A net operating loss (NOL) occurs when a taxpayer’s allowable deductions exceed its gross income for a given year. Most taxpayers are able to take advantage of NOL deductions—including individual taxpayers, exempt organizations, trusts, and most C corporations—to offset taxable income in other tax years. NOLs allow companies, both large and small, to have an average effective tax rate over time that reflects their taxable income over the long run, survive the start-up years, and survive economic downturns.
To illustrate these principles, let us say you read an article about a big company—let’s call it Fortune 50—that is paying “No Taxes!” or has an effective tax rate that is “Lower Than a Janitor!” Sensational headlines are undoubtedly effective. But once you cut away the smoke and mirrors of those headlines, it may only be buried in the article the note that Fortune 50 paid significant taxes in a prior year and/or will pay significant taxes in future years.
This article will take a step back from these sensational headlines and examine how NOL deductions make these headlines possible, and explore whether NOL policy is effective or whether there are better alternatives.
‘Lean’ and ‘Lush’ Years
Tax law is designed to have the tax rate of a company reflect its taxable gross income over a number of years. Going back to the hypothetical Fortune 50 article, consider this example—Fortune 50 has taxable income/loss as follows: Year One: $5 billion; Year Two: $6 billion; Year Three: $1 billion. Over the course of its three-year business, Fortune 50 broke even, but the headline in Year Three might be “Fortune 50 Pays No Taxes!” This may sound shocking, but if Fortune 50 makes zero profits over a three-year period, it is then unsurprising that Fortune 50 owes no taxes.
Indeed, as the Supreme Court succinctly stated in Lisbon Shops v. Koehler, “Those (NOL rules)…were enacted to ameliorate the unduly drastic consequences of taxing income strictly on an annual basis. They were designed to permit a taxpayer to set off its lean years against its lush years, and to strike something like an average taxable income computed over a period longer than one year.”
NOL deductions can also be helpful for start-up businesses, particularly the carryforward of deductions to future years, which currently is indefinite. Start-up companies focusing on creating a new product or technology may initially go through many years of investment and operations before the company’s income exceeds its annual expenses. Without NOL carryforward deductions, such companies would not be able to take advantage of deductions accrued in the early years before they achieved stability and profitability. As the US economy has increasingly been driven by companies that began as startups within the last 15 to 20 years—Airbnb, Tesla, Uber, etc.—it is evident that there are significant economic benefits to being able to carry early losses forward.
NOLs also encourage companies to maintain and/or reorganize operations during economic downturns. When companies face difficult periods—either because of a surprise business cycle or nationwide economic conditions such as the 2008 financial crisis or Covid-19—they can take comfort in the fact that NOLs occurring during such periods may be carried forward to more profitable periods in future. NOLs can provide some reassurance that may help prevent companies from making drastic decisions to scale back operations or shrink their workforces.
Legislative Tool
Congress uses NOLs as a policy tool, so the law regarding NOLs changes. For example, to help spur the economic stimulus needed in response to the dot-com crash and ensuing recession, Congress passed legislation in 2002 allowing for a temporary five-year carryback period—an extension from the then-current two-year carryback window. This extended carryback was available for NOLs arising in the taxable years 2001 and 2002. Later, in response to the Great Recession beginning in 2008, Congress again created a temporary extension to the NOL carryback rule. This allowed taxpayers to elect to carry back certain losses occurring in 2008 and 2009 for three, four, or five years.
Then, in 2018, the Tax Cuts and Jobs Act of 2017 (TCJA) made it so that NOLs are subject to a 20% haircut. This means they can only be used to offset up to 80% of taxable income and cannot be carried back to offset taxable income in prior years but can be carried forward indefinitely—hereafter, the NOL General Rule. Prior to 2018, NOLs could be carried back up to two years and carried forward up to 20 years with no haircut. Abandoning the carryback dulls the effectiveness of NOLs when it comes to their usefulness and ability to help businesses survive a slowdown. Under the NOL General Rule enacted by the TCJA, distressed companies will no longer be able to use NOLs to obtain quickie refunds either.
Presumably recognizing these NOL benefits, on March 27, 2020, as part of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), Congress retroactively modified and expanded the NOL General Rule for certain years. Under the CARES Act, NOLs arising in the years 2018 through 2020 can be carried back five years, and the 20% NOL haircut is temporarily suspended for NOLs carried forward to years beginning before 2021.
As illustrated by the foregoing, Congress has shown that it is ready and able to deviate from the NOL General Rule. Yet important questions remain; for example, whether sharpening the NOL tool for specific purposes is as effective as having a stable general rule and whether other tax relief may be more effective for specific events.
For one point of comparison, the Employee Retention Credit (ERC), also introduced by the CARES Act, is a form of stimulus providing more direct help to companies struggling during the pandemic. The ERC provides relief to companies that retained employees during the pandemic, generally by relieving the companies from having to pay 50% of certain employer taxes. By tying the tax relief directly to the company’s willingness to maintain its operations and keep members of its workforce employed, the ERC has arguably been more effective in providing help to companies that would otherwise have faced pressure to reduce their workforces as a result of the pandemic.
Conclusion
NOLs can be viewed as a broad instrument for providing financial aid to companies during economic downturns. But without a requirement to link NOL relief to a specific event impacting the business Congress seeks to aid, increasing all distressed taxpayers’ ability to utilize NOLs is nothing more than a reduction in the overall effective tax rate for those businesses that might be wholly unaffected by the specific event causing the downturn.
Some of these businesses should fail under the NOL General Rule. We suggest more pointed stimulus, such as targeted NOL relief, and credits, such as ERCs. We also advocate for the return of the NOL carryback so that, without having to hope that Congress will act, companies know that there is a safety net available. Ultimately, the goal should be to encourage reasonable entrepreneurial risk-taking.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
Patrick M. “Rick” Cox is a partner with Nixon Peabody’s M&A and Corporate Transactions practice and a member of its Tax team. Rick focuses on various tax aspects facing domestic and international companies and provides significant experience in areas of capital markets, reorganizations, real estate, and private equity matters.
Brian Kenney is an associate in Nixon Peabody’s Corporate practice and a member of its Tax team. He advises corporate clients on tax matters relating to mergers, acquisitions, fund formation, private equity investments, and other business transactions, and has extensive experience advising clients on inbound and outbound tax issues on real estate investments.
Myra A. Benjamin, also a Nixon Peabody associate, is a litigator and a member of the firm’s Complex Disputes practice. She represents clients in federal and state courts in numerous commercial litigation matters, including tax disputes, lender liability, contract disputes, bankruptcy and creditor-debtor, fraud, business torts, and real estate foreclosures.
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