The CARES Act included several provisions allowing companies to claim net operating losses for past tax years, temporarily reversing some of the limitations in the Tax Cuts and Jobs Act. Those changes are likely to encourage more companies to pursue mergers and acquisitions once the market recovers from the economic downturn from the novel coronavirus pandemic.
Under the Tax Cuts and Jobs Act of 2017, net operating losses could no longer be carried back to prior tax years to offset taxable income, though they could be carried forward indefinitely from 2018 and on.. The CARES Act, which Congress passed in March to aid the economy in the wake of the COVID-19 pandemic, allows any NOL generated in a taxable year starting Dec. 31, 2017 and ending Jan. 1, 2021, to be carried back five years
“The whole purpose of the CARES Act was to put cash back in the hands of business taxpayers, and when I’m talking about business taxpayers, I’m not just talking about corporations,’ said Randy Schwartzman, national tax office corporate and mergers and acquisitions technical practice leader at BDO. “There are NOL provisions for individuals and trusts and estates, S corps and LLCs.”
He noted that they can now take advantage of the lower tax rates that came about as a result of the Tax Cuts and Jobs Act. He sees benefits for companies doing MA deals, especially now that the corporate tax rate is 21 percent. “Before the Tax Cuts and Jobs Act, the TCJA, the rates were in a progressive system where they gradually increased until they got to a high average rate of 35 percent,” he said.
The NOLs can be leveraged to get higher tax refunds, and it can be combined with technical corrections in the CARES Act that allow improvements to businesses like restaurants and retail stores to be written off more quickly. “NOLs, or net operating losses, are true economic losses that taxpayers are seeing because of the decrease in revenue,” said Schwartzman. “But we try to increase the NOL over and above the true economic loss to make it greater so we have more money to carry more loss back and get more refunds. The TCJA came into effect in 2018 and forward, so when we were doing 39-year depreciation on qualified improvements, we’re now going back. You have two choices: You can catch up on 2018 and do what you did in 2019 and do a [Form] 3115 change in method, and take that on your 2019 return and go back four years to 2014, or you can amend your 2018 return and take the deduction in that year as far as 2013, five years back, and get a refund.”
The changes in the CARES Act undo some of the offsets in the TCJA that aimed to keep the overall budget impact of the legislation to around $1.5 trillion. That budget impact has now been dwarfed by the $2.2 trillion CARES Act.
“Before the Tax Cuts and Jobs Act, the first major piece of legislation that came into play in Trump’s administration, there was a two-year NOL carryback and the 20-year carryforward,” said Schwartzman. “The TCJA paid for the lower corporate tax rate, which was meant to make American businesses more competitive, with some givebacks, and the givebacks eliminated the carryback. They said you could carry forward indefinitely, but when you carry forward your loss from 2018 on, you could only use 80 percent of the loss against taxable income. So if your taxable income was a million in a particular year, you could only use $800,000 in NOL no matter how much you have.”
The CARES Act now opens up the possibility of doing carrybacks again, and that could spur companies to acquire others for their net operating losses.
“What the CARES Act did was say, ‘OK, we’re going to do a do-over from the TCJA, and we’re going to make the TCJA rules effective in 2021, and from 2019 to 2018 we’ll give you a five-year carryback and unlimited carryforward, and we’re not going to have this 80 percent rule that limits the amount of the deduction that you can take.,” said Schwartzman. “So we now have a five-year carryback and we have an unlimited carryforward, and if you use the NOL carryforward before the end of 2021, you don’t have to worry about the 80 percent limitation. The benefit of going back five years is the rates were much higher back then, and if you do an NOL carryback and you do it on a Form 1139 for corporations and a Form 1035 for individuals you get the refund in up to 90 days of filing, whereas under normal rules, if you do a 1040X for individuals or a 1120X for corporations, it can take several months to get your refund. So corporations that are acquisitive have to think about whether or not they want to carry back.”
