INSIGHT: Monetizing Tax Losses From Covid-19 and Under CARES Act

This article provides practical observations of select income tax provisions that will likely be utilized as a result of the global pandemic, including the Coronavirus Aid, Relief, and Economic Security Act, P.L. 116-136 (the “CARES Act”), signed into law on March 27, 2020. Per Senate Bill, S. 3548 (March 19, 2020), the CARES Act was intended “to provide emergency assistance and health care response for individuals, families, and businesses affected by the 2020 coronavirus pandemic.”

The economic shock of the Covid-19 pandemic and the resulting malaise is unprecedented in the U.S. and recent world history. Specific industries have suffered adverse financial consequences ranging from severe loss of revenue to the inability to reduce fixed costs, crystalizing massive losses in 2020. In a UC Berkeley discussion forum, some economists forecast that as much as one-third of the U.S. economy may be shut down temporarily and that the real unemployment rate may exceed 25%. In addition to multiple rounds of quantitative easing and other measures by the U.S. Federal Reserve Bank, the federal government has already enacted several economic relief packages to inject liquidity into the economy, provide financial relief to businesses and individuals, and partially fund the unprecedented acute and long-term healthcare needs.

Executive Summary

Several federal income tax provisions that allow taxpayers to monetize their tax losses and obtain much needed financial relief are discussed within this article:

• Temporary repeal of the 80% limitation on the absorption of a net operating loss (NOL)
• Modification of the rules limiting the carryback of NOL, subject to limitations relating to transition-tax years, to allow for a five-year carryback of NOL
• Suspension of the $250,000 ($500,000 for married filing joint) limitation, indexed for inflation, on the deduction of excess business losses by non-corporate taxpayers
• Temporary increase in the limitation on the deduction of business interest expense to 50% (from 30%), under Section 163(j)
• Bad debt deduction for write-off of uncollectible receivables
• Worthless stock deduction

NOL Deduction Modifications

The CARES Act temporarily repeals the 80% taxable income limitation on NOL deductions, thus allowing the NOL deduction to fully offset taxable income. For tax years beginning before Jan. 1, 2021, taxpayers can take an NOL deduction equal to 100% of taxable income (rather than the 80% limitation under prior law). For tax years beginning after Dec. 31, 2020, the rules in place before the CARES Act will resume and taxpayers will be able to take: (1) a 100% deduction of NOL arising in tax years prior to 2018, and (2) a deduction limited to 80% of modified taxable income for NOLs arising in tax years after 2017.

The CARES Act also provides that NOLs arising in a tax year beginning after Dec. 31, 2017, and before Jan. 1, 2021, may be carried back to each of the five tax years preceding the tax year of such loss. Prior to the CARES Act, Section 172(b)(1) provided that an NOL for any tax year can be carried forward to tax years following the tax year of the loss but cannot be carried back to any tax year preceding the year of the loss, subject to exceptions for farming losses and losses of property and casualty insurance companies. Taxpayers are allowed file an election to either waive the entire five-year carryback period or to exclude all of their Section 965 years from the carryback period. Taxpayers that have a carryback to a Section 965 year are deemed to have made a Section 965(n) election that limits the amount of the loss that can be carried back to each such 965 year. Note, that there are special rules for real estate investment trusts (REITs), and insurance companies.

Practice points. Most taxpayers will appreciate the lifted restrictions on using NOLs. Taxpayers with foreign subsidiaries or controlled foreign corporations (CFCs) should be aware of existing international tax rules under the Tax Cuts and Jobs Act (TCJA). CFCs’ net income may be subject to annual, minimum U.S. income taxation under the global intangible low taxed income provisions (GILTI). Generally corporate taxpayers that own CFCs are entitled to a deduction of 50% of their GILTI resulting in an effective federal income tax rate of 10.5% to 13.125% (considering the foreign tax credit limitation). Both deductions under Section 250 (e.g., GILTI) are limited by the domestic taxpayer’s (shareholder’s) U.S. taxable income, taking into account its NOLs. Thus, taxpayers with CFCs subject to GILTI will want to carefully analyze the effects of using NOLs to offset taxable income at 21% vs. 10.5%.

Example

Phoenix Manufacturing Inc. (“Phoenix”) is expected to generate an NOL for the tax year 2020 of $10 million and had taxable income for the tax year 2015 of $1 million, 2016 of $2 million, 2017 of $5 Million, 2018 of $3 million, and 2019 of $4 million. Phoenix recognized Section 965 income of $3 million in 2017, did not have any foreign tax credits for any prior year and is not subject to the alternative minimum tax in any relevant year. In addition, Phoenix elects to waive the carryback of the NOL to 2017, the transition tax year.

The federal cash tax benefit to Phoenix of the carryback of the 2020 NOL to five prior tax years is $2,520,000, as illustrated in the table below. Please note that any state and local tax benefit to Phoenix, of the carryback of the NOL is excluded from the computation shown below.

