NOL deductions may be protected with change of fiscal year
TAX ALERT |
Authored by RSM US LLP
Corporations’ ability to reduce their taxable income by 100% of their net operating loss (NOL) deductions is scheduled to ‘sunset.’ The Tax Code will permit certain NOL deductions to offset only 80% of taxable income for taxable years beginning after Dec. 31, 2020.1 Many corporations are expecting losses in 2020 due to the COVID-19 pandemic, and these corporations may be looking for ways to fully utilize these losses to offset future taxable income. One way may be for the corporation to change its taxable year to extend its ability to offset 100% of its federal taxable income with NOL deductions.
Eighty percent NOL deduction limitation
Congress enacted the limitation of certain NOL deductions to 80% of taxable income in 2017, as part of the Tax Cuts and Jobs Act (TCJA) legislation. The TCJA made the new 80% limitation applicable to deductions for tax years beginning after Jan. 1, 2017 of NOLs generated in years beginning after Dec. 31, 2017 (Post-2017 NOLs).
In response to the COVID-19 pandemic, Congress suspended implementation of the 80% limitation in March of 2020, as part of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act).2 As a result of this suspension, the Tax Code now makes the 80% limitation applicable to NOL deductions claimed for taxable years beginning after Dec. 31, 2020. The IRS has subsequently issued guidance addressing the 80% NOL deduction limitation.3
Eighty percent NOL deduction limitation kicks in based on financial reporting year (fiscal year) and taxable year
As it stands now, the 80% limitation on deduction of Post-2017 NOLs will apply to taxable years beginning after Dec. 31, 2020. A corporation using the calendar year as its fiscal year and taxable year would apply the 80% NOL deduction limitation to a year beginning on Jan. 1, 2021.
If the corporation expects significant income in 2021 – for example, because its business generally is profitable now, or because a business unit will be sold in 2021 – its Post-2017 NOLs will as a result not be able to completely offset that income, no matter how large the corporation’s NOL carryforward. Because a corporation’s taxable year generally follows its financial reporting year,4 a change to the corporation’s fiscal and taxable year-end might mitigate this unfavorable result.
Changing taxable year automatically requires change in financial reporting year
Would a corporation changing its fiscal year-end to, say, Nov. 30, 2020, preserve full deductibility of its NOLs for a taxable year beginning Dec. 1, 2020? A fiscal year-end change will not always result in a taxable year-end change. Although a corporation’s taxable year generally follows its fiscal year, as noted above, there are exceptions to this general rule.5 If one of those exceptions apply to a corporation, the corporation would either be precluded from changing its taxable year or would only be able to change its taxable year with special IRS approval requiring IRS scrutiny of the corporation’s specific facts and business purpose. If the exceptions do not apply, a change to a corporation’s fiscal year can result in a matching change to its taxable year.
Changing fiscal year
A corporation may find that the change in fiscal year generally necessary for a change to its taxable year would be burdensome, undesirable or infeasible. To effect a taxable year change, a corporation generally must match its books and records, including its financial statements and creditor reports, to the requested tax year.6 Applying a fiscal year change may be burdensome, depending on factors such as the complexity of the corporation’s operations, contractual obligations and books and records. The preferences and needs of shareholders and other stakeholders should be considered and may make a change of fiscal year either desirable or undesirable. The potential impact to the corporation’s audit-related (or other assurance-related) procedures also should be considered.
