COVID-19 Response: Tax Update - Businesses Can Claim Tax Refunds and Revisit Previous Tax Elections Based on CARES Act
(April 24, 2020) - In initially analyzing the tax provisions of the CARES Act, we identified some opportunities for businesses to claim refunds of federal taxes paid for tax years preceding 2020. See "COVID-19 Response: Tax Update - Using CARES to Conserve or Generate Cash, and Other Changes to Federal Tax Law”.
Since then, the IRS has been parceling out procedures to claim refunds, make tax elections, and revisit previously filed tax elections, all in view of the CARES Act. Here is how businesses may benefit concerning:
- Net Operating Losses
- Partnership Amended Returns for 2018 and 2019
- Elections Involving Business Interest Limitation
- Write-Offs of Leasehold Improvements
This alert describes generally applicable deadlines by which taxpayers (in view of the CARES Act) may reconsider prior tax choices. Under the procedural guidance the IRS has been issuing, however, special deadlines apply in particular situations. Taxpayers should consult their tax advisers about the particular procedures and deadlines that apply to whatever new tax choices the taxpayer contemplates making.
In considering these opportunities, please understand that situations differ. In most if not all cases, a business should "run the numbers" to decide whether to seek a refund, make a new tax election, or revisit a prior decision.
Net Operating Losses (NOLs)
Net operating losses (NOLs) from tax years 2018, 2019, or 2020 may (in fact, generally must under the CARES Act) be carried back up to five years. By carrying back NOLs, a business can offset income previously reported for earlier years and may generate tax refunds. Eligible taxpayers consist of corporations and other businesses having NOLs that arise in tax years 2018, 2019, or 2020.
Businesses that would rather carryover NOLs from tax years 2018, 2019, or 2020 may elect with the IRS to forego carrying them back.
Special rules apply to (i) some previous tax years described later and (ii) taxpayers that have been required to include in their taxable income accumulated, previously unrecognized earnings from foreign operations.
A corporation or other business realizes a NOL if its tax deductions exceed its taxable gross income. In general, taxpayers have been allowed to carryover NOLs and deduct them from future years’ net income until the NOLs were fully used. Periodically, the tax laws have allowed NOLs to be carried back to prior years, but not recently.
Enhancements by CARES Act
In order to ease tax burdens on businesses, including those adversely affected by the coronavirus, the CARES Act temporarily enhances the deductibility of NOLs in two ways:
- NOL carrybacks and carryovers to a tax year may offset 100% of the year’s taxable income (rather than being limited as usual to 80% of taxable income). This temporary change applies to tax year 2020.
- NOLs from tax years 2018, 2019, or 2020 may (in fact must) be carried back up to five tax years unless the taxpayer elects otherwise. Any NOLS from those years not absorbed by carrying them back will carryover. If a taxpayer elects not to carry back NOLS, then the NOLs solely carryover.
How to Carry Back NOLs and Claim Refunds
The fastest way a business can carryback NOLs and claim refunds from the IRS of prior taxes consists of filing with the IRS a "quickie" claim for refund. Corporations should file IRS Form 1139, Corporation Application for Tentative Refund; other businesses should file IRS Form 1045, Application for Tentative Refund.
Unless the IRS finds errors in the form, it must issue the claimed refund within 90 days. (The IRS reserves the right to audit the refund later.) Ordinarily, businesses must mail these forms to the IRS. Because most IRS offices are closed on account of the coronavirus, the IRS has announced special procedures under which businesses temporarily can fax Form 1139 or 1045 to the IRS.
Carrybacks to Deferred Foreign Income Years
A few years ago, taxpayers became, under the Tax Cuts and Jobs Act of 2017, subject to tax on previously untaxed, deferred foreign income from controlled foreign corporations. For details, see Internal Revenue Code (IRC) Section 965.
Businesses that have recognized deferred foreign income under IRC Section 965 and have NOLs from 2018, 2019, or 2020 have three options.
First, they can carry back the NOLs and ignore the previously included foreign income and associated deductions. Ignoring those items generally will reduce taxable income that the carried back NOLs can offset.
