There are two main provisions included in the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) that small contractors should focus on for immediate tax benefits. They include the reinstatement of net operating loss (NOL) carrybacks and the temporary suspension of the excess business loss rules.
Effective January 1, 2018, the Tax Cuts and Jobs Act (TCJA) eliminated taxpayers’ ability to carry back NOLs and limited the use of carryforwards to offset only 80% of taxable income. The TCJA also limited individual taxpayers’ net business losses to offset non-business income up to $250,000 for single-filers, and $500,000 for married-filing-joint filers.
The first significant provision of the CARES Act is the allowance for NOLs arising in a taxable year, beginning after December 31, 2017 and before January 1, 2021, to be carried back to the previous five tax years – beginning with the earliest year first. In addition, the act suspends the 80% of taxable income limitation through the 2020 tax year.
Individual taxpayers may claim a refund relating to an NOL carryback by either filing an amended tax return (Form 1040X) for the carryback year or by filing an application for a tentative refund (Form 1045). The deadline to file an amended return to claim a refund for an NOL carryback is three years from the original due date of the return for the year the NOL was generated. If the return was extended, the deadline would be three years from the date the return that generated the NOL was actually filed. For example, if an individual taxpayer incurred a net operating loss in 2018, the taxpayer has until April 15, 2022 (or until three years after the date the 2018 return was actually filed if the return was extended) to file an amended refund claim for the carryback year.
Taxpayers are now allowed to elect to waive the entire carryback period with respect to an NOL arising in 2018, 2019 and 2020. The election generally must be made by the due date, including extensions of the taxpayer’s federal income tax return for the year the NOL arose. If such an election is made, the NOL must be carried forward.
In the case of an NOL arising in 2018 or 2019, Revenue Procedure 2020-24 provides that the election to waive the carryback period must:
The second significant provision of the CARES Act to focus on is the repeal of the net business loss limitation for years beginning before January 1, 2021. As a result, individual taxpayers that were subject to an excess business loss limitation in 2018 and/or 2019 should consider amending their 2018 and/or 2019 income tax return(s) to remove the limitation. The act also changed the calculation of an excess business loss. As a result, when these rules come into effect in 2021, an excess business loss will be determined without including:
In addition, the amount of net capital gain included in the excess business loss calculation may not exceed the lesser of the taxpayer’s net capital gain attributable to trades or businesses or total net capital gain.
The reason these provisions may be especially applicable to small contractors is that, with the passage of the TCJA, the average annual gross receipts threshold to be considered a small taxpayer was increased from $10 million to $25 million. This change prompted many contractors to take advantage of the automatic change procedures and move to either the full cash method or the completed contract method. As a result, many small contractors that changed methods generated significant tax losses for the 2018 and 2019 tax years. At the time, those losses may have been limited by the excess business loss rules. With the CARES Act’s revisions, a taxpayer would be allowed to amend those tax returns and take advantage of 100% of the losses (subject to basis limitations), creating an NOL that would be eligible for carry back up to five years. That NOL would be very valuable, not only because of the immediate cash flow benefits, but because the carryback gives taxpayers an opportunity to secure permanent tax savings by using losses to offset income generated in higher tax rate years. For example, an individual NOL from 2018 can be carried back to offset income from 2013 that may have been subject to a top rate of 39.6% rather than carried over to 2019 when that income could be subject to an effective tax rate of 29.6%, after factoring in the Section 199A deduction. Taxpayers will still want to consider the tax environment going forward and whether income in future years will be subject to higher tax rates than income in the carryback period. In some cases, the taxpayer may prefer to waive the carryback.
It’s crucial that all small contractors review their 2018 and 2019 tax filings to determine if there is a benefit to applying any of the CARES Act’s provisions. The reinstatement of NOL carrybacks, and the temporary suspension of the excess business loss rules are two of the more significant provisions that all small contractors should focus on, especially in the scenarios discussed above.