He sees several options for companies. “If you’re going to go out and buy a company, there are basically four ways to do it,” said Schwartzman. “You do a stock deal or an asset deal. You do a taxable deal or a tax-free deal. In any type of stock deal, where you buy the stock of another company, whether you issue your own stock for stock, that’s a tax-free deal, or you issue cash for stock, that’s a taxable stock purchase. When the group has a net operating loss, it allocates the total loss of the group to all of its members. So some have income and some have losses. You apportion the consolidated loss based on all the loss corporation’s contribution to the overall loss.
“It’s like a formula,” he explained. “And the formula goes: a portion of consolidated NOL is equal to separate members’ NOL divided by the sum of all loss members’ NOL times the consolidated NOL. So once the target enters your group and it has a loss and — let’s say everybody has losses due to the pandemic and revenue being down — if the group carries back its NOL, it has to carryback to a different group because you can’t take in a stock deal a subsidiary that you acquire as) a target and carry back to your previously taxed income. You have to carry it back to where it found its returns in the last five years. When that happens, if we bought that subsidiary out of a consolidated return group, we need to ask permission because a common parent of that group gets permission to keep the refund.”
That would normally be memorialized in the stock purchase agreement. “A stock purchase agreement, when you buy a stock, either says, ‘You will agree not to carry back to that group, or if you carry back to that group, you can keep the refund. Or if you carry back to that group, we keep the refund.’ If it’s silent, you would have to negotiate it, or technically they’re entitled to keep the refund, the common parent of the group you bought it from,” Schwartzman explained. “And so we look at the stock purchase agreement, and if we see that we can’t keep the loss from the target that we acquired, we can do what’s known as a split carryback waiver. It’s under Treasury rec section 1.1502-21(b)(3). And what it does is it says that if our group has a loss, we can carry back that loss. But with respect to the target that we just bought, we’re not carrying it back. We’re carrying it forward.
“You first apportion the loss to each member,” he added. “If the member wasn’t a member in the carryback period, we have to carry it back to a different period where it filed its own return. If it was a standalone owned by individuals, we see what the stock purchase agreement says as to who keeps refunds in the pre-acquisition period. But if it was owned by a corporation, we have to see who gets to keep the refund, and then we make a decision whether to waive the carryback for that target. Just that target, not our whole group. We split it and we carry back everything for our group, but for the target, we waive the carryback period, the five-year period, and we elect to carry forward only.”
He cautioned that if a taxpayer carries forward a pre-existing loss, they could be subject to change-in-ownership rules, but sometimes they can go back and make changes. “Let’s say you bought the stock in 2019,” said Svhwartzman. “You may not want to be subject to the change-in-ownership rules, which limit the NOLs going forward. But the change-in-ownership rules under Section 382 do not apply to carrybacks. So a lot of times we’ll want to carry back. Now we have to compare that to buying a sub in an asset deal. An asset deal is where the assets of the target end up inside of the buyer. And the way that can happen is you can just purchase the assets. You agree to sign an asset purchase agreement and you pick the tangible and intangible assets and the liabilities you are willing to assume and buy those assets, or you can buy the stock and make a joint deduction under section 338(h)(10) or 336(e) to treat the stock deal as an asset deal, or you can make an election under 336(e). It’s a unilateral election. You as) the buyer to treat it as an asset deal. And when you have to treat it as an asset deal, even though you bought the stock, you’re under the asset rules.”
Another area to consider for portfolio companies would be add-on acquisitions that are structured as “actual” or “deemed” asset sale transactions, that is where a Section 338(h)(10) or Section 336(e) election is made, for income tax purposes. “This is especially true in a capital-intensive industry as most tangible assets can qualify for 100 percent bonus depreciation, thus producing an immediate tax shield for the acquiring group,” said Schwartzman..
