Guidance

RESOURCES TO HELP SHAPE YOUR FINANCIAL FUTURE

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Daniel F. Rahill, LL.M, CPA, J.D.
Managing Director
Wintrust Wealth Services
 

At this point, most of us are familiar with the Coronavirus Aid, Relief, and Economic Security (CARES) Act passed earlier this year, which provided $2.2 trillion in economic impact payments, assistance to small businesses, and more amidst the ravages of COVID-19. Now, months later, economic output and employment remain far below their pre-pandemic levels and many of our clients are desperately seeking ways to generate liquidity.

Those who only see the CARES Act as a way to access immediate liquidity from loans may be overlooking significant tax provisions that can generate cash flow in 2021 and beyond. The Act contains several temporary changes to the Tax Cuts and Jobs Act of 2017 (TCJA) of which CPAs can take advantage. Following are three strategies to take advantage of CARES Act provisions to maximize cash flow long after the loans have been disbursed and stimulus payments have been spent.

Strategy 1: Maximize Tax Value of Net Operating Losses and Carrybacks
Under the CARES Act, net operating losses (NOLs) arising in tax years beginning after December 31, 2017, and before January 1, 2021 may be carried back to each of the five tax years preceding the tax year of such loss. Under the TCJA, NOLs generally could not be carried back; they could only be carried forward indefinitely, and NOLs could only be used to offset 80 percent of taxable income. The CARES Act temporarily removes the 80 percent limitation, reinstating it for tax years beginning after 2020. Special carryback rules are provided for some businesses such as real estate investment trusts (REITs) and life insurance companies.

In addition, organizations are allowed to use an NOL from a tax year with a lower corporate tax rate such as 2020, where the federal corporate tax rate is 21 percent, to offset taxable income that was subject to a higher corporate tax rate in an earlier tax year, such as 2015, where the corporate tax rate was 35 percent. This provides a unique opportunity to use deductions generated in the lower tax bracket years of 2018 to 2020 to offset income in the higher tax bracket years of 2013 to 2017.

Organizations can still waive the carryback and elect to carry NOLs forward to subsequent tax years in certain situations where that may be more beneficial. Taxpayers such as international corporations will want to consider how other tax attributes such as foreign tax credits or the transition tax on repatriated income will be impacted by an NOL carryback and plan accordingly. Organizations participating in an M&A transaction will also want to consider contractual limitations affecting their ability to carry back, or carry over, an NOL.

The tax returns for 2019 and 2020 must be filed before a refund may be requested. Therefore, in early 2021, expect a significant boost to cash flow for calendar year 2020 taxpayers who incur significant losses because of the COVID-19 crisis. These taxpayers should file their returns as soon as possible after their year-end so that a refund claim may be filed. A refund may be requested by filing either Form 1120X or Form 1139 for corporations, or either Form 1040X or Form 1045 for individuals. Forms 1139 and 1045 are a much faster process, as the IRS is required to issue a tentative refund by the later of 90 days after filing the form, or 90 days from the last day of the month of the due date of the taxpayer’s return for the NOL year, including extensions. Taxpayers who file their 2020 tax returns by April 15, 2021 should therefore begin receiving their refunds by the summer of 2021.

Strategy 2: Accelerate Excess Business Loss Tax Benefits
Under the TCJA, for tax years beginning after December 31, 2017 and ending before January 1, 2026, taxpayers other than C corporations are not allowed to deduct excess business losses. For this purpose, and with some exceptions, “excess business loss” essentially means taxpayers’ otherwise deductible trade or business losses in excess of $250,000 for single filing taxpayers, or $500,000 for married taxpayers filing jointly, adjusted for inflation. Disallowed excess business losses were carried forward and treated as a net operating loss in subsequent tax years. Under the CARES Act, the excess business loss limitation for non-C corporations is retroactively eliminated for tax years beginning before 2021, potentially increasing the amounts available for loss carryback.