Excess business loss deduction modification for non-corporate taxpayers

The CARES Act temporarily suspends the $250,000 ($500,000 for married filing joint) loss deduction limitation for non-corporate taxpayers to allow the deduction of excess business losses arising in 2018, 2019, and 2020, without such limitation. The provision also clarifies that, because capital losses cannot offset ordinary income under the NOL rules, capital loss deductions are not taken into account in computing the Section 461(l) limitation, and that the amount of capital gain taken into account in calculating the Section 461(l) limitation cannot exceed the lesser of capital gain net income from a trade or business or capital gain net income.

Practice points. Taxpayers may not be able to take advantage of the relaxed rules for excess business losses due to other coordinating rules, including the at-risk rules or passive activity loss (PAL) rules. The temporary allowance to use excess business losses has been perceived as a further handout to wealthy taxpayers who may not need as much cash and economic relief as others due to the coronavirus induced economic situation. Taxpayers should note that (1) excess business losses are determined without regard to any capital losses or any deductions, gross income, or gains attributable to any trade or business of performing services as an employee; and (2) the net operating loss and qualified business income (QBI) deductions are not taken into account in determining excess business losses. The excess business loss suspension and the five-year NOL carryback are mandatory for 2018 tax returns, and thus an amended 2018 tax return will be required.

Temporary increase in the deductibility of interest expense

The CARES Act temporarily and retroactively increases the limitation on the deductibility of interest expense under Section 163(j) from 30% to 50% of adjusted taxable income, for tax years beginning in 2019 and 2020. Partnerships may elect out of the 50% limitation for 2020. For 2019, partners may treat 50% of their excess business interest expense (EBIE) as automatically paid or accrued in their 2020 tax return without further Section 163(j) limitation.

In addition, taxpayers can elect to calculate the interest limitation for their tax year beginning in 2020 using the adjusted taxable income for their last tax year beginning in 2019 as the relevant base. For partnerships, this election must be made by the partnership, rather than by each partner.

If an election is made to calculate the interest limitation using 2019 adjusted taxable income for a tax year that is a short tax year, the adjusted taxable income for the taxpayer’s last tax year beginning in 2019 will be annualized to determine the taxable income for a full year.

Practice points. While the Section 163(j) limitation was expanded by the TCJA to include related and unrelated party debt, and applies to all U.S. businesses, the increase to 50% of adjusted taxable income will be welcome by traditionally leveraged industries and businesses that will need to rely on debt financing to get through the Covid-19 induced economic situation. In the cross-border context, businesses should consider the transfer pricing and withholding tax implications on (downward) adjustments to interest rates on intercompany loans between related parties.

Bad debt deduction/write-off

Although the CARES Act did not change the rules relating to the bad debt deduction, this should be considered as part of the planning for carryback of NOLs. Section 166 allows a deduction for debt that becomes worthless, e.g., uncollectible accounts receivable and uncollectible notes receivable. There are three requirements for claiming a bad debt deduction: (1) the debt must be bona fide, (2) it must be determined whether the debt is a business debt or non-business debt, and (3) it must be established that the debt is worthless in the applicable tax year.

Bona fide debt arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money. In general, business debt is debt incurred in connection with operating a trade or business. Non-business debt is defined broadly as everything else. Section 166 does not define the term “worthlessness,” but instead refers to evidence of worthlessness. Thus, a taxpayer must consider all of the relevant facts and circumstances when determining whether a debt is wholly or partially worthless.

The specific write-off method is the more commonly used method to determine the amount of the deduction. Although the non-accrual experience method is available, it has limited application.

Practice points. Generally, to deduct a bad debt, the taxpayer must have previously included the amount in its income or loaned out its cash. Generally, cash method taxpayers such as most individuals are not able to take a bad debt deduction for unpaid salaries, wages, rents, fees, interests, dividends, and similar items. Taxpayers should maintain documentation and analysis to show that a debt became totally worthless (or “bad”) in a particular year. Finally, taxpayers should consider maintaining an accounting policy for bad debt write-off treatment as IRS tax auditors may request to review such policies.

Example

Gotham Technology Services, Inc. (Gotham), a technology services provider that reports taxable income on the accrual basis of accounting, provides generous credit terms to its main customer, Covid International Corp. (“Covid”), a global retailer. Gotham has accounts receivable from Covid of $19 million on March 31, 2020.

In April 2020, Covid filed for bankruptcy, and Gotham does not expect to receive any portion of the $19 million unsecured and un-preferred trade receivable from Covid’s bankruptcy estate. Gotham wrote-off the entire $19 million receivable in April 2020 and is expected to deduct the full $19 million as a bad debt deduction for the tax year 2020, as it is determined that the worthlessness of the debt occurred in 2020.

The $19 million bad debt deduction increases Gotham’s loss for 2020 to $25 million. This $25 million loss may be carried back for five years, starting with the 2015 tax year.

