Have you recently acquired a business that is a corporation, or are thinking of acquiring one this year? If so, then you should examine how changes in the Tax Cuts and Jobs Act (“TCJA”) and the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act have impacted the utilization of net operating losses (“NOLs”) in the context of mergers and acquisitions.
Background
Before the TCJA, which was signed into law on December 22, 2017, taxpayers were permitted to carry an NOL back two years and forward 20 years. Since the TCJA was enacted, for NOLs arising in 2018 or later, taxpayers can no longer carry the NOL back but can carry it forward indefinitely. Moreover, NOLs arising in 2018 or later are limited to 80% of taxable income for the carryover year (i.e., the year in which the NOL is utilized).
The CARES Act, which was passed on March 27, 2020 in response to the COVID-19 pandemic, temporarily relaxed the TCJA’s restrictions on utilizing NOLs to provide taxpayers with greater cash flow. Thus, in addition to indefinite carryforward, the CARES Act permits a five-year carryback period for NOLs arising in 2018, 2019, or 2020 tax years. Additionally, for NOLs arising in these years, the 80%-of-taxable-income limitation is suspended.
Impact and Significance
For tax years beginning in 2018 or later, the TCJA also lowered the corporate tax rate from 35% (the highest bracket) to a flat 21%. As a result, a taxpayer who carries back an NOL arising in 2018, 2019, or 2020 to pre-TCJA tax years (i.e., 2017 or earlier) will recognize a greater cash benefit than carrying the NOL forward to a post-TCJA tax year (i.e., 2018 or later).
For example, suppose a taxpayer has an NOL of $1,000,000 in 2019 that it carries back to 2014. If that NOL is fully utilized in 2014, then it would reduce taxable income by $1,000,000 and thereby generate a refund of approximately $350,000, applying the highest marginal tax rate of 35%. Now, suppose a taxpayer carries that NOL forward to 2020. If that NOL is fully utilized in 2020, then it would generate a refund of only $210,000. Thus, the taxpayer receives approximately $140,000 more in cash by taking advantage of the CARES Act’s modified NOL carryback provisions.
Taxpayers will need to consider these facts and others to determine whether it is more beneficial from a tax perspective to carry the losses back or to carry them forward. In addition, taxpayers filing a consolidated tax return will require special considerations.
Consolidated Returns
In the context of mergers and acquisitions, the tax rules permit an acquiring consolidated group to make an irrevocable “split-waiver” election to relinquish, for all CNOLs attributable to the new member, the portion of the carryback period for which the new member was a member of a prior consolidated group. Thus, this election allows the acquiring consolidated group to elect to waive carrybacks of the newly acquired member to the extent the NOL’s would be carried back to the new member’s former group’s consolidated return.
A split-waiver election must be made in the year in which the new member becomes a member of the consolidated group. If the election is not made by the acquiring group in the year of acquisition, then the group has two choices.
First, it must carry the new member’s allocable share of its CNOL back to pre-acquisition periods, which would result in an unintended tax benefit to the new member’s former group. Second, the acquiring group could make an annual election to forgo the entire group’s carryback. Thus, failing to make the split-waiver election often results in a lose-lose situation for the acquiring group.
New Temporary Regulations
On July 2, 2020, the IRS and Treasury released temporary and proposed regulations that provide a means by which an acquiring group may waive all or a portion of the carryback period for CNOLs attributable to an acquired member for pre-acquisition years. The temporary regulations may be applied retroactively to CNOLs generated in 2018 or later.
First, with the amended statute split-waiver election, the acquiring group can elect to waive any carryback of that portion of the CNOL to periods in which the new member was a member of the former group. Thus, with this election, the former group does not benefit from the acquiring group’s CNOL carryback. This election is made annually and any CNOL carryback that is waived simply carries forward to the succeeding year.
Second, the extended split-waiver election is mostly the same as the amended statute split-waiver election, except it would waive the extended five-year carryback period but not the default carryback period (i.e., zero years). This election may not be as useful for NOLs generated in 2019 or 2020 since the TCJA eliminated NOL carrybacks; as such, there is no applicable default carryback period for those NOLs.
Taxpayers need to act fast; they have until November 30, 2020, to make the alternative split-waiver elections on an amended return.
Effect on M&A Transactions
After the TCJA was enacted, parties to an M&A transaction may not have considered the treatment of the new member’s or the acquiring group’s CNOL carrybacks in the acquisition agreement because carrybacks were prohibited at the time.
Now, given the favorable changes in the CARES Act and the temporary and proposed regulations, an acquiring group should ask itself the following questions:
- Did we make a split-waiver election with respect to an acquisition agreement signed in 2018, 2019, or the first part of 2020?
- If not, then can we make a split-waiver election now? What are the requirements for doing so?
- For acquisition agreements that have yet to be drafted and/or signed, should we include a provision for making a split-waiver election?
For example, if acquisition documents were already drafted and signed but no split-waiver election was made, then the new member’s former group may be entitled to a refund generated by the acquiring group’s activity. Thus, the acquiring group should consider making an amended statute or extended split-waiver election by November 30, 2020 to take advantage of the retroactive election provisions in the temporary regulations.
In such financially challenging times, it is more important than ever to revisit acquisition agreements that were executed during the past few years to determine which party has the right to any tax refunds from CNOL carrybacks. Without a split-waiver election, a new member’s former group may be entitled to your refund. Think fast, though, because the generous election provisions in the temporary regulations have a time-limit.
Legislative changes to the Tax Code and regulations can be both cumbersome and complex for an acquiring group in an M&A transaction. Although reviewing the acquisition documents is a necessary first step, it is equally important to consult with your tax advisor as soon as possible to confirm your qualifications and ensure that you take advantage of the amended and extended election provisions in a timely and accurate manner.
For more information, please contact your compliance team leader and/or any of the following individuals:
Name: Derya Duyum, CPA
Office: Los Angeles, CA
Phone: (949) 623-0501
Email: [email protected]
Name: Meghan Andersson, JD, LLM
Office: Irvine, CA
Phone: (949) 623-0542
Email: [email protected]
Name: Steve Cupingood, CPA
Office: Los Angeles, CA
Phone: (310) 481-7478
Email: [email protected]