Carrybacks in and out of groups adds complexity to the analysis
The Coronavirus Aid, Relief, and Economic Security Act (the CARES Act) included the ‘five-year NOL carryback rule.’ For further details on the five-year carryback rules relevant to corporate taxpayers, see our prior alert, CARES Act delivers five-year NOL carryback to aid corporations. If a consolidated group of corporations chooses to take advantage of the carryback opportunity, the group needs to consider how the use of net operating losses (NOLs) attributable to certain members may be limited.
Carrying back NOLs under the CARES Act
Under the five-year carryback rule, corporations may carry back NOLs arising in tax years beginning after Dec. 31, 2017, and before Jan. 1, 2021 to the five taxable years preceding the loss year. This rule effectively allows corporate taxpayers the opportunity to carry back NOLs to tax years as far back as 2013. The five-year NOL carryback rule is a departure from the NOLs rules enacted under the Tax Cuts and Jobs Act (the TCJA), which eliminated carrybacks for NOLs arising in a tax year ending after Dec. 31, 2017.
The CARES Act further allows taxpayers to make an irrevocable election to relinquish the entire five-year carryback period with respect to a particular year’s NOL. Moreover, taxpayers may elect to exclude section 965 transition-tax inclusion years from the carryback period.
For a discussion on recent guidance published by the Service with respect to NOL carryback procedures, see our prior article, IRS issues long-awaited guidance on NOL carryback procedures.
Carrying back NOLs
Given the opportunity to carryback NOLs under the CARES Act, corporate taxpayers need to revisit the carryback rules that are now relevant again. Because of certain corporate transactions such as mergers and liquidations, NOLs may not be eligible for carryback.
Example 1: To facilitate the acquisition of T (a stand-alone corporate filer), P forms merger subsidiary that merges with and into T with T surviving. To simplify the structure P causes T to merge upstream with and into P. Post-merger, the T business generates NOLs. Though T, prior to the merger, had 5 years of taxable income, P may not carry back those NOLs to T’s prior tax years. Instead, P carries the NOLs back to prior P tax years. However, the result differs if T remains in existence as a corporation.
Similar results may occur in the context of a consolidated group. Thus, when carrying NOLs to a prior tax year under the five-year NOL carryback rule, affiliated corporations filing a consolidated return must additionally consider the application of the consolidated net operation loss (CNOL) carryback rules under Treas. Reg. 1.1502-21.1 The provisions under 1.1502-21(b) specifically cover how to use NOLs attributable to certain members of a consolidated group. The regulations provide rules for the carryback of NOLs generated by newly created entities within a group, as well as carrying back NOLs to different consolidated groups.
The offspring rule. If a consolidated group member creates a new subsidiary and that subsidiary was continuously a member of that group since its formation (determined without regard to whether the member is a successor to any other corporation), its NOLs are carryback eligible to consolidated return years before the member's existence (the ‘offspring rule’). If there was no consolidated return in the carryback year, the NOLs are carryback eligible to the separate return year of the common parent if the parent was not part of another consolidated or affiliated group in that carryback year.2
Example 2: Assume a consolidated group organized a new member in 2017 (S). The consolidated group sustained a CNOL in the tax year that ended Dec. 31, 2018. A portion of that CNOL is attributable and apportioned to S. Under the offspring rule described above, the consolidated group may carry back those NOLs attributable to S in 2018 to the 2013 consolidated return year. If the common parent was not filing a consolidated return in the carryback year, the common parent could carry back S’s NOLs to the common parent's separate year return assuming the parent was not a member of another consolidated or affiliated group.
The offspring rule also applies to a target corporation that was acquired in a stock purchase for which an election under section 338(h)(10) was made. As part of the fiction of the deemed asset acquisition, the acquiring corporation is treated as forming a new corporation, which is then deemed to purchase the assets of the acquired corporation. As a result, if the acquired corporation generates NOLs post-acquisition, the consolidated group may carry back those NOLs to a prior consolidated return year in which the acquired corporation was not a member of the consolidated group. However, the NOLs are not available for carryback to prior tax years of the acquired corporation.