Worthless stock deduction—general

If a security that is a capital asset becomes worthless during the tax year, the resulting loss is treated as a loss from the sale or exchange of a capital asset on the last day of that tax year. A security (including a share of stock in a corporation) that meets the requirements of Section 165(g)(3) is not treated as a capital asset for purposes of determining the character of income. Section 165(g)(3) provides an exception to capital loss treatment by allowing a domestic corporation an ordinary loss deduction on the worthlessness of securities of affiliated corporations, provided that (1) the taxpayer directly owns at least 80% of the total voting power of the stock of the corporation and 80% of the total value of the stock of the corporation, and (2) more than 90% of the aggregate of the corporation’s gross receipts for all tax years is from sources other than royalties, rents, dividends, interest, annuities, and gains from sales of stocks and securities.

Worthless stock deduction—controlled foreign corporations

Regulations provide that the exception for affiliated corporations applies to any security of a domestic or foreign corporation. Provided that both the ownership and gross receipts tests are met, the stock of a CFC is eligible for a worthless stock deduction, where the entity is insolvent. Whether a loss due to worthlessness is actually sustained during the taxable year, is a factual determination. A taxpayer must prove with objective evidence that the stock in question becomes worthless during the taxable year.

Either an actual liquidation of the CFC or an entity classification election to treat the CFC as a disregarded entity (i.e., a deemed liquidation per Rev. Rul. 2003-125) should trigger the worthless stock deduction of an insolvent CFC. Because assets are worth less than liabilities, Section 332 is not applicable and Section 165(g) applies.

The amount of the worthless stock deduction is measured by the U.S. shareholder’s basis in the stock of the CFC. For purposes of determining basis, the U.S. shareholder’s basis is increased for income inclusion by the U.S. shareholder, for subpart F income under Section 951(a), transition tax basis adjustment for Section 965(a) inclusion amount, Section 965 basis adjustment election, and GILTI inclusion under Section 951A, among other adjustments. The U.S. shareholder’s basis is decreased for distributions of previously taxed income, Section 965 basis reduction due to the gain reduction rule, and dividends excluded under Section 245A solely for purposes of determining loss on the stock, among other adjustments. Note that GILTI regulations under 1.951A-6 may require downward basis adjustment when using the tested loss of a CFC and thus may affect the worthlessness determination of the CFC stock.

Key considerations for the worthless stock deduction of a CFC’s stock are the determination of the value of assets, liabilities owed, the basis in the CFC, and whether complete worthlessness is actually sustained during the taxable year.

Example

As depicted in the diagram below, Protective Garments Inc. (PGI), a U.S. corporation that is engaged in the manufacture and distribution of apparel, has a wholly-owned subsidiary in China, PPE Products Ltd. (PPE), that is engaged in the manufacture of protective garments. On April 30, 2020, PPE is insolvent by $5 million, based on the fair market value of its tangible and intangible assets, of which substantially all of the asset value is in cash and cash equivalents. Assume that either (1) PPE is liquidated, or (2) an entity classification election is made to treat PPE as a flow-through entity, and PPE had more than 90% of its gross receipts in all years from sources other than royalties, rents, dividends, interest, annuities, and gains from sales of stocks and securities.

Scenario 1. PGI owns 100% of the stock of PPE and PPE did not have more than 10% of gross receipts derived from passive income during any tax year. Thus, PGI should recognize an ordinary loss of $5 million on an actual or deemed liquidation (e.g., entity classification election) because PGI meets the 80% ownership test of vote and value with respect to the shares of PPE.

Scenario 2. PGI owns 50% of the stock and has 50% of the voting interest of PPE. Thus, PGI should recognize a capital loss of $2.5 million (50% of the loss of $5 million). This is because PGI owns less than 80% of the stock and has less than 80% of the vote of PPE.

Practice points. The worthless stock deduction is available only when a security or stock (e.g., a CFC) becomes wholly worthless. Thus, partial impairment and downward fluctuations in the market value of the security or stock, even if permanent, are not eligible for the Section 165(g)(3) worthless stock deduction. It is imperative that U.S. corporations that own foreign companies, especially where both the ownership and vote are more than 80%, reevaluate such investments to ascertain whether a worthless stock deduction may be helpful in monetizing the insolvency of the investment in the foreign subsidiary through the carryback of an NOL in the U.S.. Note that the perhaps the more desirable ordinary loss treatment is not available to individual and non-corporate shareholders of worthless CFCs.

Summary

The CARES Act and pre-TCJA tax rules should provide some relief and perhaps tax planning opportunities for taxpayers that are able to monetize losses. Taxpayers should also consider whether the worthless stock deduction and/or bad debt deduction from write-offs of accounts receivable would be beneficial in the carryback of NOLs. Modeling the federal and state income tax effects of interconnected tax rules under temporary (e.g., CARES Act) and existing tax laws should be common practice for the near and mid-term future, both for businesses that continue to operate and those that evaluate exit, merger, and acquisition opportunities.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Adnan Islam is a partner and co-practice leader of Friedman LLP’s International Tax group. Adnan also serves as the Blockchain/ Cryptocurrency Tax Transactions Leader for Friedman LLP. Ed Ajodah is a principal within Friedman LLP’s International Tax group.