Amid all the other stimulus provided in the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) is a major change in the tax treatment of net operating losses (NOLs). This change is especially relevant for:
- acquirers and sellers of business assets and
- businesses who engaged in an initial coin offering (ICO), initial exchange offering (IEO) or any other major income-producing event since 2015.
Summary of NOL Rules
Under the CARES Act, NOLs incurred in 2018, 2019 and 2020 can be carried back up to five years. Before this change, NOLs from those years could only be carried forward to future years. This opens the door for significant tax savings from tax refunds, particularly if a business can carry back an NOL to 2017 or earlier when the corporate tax rate was 35%.
Beginning in 2018, there was a new limitation on NOLs. NOLs that were carried forward from 2018 and later could only offset 80% of a corporation’s taxable income. For example:
Cloud Inc. generates a loss of $100,000 in 2018. In 2019, Cloud Inc. has $50,000 in taxable income. Before the Act, Cloud Inc. could only offset $40,000 of its income with the NOL carryforward from 2018 (80% of $50,000). After applying the NOL of $40,000, Cloud Inc. would have $10,000 of taxable income. After the Act, Cloud Inc. can offset all $50,000 of taxable income in 2019 with its 2018 NOL carryforward.
NOL Carryforwards for Asset Sales
In M&A transactions, buyers frequently prefer to acquire a seller’s assets rather than stock. On the corporate side, the buyer avoids inheriting unknown liabilities of the seller. On the tax side, the buyer gets an increased tax basis in the assets.
From a tax perspective, if not for a corporate-level tax (more on that below), sellers are essentially indifferent between an asset transaction or a stock deal. Following an asset sale, the corporation liquidates, distributes its cash and any other property to its shareholders, and the shareholders report gain or loss based on the difference between what they receive in the liquidation and their tax basis in their stock. This is essentially the same as in a sale of stock.
Why doesn’t everyone choose an asset deal? It’s partly because the mechanics of transferring assets can be challenging. But more important, an asset sale can generate a massive corporate tax liability. If the corporation has gain when it sells its assets, it has a corporate tax liability. This tax liability can be avoided in a stock sale. Therefore, sellers sometimes insist on a stock sale to avoid the corporate tax liability. But the corporate tax liability can also be avoided if a corporation has NOL carryforwards.
Before the Act, businesses seeking to engage in taxable asset sales were increasingly coming up against the 80% limitation on NOLs. After the Act, corporations may now use 100% of their NOLs from 2018 and 2019 to offset taxable income. This will facilitate asset sales.
In this harsh economic environment, loosening the rules on the sue of NOLs to facilitate assets sales provides welcome relief. It may also encourage buyers to acquire targets with NOLs hoping to preserve the NOLs. This requires buyers to navigate the strict rules restricting the use of a target’s NOLs following a change in control.
NOL Carrybacks for ICOs and IEOs
After fitting in three obscure acronyms in a single title, it’s worth considering the implications of NOLs for companies that paid large tax bills on an ICO or IEO. Companies that launched successful ICO or IEO offerings face significant tax liabilities. For U.S. tax purposes, an ICO or IEO is taxable. This makes ICOs and IEOs very different than stock or debt offerings, which are tax-free for corporations.
The advent of ICOs coincided with the new tax restrictions on NOLs in 2018. But now, those restrictions are lifted for losses in 2018, 2019 and 2020. Now, if a company had a significant tax liability from an ICO or IEO, it can carry back losses from 2018, 2019 and 2020 to offset its income from the ICO or IEO and generate a refund. It’s rare that a change in tax law can bring retrospective relief!