Strategy 3: Capitalize on Increased Deduction Allowances
Qualified Improvement Property Deductions
The CARES Act qualified improvement property (QIP) provision enables businesses to use bonus depreciation to immediately write off costs associated with improving facilities instead of having to depreciate those improvements over the 39-year life of a commercial building. QIP is defined as any improvement made by a taxpayer to an interior portion of a nonresidential building after the building was placed in service. The QIP provision, which corrects an error in the TCJA often referred to as the “retail glitch,” not only increases companies’ access to cash flow by allowing them to claim the benefit retroactively, but also incents them to continue to invest in improvements as the country recovers from the COVID-19 economic fallout. Either amending 2019 tax returns for this law change if already filed or claiming bonus depreciation now as 2019 tax returns are filed, can produce significant cash flow benefit.

The CARES Act changes to depreciation are further enhanced by the bonus depreciation rules and cost segregation studies. Bonus depreciation allows individuals and businesses to immediately deduct a certain percentage of their asset costs the first year they are placed in service. The TCJA made used property eligible for bonus treatment for the very first time, and it also increased the bonus percentage to 100 percent through tax year 2022. Prior to this, only new property was eligible, and bonus depreciation was expected to be only 50 percent in 2019. Any assets that are removed from the “real property” category and placed in the “personal property” category may now be eligible for bonus depreciation and can be immediately expensed in the first year.

A cost segregation study is an established technique used to further enhance cash flow, reduce tax liability, and uncover missed deductions. The study assesses an entity’s real property assets to identify the portion of those costs that can be treated as personal property. By segregating personal property from the building itself, the study will allow for costs that would have otherwise been depreciated over a 39-year period to be reassigned to asset groups that will be depreciated at a much quicker pace, or perhaps even expensed immediately as bonus depreciation.

Business Interest Deductions
Under the TCJA, business interest expense deductions are generally limited to 30 percent of a company’s adjusted taxable income. The CARES Act increases that to 50 percent for taxable years 2019 and 2020. In addition, a company can elect to use their 2019 adjusted taxable income (which is likely higher than their 2020 adjusted taxable income) to compute the business interest expense deduction for the 2020 taxable year. It should be noted that special rules apply to businesses taxed as partnerships.

Increased Charitable Deduction Limits
One significant consequence of the TCJA is the dramatic reduction in the number of taxpayers that itemize deductions. Many donors now opt for an increased standard deduction (and do not itemize their deductions) and therefore get no tax benefit for their charitable contributions.

This changes under the CARES Act. An individual can now claim an above-the-line deduction of up to $300 for donations made to qualified charitable organizations. As a result, donors may be entitled to a charitable deduction whether or not they itemize. One caveat: The deduction is not available for contributions to private foundations or donor-advised funds. The first $300 donated in 2020 goes toward this deduction. Therefore, itemizers will benefit from the deduction before claiming any other donations on Schedule A. Any excess is carried forward for up to five years.

Prior to the CARES Act, an individual’s annual deduction for cash contributions was limited to 60 percent of adjusted gross income (AGI). This limit was raised from 50 percent of AGI for 2018 through 2025 by the TCJA. The CARES Act increases this deduction limit to 100 percent of AGI for 2020. Therefore, a taxpayer who itemizes can generally write off the full amount of his or her charitable contributions of cash or cash-equivalents in 2020. Any excess above 100 percent of AGI is carried forward for up to five years. As is the case with the new $300 deduction, this provision does not apply to private foundations or donor-advised funds.

The TCJA also imposes limits on deductions for charitable contributions made by corporations: the annual deduction for contributions by a corporation cannot exceed 10 percent of its taxable income, with any excess carried forward for up to five years. Under the CARES Act, the annual threshold for corporate deductions is increased to 25 percent of taxable income for 2020, with any excess carried forward for up to five years.

The CARES Act offers a unique opportunity to help businesses and individuals impacted by COVID-19 maximize cash flow long after 2020 tax returns are filed. By exploring these options and implementing the best available strategies, organizations and individuals alike can generate liquidity during this economically challenging time.

 

About the Author
Illinois CPA Society member Daniel F. Rahill, CPA, JD, LL.M., CGMA, is a managing director at Wintrust Wealth Services. He is also a former chair of the Illinois CPA Society Board of Directors.