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A Look Ahead: Complexities Plague COVID-Related Loss Carrybacks

Posted on Jan. 4, 2021

Following an unprecedented tax return filing season, businesses face heightened challenges in 2021, including taking positions on pandemic-related losses and determining how best to monetize the tax benefits.

Practitioners have reflected on the 2020 season and offered perspectives on taxpayers’ options in the year ahead and the difficulties that may arise when guidance is lacking, such as the applicability of the section 165(i) disaster loss rules, which didn’t contemplate anything close to the coronavirus.

The government has been considering how those rules — which allow taxpayers to deduct eligible losses from federally declared disasters on their prior-year tax returns — apply to COVID-19, but it failed to provide guidance in time for taxpayers’ consideration in preparing their 2019 returns.

Other issues carrying over into 2021 that affect the filing of tax returns or claims for refunds include the IRS’s processing backlog, its ability to comply with statutory time requirements, and guidance presented in FAQ format that taxpayers can’t rely on because it hasn’t been published in the Internal Revenue Bulletin.

Tougher NOL Calculus

Among the lessons learned from the 2020 corporate filing season is the recurring need for modeling, according to Ellen Berger of EY. Speaking during a webcast sponsored by her firm December 1, 2020, Berger said the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136) “brought opportunities to carry back net operating losses to higher-rate tax years and an acceleration of the refundable minimum tax credit, which resulted in many taxpayers filing carryback claims.”

Under the CARES Act, taxpayers must carry back NOLs for tax years beginning after December 31, 2017, and before January 1, 2021, to each of the five years preceding the year of the loss unless they make an irrevocable election not to carry back the NOLs.

As businesses did in evaluating their 2018 and 2019 NOLs, they need to determine whether it’s beneficial to carry back 2020 losses, although the calculus has become more complicated, Kevin M. Jacobs of Alvarez & Marsal Taxand LLC told Tax Notes.

According to Jacobs, taxpayers need to assess the advantages of carrying back losses to a 35 percent tax year along with the implications for tax credits, and compare that with carrying the loss forward to a year in which tax rates may be increasing but the losses can only be used to offset 80 percent of taxable income.

More NOL guidance is needed, however, and in some cases, IRS guidance made available “hasn’t been truly finalized,” Jacobs said. An example is how corporations should carry back NOLs to pre-Tax Cuts and Jobs Act years subject to the alternative minimum tax rules.

That was a source of taxpayer confusion to which the IRS responded with FAQ guidance, which raised more questions and drew criticism as contrary to statutory provisions.

Treasury and the IRS have decided not to put those FAQs “into ‘published guidance’ that’s binding,” so taxpayers must determine whether they are going to follow it, Jacobs said.

Because the IRS changes FAQs and occasionally removes them from its website, Berger emphasized the importance of having “contemporaneous documentation and audit-ready work papers,” which means, for example, printing and saving the IRS postings that were relied on in preparing a return.

Disaster Loss Guidance Lacking

The section 165(i) loss rules for federally declared disasters are another area in which taxpayers must take positions without guidance if they elect to deduct eligible 2020 losses on their 2019 returns. The rules are more difficult to navigate for the COVID-19 crisis compared with traditional disaster losses, such as those from a hurricane.

The gating issue is establishing whether a particular loss was attributable to the COVID-19 pandemic, Joshua T. Brady of Grant Thornton LLP said.

The American Bar Association Section of Taxation argued in a September 14, 2020, report that the scope of that term should be interpreted broadly, but Brady said that “in the absence of affirmative guidance by the IRS, taxpayers may be hesitant to claim a section 165(i) loss if other factors could be seen as impacting the loss.”

Because the statute and regulations didn’t envision a disaster like a pandemic with its duration, broad scope, and geographic reach, taxpayers are trying to figure out how to apply them, Jacobs said.

There’s a host of questions, such as which losses are eligible and how to measure them; what the start date for measurement is; and when the COVID-19 pandemic is deemed to have ended, Jacobs said, adding that further challenges arise in applying the rules if the pandemic spans two tax years.

It’s disappointing that the IRS hasn’t been able to provide rules on how to apply the disaster loss provisions to the coronavirus pandemic, but “even without guidance, companies relied on section 165(i) to reduce tax payments for 2019 and request tentative [refunds] of overpaid estimated taxes and/or to increase 2019 NOLs to be carried back,” Ellen McElroy of Eversheds Sutherland (US) LLP told Tax Notes.

