and had been a part of both the House and Senate plans. Its effective date may be surprising, however, particularly for fiscal year corporations reporting an NOL for a tax year that includes Dec. 31, 2017 and ends after Dec. 31, 2017. For example, under a plain reading of the statute, a corporate taxpayer projecting an NOL for a fiscal year ending March 31, 2018 appears subject to the NOL carryback disallowance because the tax year ends after Dec. 31, 2017.
Initially, the new NOL carryback rule effective date may appear confusing for a few reasons. First, there are two separate effective date provisions for the new NOL rules (see separate effective date for NOL limitation below). Having two effective dates for such closely related subject matter is somewhat unusual. Second, the effective date provisions of the bill originally passed by the House of Representatives were different than the enacted effective dates. Third, the Act’s legislative history contains an inaccurate description of the effective dates in the bill originally passed by the Senate. Its description may be indicative of legislative intent but it conflicts with the bill’s text. Speaking at a conference, one counsel to a Senator on the Finance Committee stated that in his view the legislative history reflects what the Senate intended, and the enacted rule does not.
Absent a technical correction or further change to the statute, taxpayers should follow the Act’s clear effective date language. It plainly states that the law is effective for NOLs arising in tax years ending after Dec. 31, 2017. If this statutory language was a mistake, Congress should correct it.
NOL income limitation
In addition to the carryover and carryback changes, the Act also introduces a limitation on the amount of NOLs that a corporation may deduct in a single tax year under section 172(a) equal to the lesser of the available NOL carryover or 80 percent of a taxpayer’s pre-NOL deduction taxable income (the “80-percent limitation”). Interestingly, this limitation applies only to losses arising in tax years that begin after Dec. 31, 2017 based upon section 172(e)(1) of the amended statute. As a result, taxpayers with historic NOLs (or fiscal year taxpayers projecting a current NOL) may see a silver lining around the cloud of this limitation, because for NOLs generated in tax years ending before Jan. 1, 2018, the historic rules appear applicable.
For example, if calendar year corporation XYZ has $100 million in NOLs generated through December 31, 2017 and incurs a $20 million NOL in the tax year ending Dec. 31, 2018, the applicable NOL rules would require XYZ to track the 2017 and prior NOLs separately from the 2018 NOL, which is subject to the limitation. If in 2019 XYZ generated $100 million in income, it would appear that the entire $100M of 2017 and prior NOL would be available. If on the other hand, XYZ generated $110 million in income the answer appears less clear. Could XYZ argue that they should be able to offset the additional $10M in income with $8 million of NOL, or is the utilization of the 2018 NOL zero because 80 percent of $110M is $88 million, which is less than the $100 million of NOL applied to the income in the current tax year? A plain reading of the statute would appear to place a limitation of $0 on the 2018 NOL.
Like many tax changes made by the Act the amended NOL provisions appear to have winners and losers. Barring a change, fiscal year taxpayers with years ending after Dec. 31, 2017 that incur an NOL appear unable to carryback that loss. On the other hand, it appears that NOLs incurred in years beginning prior to Jan. 1, 2018 avoid the 80 percent income limitation and remain fully available, barring other limitations, to offset taxable income.
Now more than ever you should consult a tax adviser when applying NOL deduction and carryover rules.