Second, the business can disregard all the years in which it recognized the deferred foreign income and not take them into account in determining the years to which the NOLs are carried back. Ignoring those years can increase the amount of any NOLs deductible in any remaining carryback years.
Third, the business can elect to forego carrying back the NOLs (in which case the NOLs solely carryover).
Carrybacks of NOLs Arising in Certain Prior Years
In general, a business must file with the IRS a quickie refund claim on Form 1139 or 1045 within 12 months after the end of the tax year in which the NOL arose. That deadline has expired for some tax years whose NOLs now may be carried back under the CARES Act. However, the CARES Act and IRS interpretations of it temporarily have extended the deadlines for particular tax years:
- Tax years that began before January 1, 2018, and ended after December 31, 2017 (a "2017-2018 Fiscal Year"): applications to carryback NOLs may be filed with the IRS by July 27, 2020.
- Tax years that began during 2018 and ended on or before June 30, 2019 (for example, a calendar year 2018 tax year): applications to carry back NOLs may be filed with the IRS by June 30, 2020.
Revenue Procedure 2020-24, effective April 9, 2020.
Notice 2020-26, issued April 9, 2020.
Partnership Amended Returns for 2018 and 2019
Partnerships generally may amend their previously filed federal income tax returns for 2018 and 2019 and report items to partners differently than originally reported. By amending their returns, eligible partnerships may enable partners to benefit from changes by the CARES Act affecting the partners’ 2018 and/or 2019 tax years.
BBA Partnerships that filed partnership tax returns with the IRS and furnished their partners Schedules K-1 for a partnership tax year beginning in 2018 or 2019 and ending before April 8, 2020 are eligible. For example, a BBA Partnership using the calendar year as its tax year may amend its return and Schedules K-1 for its 2018 or 2019 tax year. For this purpose, a "BBA Partnership" means a partnership the IRS generally would examine, assess, and collect resulting deficiencies at the partnership level under the “centralized partnership audit procedures.”
A BBA Partnership must file a new Form 1065, U.S. Return of Partnership Income (checking the box "Amended Return"), and furnish to its partners correspondingly amended Schedules K-1.
A BBA Partnership under examination by the IRS may amend its return and Schedules K-1 only if the partnership sends notice to the assigned revenue agent and provides the agent a copy of the amended return.
For either tax year 2018 or 2019, an eligible partnership must amend its Form 1065 and revise its Schedules K-1 before September 30, 2020.
Further Action Needed by Partners
Partnerships themselves are not subject to federal income tax. Rather, a partnership computes income, deductions, and credits at its level and reports to each partner on Schedule K-1 the partner's distributive share of those items.
In order to avail themselves of these amended-return opportunities in a way that would affect their tax liabilities for 2018 and/or 2019, the partners must amend their own federal income tax returns (or use the information from the partnership in filing a partner return not yet filed).
Revenue Procedure 2020-23, issued April 8, 2020.
Elections Involving Business Interest Limitation
Certain real estate and farming businesses can either elect out of the limitation on deducting business interest or revoke a previous election out of that limitation.
In applying the limitation for tax year 2020, taxpayers may elect to use income from 2019 instead of 2020.
Taxpayers may elect out of using the temporary 50% limitation on deducting business interest and instead apply the standard 30% limitation.
Limitation on Deducting Business Interest
Starting with tax year 2018, businesses generally have faced a limitation on how much business interest expense they may deduct in determining their taxable income. They generally have been limited to deducting business interest only to the extent of (i) business interest income plus (ii) 30% of adjusted taxable income. Disallowed business interest carries forward until later allowed under these same annual limitations.
Small businesses earning annual gross receipts averaging less than $25 million are exempt from this limitation. Additionally, Real Property Trades or Businesses (RPTBs) and certain farming businesses may elect out of applying the limitation. The term “RPTB” encompasses a broad range of real-estate business activities including development, construction, acquisition, rental, management, leasing, and brokerage. See IRC Section 469(c)(7).