For positions taken on previously filed returns, the resolution of those issues will likely “occur on a case-by-case basis in an examination context rather than more globally, which would have occurred if guidance had been issued,” McElroy said.

Treasury and the IRS added guidance on COVID-19 pandemic losses under section 165(i) to their initial 2020-2021 priority guidance plan released in November 2020. So perhaps guidance is in the queue after the government completes its push to release TCJA reg packages, or it could be further stalled pending the new administration’s review of Treasury’s plans.

Multiyear Return Convergence

Many taxpayers navigated through their 2019 tax returns knowing, or being fairly sure, that they will have to amend those and earlier returns, with NOL carrybacks being a major focus for 2020 returns, said Scott T. Mackay of EY during the webcast with Berger.

Mackay said the CARES Act provisions play off each other — reestablishment of NOL carrybacks, an election to use prior year’s taxable income for computing the 2020 business interest deduction, and the retroactive technical correction to qualified improvement property depreciation.

Taxpayers in the post-filing period are starting to home in on changes needed and, with greater confidence in 2020 taxable income estimates, are considering options to effectuate an NOL carryback as well as the positions they want to take on the section 163(j) business interest limitation rules, according to Mackay.

For transitioning to the new rules, Treasury and the IRS provided taxpayers considerable flexibility in deciding which year “to land deductions or income . . . and that’s super powerful,” although it adds complexity, Mackay said.

With 2020 being the last year, at least currently, for which NOLs can be carried back five years, “it’s going to be another year of just nonstop work to integrate all these pieces and get to the right place,” Mackay cautioned.

Another possible consideration for taxpayers is a change in their tax year, according to Brady. He noted that some calendar-year corporations anticipating substantial losses in 2021 are changing their tax years to end November 30, which means “the losses incurred in taxable year beginning December 1, 2020, should be eligible for the five-year carryback provisions of the CARES Act and should not be subject to the 80 percent limitation.”

“While changing taxable years can be a heavy lift for corporations, especially considering the book conformity requirement, Rev. Proc. 2006-45, [2006-2 C.B. 851], offers corporations the ability to obtain automatic consent in many circumstances,” Brady said.

Fork in the Road

Corporations are weighing their options for carrying back 2020 NOLs and obtaining tax refunds — that is, whether to file Form 1139, “Corporation Application for Tentative Refund,” or Form 1120-X, “Amended U.S. Corporation Income Tax Return.”

Taxpayers that need cash quickly can take advantage of the expedited refund procedures for an NOL carryback via Form 1139, for which the IRS conducts a limited review.

The IRS is required by statute to process Forms 1139 within 90 days but historically has invariably processed them within 45 days because of interest due to the taxpayer if refunds aren’t paid within that time frame, McElroy said.

Amid the pandemic, “the IRS has been extremely slow to process refund claims,” perhaps because of mail and processing backlogs stemming from the lockdown and closing of IRS offices or the volume of loss claims being filed, McElroy said. But it’s concerning that the IRS might not be able “to timely address and evaluate the overwhelming number of claims they’ve received and/or [are] heading their way,” she said.

Similarly, Jacobs noted that there’s still a backlog of 2019 returns, so it’s uncertain how quickly the IRS will be able to get out from under the deluge of prior-year filings to be able to process the 2020 forms.

Thus, taxpayers might not receive their 2020 Form 1139 refund claims within the 90-day period — that the IRS has said it is trying to comply with — but they should receive them more quickly than if they filed amended returns, because the tentative refund payments are processed before IRS audit activity and review by the Joint Committee on Taxation, if applicable, Jacobs said.

But other considerations factor into a taxpayer’s decision of whether to file the tentative refund claim or amend prior-year tax returns to obtain a refund.

McElroy noted that Form 1139 eliminates a taxpayer’s burden of filing multiple amended returns if it has significant losses that must be carried back to more than one tax year, so many companies have taken that path or are considering it.

Because Form 1139 isn’t viewed as a tax return, however, some taxpayers may want to file an amended return instead, Jacobs said, noting that could be the case when a taxpayer is in bankruptcy. So it depends on the taxpayer’s circumstances — weighing the advantages of supposedly quicker cash for liquidity against the potential detriments associated with Form 1139, he added.

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