Changing taxable year
IRS approval of a corporation’s change of annual tax accounting period to conform with the corporation’s fiscal year typically is available under Rev. Proc. 2006-45.7 A corporation complying with this revenue procedure is granted ‘automatic’ IRS approval of its year-end change. ‘Automatic,’ in this context, means that the corporation may change its taxable year-end without any action on the part of the IRS. This automatic year-end change procedure can make the federal income tax aspects of changing a corporation’s taxable year relatively simple. Under certain circumstances, however, this procedure is not available. For example, the automatic procedure is unavailable and special permission from the IRS generally would be required to change a corporation’s year-end if:
- The corporation has changed its taxable year-end within the past 48 months;8 or
- The corporation holds an interest in either a pass-through entity or a controlled foreign corporation (CFC), and the corporation’s year-end change would result in a greater deferral period for the corporation’s taxable income from the pass-through entity or CFC than the deferral (if any) that already applies.9
Additional tax considerations may be triggered by a change to a corporation’s year-end. These may include, for example:
- If a corporation holds a majority interest in a partnership, a change in the annual accounting period of the corporation may trigger a cascading effect for the accounting period of the controlled partnership.10
- A change in the annual accounting period of a corporation may result in some acceleration of the corporation’s recognition of an unfavorable section 481(a) adjustment relating to a change of accounting method;11
- If a corporation generates an NOL (or a capital loss) in the short period resulting from the year-end change, carrying that NOL (or capital loss) back to obtain a refund of federal income taxes paid would be unavailable in certain circumstances;12 and
- If a corporation qualifies for certain tax credits in the short period resulting from the year-end change, those credits generally may not be carried back to obtain a refund of federal income taxes paid.13
In 2018, the IRS restricted a CFC’s ability to change its taxable year to defer the section 965 ‘transition tax’ on accumulated CFC earnings enacted in the TCJA.14 This transition tax represented substantial sums in many cases. Congress had granted the IRS special regulatory authority with respect to the section 965 transition tax, and the legislative history specifically mentioned tax year changes. The IRS’ restriction on these accounting period changes was a special case, given that the transition tax was a one-time event and Congress expressly recognized the appropriateness of restricting taxable year changes. However, given that the IRS has broad authority in the area of taxable year-end changes, it is conceivable that the IRS may seek to counteract preservation of the 100% NOL deduction for corporations that change their taxable year-ends.
Corporations that can change their fiscal years may seek to preserve the ability to offset their NOLs against 100% of their taxable income. Changing the taxable year-end may provide significant tax benefits to a corporation that has Post-2017 NOL carryforwards and expects significant income in 2021. However, a corporation may find that the change in fiscal year generally required to effect a taxable year-end change would be burdensome, undesirable or infeasible. Corporations should consult with their tax advisors regarding any potential change in taxable year, and should consider the tax and non-tax ramifications of making a change.
1Section 172(a)(2). For a corporation with a 52-53 week taxable year ending with reference to the end of December, the 80% limitation applies to taxable years after the year ending with reference to the end of December 2020. See Reg. section 1,441-2(c).
2Notably, the CARES Act also permitted corporation to carry NOLs back and obtain tax refunds. We do not discuss NOL carrybacks in this article, but have discussed them in numerous prior Tax Alerts, including, for example: CARES Act delivers five-year NOL carryback to aid corporations, Carrying back consolidated net operating losses under the CARES Act, CARES Act NOL carryback: State DPAD and international considerations, New IRS website guidance regarding CARES Act NOL carrybacks and AMT, IRS further explains extended NOL carryback claim period, The impact of NOL carryback on the foreign tax credit.
3The IRS’ guidance addressing the 80% NOL deduction limitation includes the explanation in IR-2020-138 (July 2, 2020) and regulations addressing consolidated groups of corporations released in T.D. 9900 (July 8, 2020) and in T.D. 9927 (Oct. 27, 2020). Our prior Alerts discussing these developments include: New rules for consolidated group NOL carryback waivers, and New consolidated group net operating loss (NOL) rules proposed.
4See sections 441(b)(1) and 441(c) and Reg. section 1.441-1(b)(1)(iii). For the sake of simplicity, this article uses the term “fiscal year” to the “annual period … on the basis of which the taxpayer regularly computes its income in keeping its books,” which the Tax Code and regulation call the “annual accounting period.” See section 441(c) and Reg. section 1.441-1(c). By contrast, the Tax Code and regulations generally exclude annual accounting periods ending in December from the term “fiscal year.” See section 441(e) and Reg. section 1.441-1(c).
5See Reg. sections 1.441-1(b)(1)(i) and -1(b)(1)(ii). This article does not discuss these exceptions.
6See Rev. Proc. 2006-45, section 6.02. These requirements specifically apply to effecting a taxable year change under the automatic procedure set out in Rev. Proc. 2006-45.
7Rev. Proc. 2006-45, 2006-2 C.B. 851. This Revenue Procedure applies to corporations that are not S corporations (as defined in section 1361).
8See Rev. Proc. 2006-45, section 4.02(1).
9See Rev. Proc. 2006-45, section 4.02(2). A taxable year-end change raises a number of considerations for a U.S. corporation that owns stock in one or more CFCs.
10See generally section 706(b).
11Recognition of an unfavorable section 481(a) adjustment resulting from a change of tax accounting method generally occurs over four taxable years.
12See Rev. Proc. 2006-45, section 6.06.
13See Rev. Proc. 2006-45, section 6.07.
14See Prior RSM Alert, IRS prohibits changes to accounting periods to avoid transition tax.
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This article was written by Christian Wood, Stefan Gottschalk, Ryan Corcoran , Andrew Mizer and originally appeared on 2020-10-30.
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