When Congress passed the Tax Cuts and Jobs Act in late 2017, the Internal Revenue Code (“Code”) experienced a major adjustment. In addition to numerous, noteworthy changes in the Code, the treatment of “net operating losses” is now subject to different parameters.
A net operating loss (“NOL”) is a loss taken by a business where a company’s taxable income is lower than the company’s allowable deductions. ((Net Operating Loss – NOL, Investopedia (last visited: Mar. .27, 2018), https://www.investopedia.com/terms/n/netoperatingloss.asp.)) When expenses for a particular period exceed revenues, the resultant NOL can be used to offset the company’s future tax payments. ((Id.)) The Code’s treatment of NOLs creates a tool that businesses can utilize to counterbalance loss-making financial periods. Put simply, an NOL in one period can be utilized to maximize tax savings in another period. ((See generally Jean Murray, Net Operating Loss (NOL), the balance (Sept. 7, 2017), https://www.thebalance.com/net-operating-loss-nol-398354.))
Prior to the passage of the Tax Cuts and Jobs Act, companies could carry the amount of the NOL back two years and apply it against their prior taxable income, creating a tax rebate. ((Steven Bragg, The net operating loss carryback and carryforward, AccountingTools (Aug. 11, 2017), https://www.accountingtools.com/articles/2017/5/15/the-net-operating-loss-carryback-and-carryforward.)) Additionally, under this old version of the Code, taxpayers could carry forward the NOL, but the carryforward period was capped at twenty years. ((Id.)) Under the applicable provisions, it made the most sense to carry back the NOL to the largest extent possible, since the concept of the time value of money dictates that saving money now is presently more valuable than saving money in the future. ((Id.)) Though, carrying back was not always the most prudent financial decision. For example, if a company foresaw an impending increase in taxes, the way to maximize the value of the NOL might have been to carry it forward into a period of higher predicted tax rates.
These rules, and the above considerations, though, have undergone a transformation. Now, Section 172 of the Code disallows carrybacks (with a few limited exceptions), but has created an indefinite carry forward period. ((I.R.C. § 172.)) In strategizing how to utilize their NOLs, businesses will likely continue to take their tax savings in the earliest possible periods. But, because companies can no longer carry back their NOLs, the earliest possible period will be in a period after the NOL is claimed.
While this rule change may seem trivial, it carries enormous potential consequences. Namely, during financial downturns, this rule change could create a lower floor for an economic dip. During rough economic patches in the past, companies would carry back NOLs in order to receive tax rebates from the government. ((Lydia O’Neal, Some Tax Law Provisions Could Make for a Tougher Recession, Bloomberg BNA (Mar. 23, 2018), https://www.bna.com/tax-law-provisions-n57982089815/.)) This was a common tactic to weather economic recessions, as it provided struggling companies with quasi stimulus capital from the government. With Congress’ decision to eliminate carrybacks, this business tool has been greatly eroded.
Alan Aurback, an economics professor at the University of California Berkeley, has postulated Congress’ intention in making this change: “Legislators somehow feel that NOL recovery is sort of an inappropriate gift.” ((Id.)) He argues, however, that the old NOL carryback policies were really “a way of cushioning the effects of cyclical income,” and that the tightening of these rules “is not good for cyclical industries.” ((Id.)) Therefore, as a result of this change to the Code, retail, restaurant, travel, construction, and other industries are left vulnerable. ((Id.))
Nevertheless, this alteration isn’t necessarily all gloomy. As the marginal rates for individual taxpayer income was lowered with the passage of the new tax laws, the government needed to recuperate fiscal losses so that the federal budget could remain somewhat balanced. Because of this change to the NOL rules, along with only allowing an 80% offset against taxable income in the future, an estimated $201.1 billion in extra tax revenue will be raised by 2027. ((Id.)) So, in order for individual taxpayers to pay less in taxes, the government recuperated that deficit, in part, by eliminating the allowance of NOL carrybacks.
It will be interesting to follow how the business world responds to the Code’s changes to the NOL rules, and to see if this change will remain permanent beyond the Tax Cuts and Jobs Act’s sunset period.
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