He noted that when a portfolio company acquires a target company in a taxable or tax-free stock acquisition, without a deemed asset sale election, it must determine how much of the loss is attributable to the target company. “Under Treas. Reg. Section 1.1502-21(b)(2)(i), only the portion of a consolidated NOL that is attributable to a subsidiary that joined the consolidated group can be carried back to a separate return year of that subsidiary or to a consolidated return for a different group of which the subsidiary was a member. If this result is not desired, consider an election to forgo the carryback,” he wrote. “These rules generally allocate the loss to each member of a consolidated return group based on their relative contribution to the overall NOL of the group.”
The common parent may consider an election to forgo the carryback for the target or it could waive the carryback for the entire consolidated NOL, Schwartzman noted. “Alternatively, a split carryback election is available to forgo the carryback of the consolidated NOL attributed to certain members to prior year returns of a former group (see Treas. Reg. Section 1.1502-21(b)(3)(ii)(B)),” he wrote. “It should be noted that an acquisition of a target company into a consolidated return group where a Section 338 or Section 336(e) election was made cannot be carried back to the earlier year of the ‘old’ target since the ‘new’ target is considered an offspring of the acquiring member. 
“The deemed fiction is that a new subsidiary (the ‘offspring’) is deemed to have been formed with the cash first that was used to acquire the stock of the target, and the subsidiary used that cash to purchase the assets of the target entity,” he added. “The ‘old’ target entity is then deemed to have recorded a gain or loss on the disposition of its assets, which it then distributes in liquidation. As a result, the ‘old’ target goes out of existence, and never actually joins the acquiring company’s group from a fictional income tax perspective, so there is nothing to no entity in which to carry back the NOL.”
In a pure stock purchase, Schwartzman pointed out, one without a deemed asset sale election, a consolidated NOL is apportioned to a new group member, and it could be carried back to a prior taxable year when the subsidiary was a member of a different consolidated return group. “In this situation, any refund resulting from the carryback occurs at a time when the target stock was not owned by the buyer,” he added. “As a result, any refund that is generated would be paid to the common parent of the selling consolidated return group under the consolidated return regulations.”
If the refund is made to the common parent of another group, the stock purchase agreement (SPA) could determine whether the common parent of the other group is contractually required to pay that refund over the buying group, Schwartzman pointed out. “If the common parent of the other group is entitled to keep the refund, the parent of the portfolio company may wish to forgo the carryback claim for just that target subsidiary by making a split carryback waiver election,” he added. “If it was not covered in the SPA, a tax allocation agreement may discuss the division of tax benefits.”
A consolidated return group is required to allocate its share of losses to those entities that contributed to the overall consolidated return loss, he emphasized. “If a loss is allocable to a recently acquired stand-alone target, it may be possible to carry back that loss to the earlier returns of the target if that entity was acquired in a stock purchase,” Schwartzman added. “The Stock Purchase Agreement should be reviewed to verify whether the “old” or the “new” owners would be entitled to keep the refund.”
When a target company is acquired in a tax-free asset reorganization (that is, the target transfers its assets to another entity and does not survive as a separate taxpayer), then Treasury Regulations section 1.381(c)-1 prevents a successor in those transactions from carrying back an NOL to a separate return year of the target predecessor, he noted. “These types of transactions normally involve statutory mergers into the common parent, a disregarded entity of the common parent, or an existing or newly-created subsidiary of the consolidated return group,” said Schwartzman.
In addition, loss corporations that are acquired in a stock acquisition should consider the impact on the availability of NOLs if an ownership change as defined under Section 382 is expected to occur as it could limit the benefit of an NOL carryforward, he noted. “Since this provision is generally not applicable to carrybacks, it makes sense to do the carryback claim if available,” he said. “If the target’s losses would not otherwise be limited in the carryback year but the common parent of the portfolio company is not legally entitled to the refund, perhaps some form of negotiation will be in order with the sellers to possibly split a refund from the allowance of a carryback claim to the predecessor group or for the benefit of the predecessor owners.”