Eligible businesses that elect out must take tax depreciation on assets over somewhat longer than usual recovery periods. Technically, the electing-out taxpayer must use the "alternative" instead of the "regular" depreciation system.
For example, a RPTB that elects out of the limitation on deducting business interest must depreciate:
- Residential rental property over 30 years instead of 27.5 years.
- Nonresidential real property over 40 years instead of 39 years.
Some RPTBs have elected out of the business-interest limitation because the tax benefit of not having their interest deductions limited outweighed the tax disadvantage of depreciating property over somewhat longer lives. In many cases, another factor prompting a RPTB to elect out consisted of a glitch in the tax law requiring “qualified improvement property” (including leasehold improvements) to be depreciated over the recovery period of the associated building instead of being written off immediately by taking "bonus" depreciation. The CARES Act has eliminated that glitch retroactively to tax years beginning after 2017. See “Write-Offs of Leasehold Improvements” later in this alert.
Opportunities for RPTBs and Farming Businesses to Revisit Previous Decisions
Once an eligible business has elected out of the business-interest limitation, the election generally cannot be revoked. However, in view of the CARES Act, the IRS will allow eligible RPTBs and farming businesses to revisit their original decisions in either of two ways:
- Retroactively elect out of the business-interest expense limitation for 2018, 2019, or 2020, or
- Revoke a previously filed election out for any of those years.
Now, an eligible RPTB or farming business may either elect out of the business interest expense limitation or revoke a previously filed election out by timely filing with the IRS an amended Federal Income Tax Return, amended Form 1065 (Partnership Information Return), or Partnership Administrative Adjustment Request (AAR), as applicable. In general, this amended return or request must be filed by October 15, 2021 (September 30, 2020 by many partnerships; see “Partnership Amended Returns for 2018 and 2019" earlier in this alert).
Some RPTBs now may decide to revoke a prior election out of the business-interest limitation in order to take bonus depreciation on leasehold improvements back to tax years after 2017. See “Write-Offs of Leasehold Improvements” later in this alert.
Choices for Applying Temporarily Increased Limitation on Deducting Business Interest
The CARES Act temporarily increases from 30% to 50% of adjusted taxable income the amount of business interest expense exceeding business interest income that a taxpayer may deduct. This temporarily increased limitation applies for 2019 and 2020. Correlatively, for 2020, a taxpayer may elect to use its taxable income from 2019 instead of 2020. A taxpayer may benefit from making this election if its taxable income for 2019 exceeds that for 2020.
Applying 50% Instead of 30% Limitation
Taxpayers wishing to use the 50% instead of the 30% limitation for 2019 or 2020 need only apply that limitation in preparing their income tax returns. They need not file any additional statements or other elections with the IRS. Taxpayers who have filed their returns for 2019 can amend those returns to use the 50% instead of the 30% limitation.
Election to Use 2019 Instead of 2020 Income
A taxpayer wanting to use its taxable income for 2019 rather than 2020 to determine its allowable business interest expense for 2020 may timely file with the IRS a Federal Income Tax Return, an amended Federal Income Tax Return, an amended Form 1065, or an AAR, as applicable. A taxpayer who makes this election but then changes its mind may revoke the election by following the same procedures.
Election to Use 30% Instead of 50% Limitation
A taxpayer may elect not to apply the 50% limitation for a 2019 or 2020 tax year and instead use the traditionally applicable 30% limitation. The taxpayer must elect this choice by timely filing a return or request using the 30% limitation. No formal statement is required to make the election.
A taxpayer who makes the election but then changes its mind may revoke the election by timely filing with the IRS an amended Federal Income Tax Return using the 50% instead of the 30% limitation.
A taxpayer must elect separately for each of tax years 2019 and 2020 whether to forego the 50% limitation and instead use the 30% limitation.
Some additional wrinkles affect partnerships and partners:
- A partnership can elect out of the 50% limitation (and instead apply the 30% limitation) for 2020 but not 2019.
- A partner may elect out of the 50% limitation for 2020 or, if the partner later changes the partner’s mind, revoke the election.