NOLs of an acquired corporation. If a consolidated group acquired a loss member, the group cannot carry back the NOLs attributable and apportioned to such member to a consolidated return year of the group in which the subsidiary was not a member. However, the loss member may carry back those NOLs to its own separate return year.3 If the loss member was affiliated with another consolidated group before it was acquired, those NOLs may be carried back to the consolidated return year of that other group, assuming that the other group did not have a CNOL for that carryback year. In the context of an acquisition, the acquiring consolidated group may consider making an election under Treas. Reg. 1.1502-21(b)(3)(ii)(B) to relinquish, with respect to all CNOL attributable to the member, the portion of the carryback period for which the corporation was a member of another group. This election makes sense where the current group would not benefit from the refund.
Example 3: P owns all of the stock of S. P and S joined in filing consolidated returns in the tax years ended Dec. 31 of 2016 and 2017. In tax year ended Dec. 31, 2018, S acquired all of the stock of T who was part of another consolidated group. In 2018, the P group generated a CNOL of $100 of which $50 was attributable and apportioned to T. Under the CNOL carryback rules, the P Group cannot carry back T’s $50 loss to any consolidated tax year in which T was not a member of the P group. Therefore, if the P group chooses to take advantage of the five-year carryback rule, the P group can only carry back the NOLs attributable to and apportioned to P and S.
T may carry back its $50 NOL to the consolidated return year of its old consolidated group if that group had taxable income (whether attributable to T or another member of that group). P may also choose to waive the T carryback entirely to avoid carrying the loss back to the old group.
As with Example 1, the elimination of T via a liquidation (by law or by election) or merger affects the carryback opportunities to the benefit or detriment of the group.
Example 4: Assuming the same facts as Example 3, but that T converted into an LLC immediately after the acquisition and became disregarded from S for federal income tax purposes. The P Group is able to carry back T’s $50 loss because it is a part of S’s loss. This is favorable for the P group if they have $100 of income available to offset in the carryback period, but detrimental if only T had income in the carryback period.
NOLs of a departing member. Where a loss member leaves a consolidated group, the consolidated group first uses that member’s NOLs to offset income in the consolidated return year of the departure. Then, to the extent that the loss member is not otherwise required to reduce its NOLs,4 the loss member carries over any of its remaining NOLs to its first separate return year (or the first return year of another consolidated group).5
Example 5: Same facts as Example 3 except that S disposed of T during 2019. Assume T had an additional $50 loss through the date of disposition by S. T would first carry back its $50 loss to its separate return year and then apply the NOLs, if any remaining, to the consolidated return years in which it was a member of the group. If there are any NOLs thereafter, T may generally carry over those NOLs to T’s subsequent tax years.
The CARES Act provides a great opportunity for corporations to increase liquidity in this economic downturn. However, before filing for a loss carryback under the CARES Act, corporate taxpayers should consider the carryback provisions of the consolidated return rules in determining which NOLs may be carried back. Given the general complexity of the consolidated return rules and the absence of specific guidance in applying the five-year NOL rule, corporate taxpayers should consult with their tax, legal and financial advisors when considering this opportunity under the CARES Act.
For a more detailed analysis of the CARES Act and other COVID-19 materials affecting businesses, please go to the Coronavirus Resource Center and Coronavirus Tax Relief Resource Center.
1The Treasury Department promulgated the CNOL carryback rules prior to the enactment of the TCJA; however, the rules likely still apply to the carryback of NOLs generated in tax years beginning after Dec. 31, 2017 and carried back to tax years that ended before Jan. 1, 2018.
2Treas. Reg. 1.1502-21(b)(2)(ii)(B).
3The loss may also be carried back not only to the member’s separate return year, but also to the year of a member of the loss member’s SRLY subgroup. The detailed mechanics of this rule are outside the scope of this article.
4Section 108, Treas. Reg. 1.1502-28 or Treas. Reg. 1.1502-36.
5Treas. Reg. 1.1502-21(b)(2)(ii)(A).