Due to the coronavirus (COVID-19) pandemic, many businesses are losing money in amounts not seen since the Great Depression. Even if the economy comes back late in 2020, it seems likely that thousands of businesses, large and small, will suffer losses for years. Fortunately, Congress has acted to enable business owners to get tax relief for their losses. The Coronavirus Aid Relief and Economic Security Act (CARES Act) allows businesses to fully deduct net operating losses—not just for 2020, but for 2018 and 2019 as well.
A net operating loss, NOL for short, occurs when you have more tax deductions than taxable income. NOLs can occur in businesses of all sizes, from small sole proprietorships to big corporations. If you're a sole proprietor, your business losses are always deducted on your personal tax return. If you're the owner or co-owner of a business organized as a partnership, limited liability company (LLC), or S corporation, any losses pass through the business to you and any other owners. The owners then deduct their share of the losses on their individual returns. But, such losses may only be deducted to the extent of your basis in your ownership interest in the partnership, LLC, or S corporation. If you're the shareholder in a C corporation, any losses are deducted by the corporation, not by the shareholders.
You can always deduct an NOL against other income you have for the year, such as investment income or salary income. This reduces your taxable income for the year and lowers your tax bill. In the past, business owners could also “carry a loss back”—that is, they could apply a NOL to past tax years by filing an application for refund or amended return. This enabled them to get a refund for all or part of the taxes they paid in prior years—a huge help in times of economic stress.
However, the Tax Cuts and Jobs Act (TCJA) changed the rules for NOLs occurring in 2018 and later, making them harder to deduct. The TCJA eliminated all carrybacks of NOLs. It also allowed taxpayers to deduct NOLs only up to 80% of taxable income for the year (not counting the NOL deduction). Any unused NOL amounts had to be carried forward and deducted in any number of future years.
The CARES Act passed by Congress has temporarily restored the old NOL rules and even made them more favorable.
First, NOLs occurring during 2018, 2019, and 2020 may be used to offset 100% of income earned during those years, instead of just 80%.
If you still have all or part of your NOL for 2018, 2019, or 2020 left, you can now deduct it against taxes you paid in past years, resulting in a refund from the IRS. The CARES Act allows NOLs incurred during 2018 to 2020 to be carried back five years (rather than the two years allowed under pre-TJCA law). The carried back NOLs are not subject to the 80% income limitation. Thus, if they are large enough, they can completely eliminate the tax liability for these years—again, resulting in tax refunds.
Ordinarily, an NOL must be carried back to the earliest year within the carryback period in which there is taxable income, then to the next earliest year, and so on. For example, a 2020 NOL would first be used to reduce 2020 taxable income. Then it would be carried back to reduce taxable income for 2015 (the earliest year allowed) and the tax due for that year. If the 2015 tax due is reduced to zero, any remaining amount of the NOL is applied to 2016, then 2017, and so on through 2019. Any amount left over would then be carried forward to reduce taxable income in 2021 and any number of future years.
The decision to carry back a NOL is made on a year-by-year basis. For example, if you have NOLs for 2018 and 2019, you could carry back the 2018 NOL but elect to only carry forward the 2019 NOL. The decision whether to carry back a 2018 or 2019 NOL must be made by October 15, 2020. The decision whether to forego a 2020 NOL carry back will have to be made by October 15, 2021.
You can only take advantage of a NOL after you’ve completed and filed your tax return for the year involved. The return will show the amount of the NOL. Your return for 2018 should have already been filed. If you have a NOL for 2019 and have not filed your return for the year, you should do so as soon as possible. You won’t be able to take advantage of a 2020 NOL until the 2020 tax year ends and you file your 2020 tax return, which will be in early 2021. Thus, the earliest you can expect a tax refund for a 2020 NOL is likely April or May 2021.
There are two ways to claim a refund for prior years’ taxes. The quickest way is to file IRS Form 1045, Application for Tentative Refund. (Corporations file Form 1139, Corporation Application for Tentative Refund.) If you file Form 1045, the IRS is required to send your refund within 90 days. Ordinarily, you must file Form 1045 within one year after the end of the year in which the NOL arose. However, the IRS has extended the deadline for filing Form 1045 for 2018 NOLs by six months. Thus, you have until June 30, 2020 to file Form 1045 to apply your 2018 NOL to the prior five years. Include on the top of Form 1045 “Notice 2020-26, Extension of Time to File Application for Tentative Carryback Adjustment.” You must file the form by fax--do not send postal mail to the IRS at this time. For details, see the IRS Temporary procedure to fax certain Forms 1139 and 1045 due to COVID-19 page.
The other way to deduct a NOL is to amend your tax return for the year involved by filing IRS Form 1040-X, Amended U.S. Individual Income Tax Return. You have three years after the end of the tax year to file Form 1040-X.
Calculating a NOL and completing Form 1045 or 1040-X is complex because certain deductions, such as the personal deduction, must be added back to determine the deductible NOL amount. It's wise to seek help from a tax professional.
Another change made by the Tax Cuts and Jobs Act was to limit deductions of “excess business losses” by individual business owners during 2018 through 2025. Married taxpayers filing jointly could deduct no more than $510,000 per year in total business losses. Individual taxpayers could deduct no more than $255,000. Unused losses had to be deducted in any number of future years as part of the taxpayer’s net operating loss carryforward. The CARES Act has completely eliminated this limitation for losses incurred during 2018 through 2020. Thus, taxpayers with very large losses for any of these years can deduct them in full.