A taxpayer may decide to stay with the 30% limitation rather than apply the 50% limitation for 2019 and/or 2020 if the taxpayer anticipates that its income will increase in future years. Initially disallowed business interest expense carries forward indefinitely, subject to the same annual limitation, until it becomes fully allowed.
Revenue Procedure 2020-22, effective April 10, 2020.
Write-Offs of Leasehold Improvements
- Immediately write off costs of Qualified Improvement Property (including leasehold improvements) retroactively to 2018.
- In lieu of immediately writing off improvements, depreciate them over 15 years (under the General Depreciation System (GDS)) or 20 years (under the Alternative Depreciation System (ADS))
- In either case, claim refunds by filing amended tax returns back to 2018.
Qualified Improvement Property
“Qualified Improvement Property” (QIP) encompasses three categories of improvements a landlord or tenant makes to the interior of a non-residential building:
- Qualified leasehold improvement property
- Qualified restaurant property
- Qualified retail improvement property
CARES Act Clarifications
Correcting glitches in the Tax Cuts and Jobs Act of 2017, the CARES Act clarifies that QIP is depreciable for tax purposes over 15 years under the GDS and 20 years under the ADS. Instead of depreciating QIP over 15 years, a taxpayer eligible to use the GDS can immediately write them off (i.e., take "bonus" depreciation on them).
In general, these clarifications about depreciating QIP apply to property placed in service after December 31, 2017. Bonus depreciation now can be taken on QIP acquired somewhat earlier, after September 27, 2017, provided it was placed in service after December 31, 2017.
Opportunities for Some Real Estate and Farming Businesses
Earlier in this alert, we described real estate and farming businesses that, based on the CARES Act, can either elect out of generally applicable limitations on deducting business interest expense or revoke prior elections out of that limitation. Businesses that revoke prior elections out of the business-interest limitation can avail themselves of these clarifications concerning QIP, namely, take the bonus depreciation or depreciate the property over 15 years. Businesses that stay elected out or now elect out of the business-interest limitation cannot take bonus depreciation on QIP. They can, however, depreciate QIP over 20 years (instead of, before the CARES Act, over the recovery period of the associated building).
Other Opportunities to Revisit Prior Tax Choices
In view of the CARES Act’s clarifications regarding QIP, the IRS announced that other taxpayers (for example, retailers) may revisit prior decisions to make or forgo making various tax elections affecting allowable tax depreciation. The pertinent elections that taxpayers now can revisit consist of:
- Use the ADS instead of the GDS (IRC Section 168(g)(7))
- Accelerate depreciation of certain plants bearing fruits and nuts (IRC Section 168 (k)(5))
- Elect out of taking bonus depreciation on particular classes of property (IRC Section 168 (k)(7))
- Elect 50% instead of 100% bonus depreciation (mostly relevant for property placed in service in 2017) (IRC Section 168 (k)(10))
The IRS has provided detailed procedures and deadlines under which taxpayers now may make these elections or revoke previously filed elections for tax years 2018, 2019, or 2020.
Coordination with Requirements for Changing Tax Accounting Methods
A taxpayer wishing now to make any of these elections or revoke prior elections must comply with longstanding (predating the CARES Act) procedures to change the taxpayer’s method of tax accounting. In general, a taxpayer must obtain the IRS’ consent to change a method of tax accounting. If the new method increases taxable income compared to the old method, then the taxpayer must account for the change prospectively, generally over three tax years.
In some cases, a taxpayer must request the IRS’ permission to change a method of accounting by filing Form 3115, Application for Change in Method of Accounting. In other situations, the IRS is deemed to consent to a change if the taxpayer satisfies particular requirements for securing an "automatic" change.
A taxpayer who either makes or revokes any of the previously listed elections generally is viewed as changing a method of accounting for tax depreciation. The IRS has published detailed procedures for obtaining the IRS’ consent and effectuating the change.
Revenue Procedure 2020-25, effective April 17, 2020.
Visit Lewis Brisbois' COVID-19 Response Resource Center for more news and alerts on a variety of legal areas impacted by the pandemic.
Michael J. Grace, Partner
John J. Heber, Partner
Sara Jane Holland, Partner