Many small businesses likely will have losses for 2020. After the COVID-19 subsides, there may be some bounce back in business, but it probably won’t make up for the extended closures and cutbacks. Government assistance in the form of low- or no-interest loans will help with cash flow, but not with profits. So, let’s face it, you could very well have a tax loss for this year. What does this mean?
Businesses must report all their income and can deduct all allowable expenses. When these expenses exceed income, there’s a tax loss. C corporations treat the tax loss—the amount that can’t be used on the current tax return—as a net operating loss. For owners of pass-through entities (sole proprietorships, partnerships, limited liability companies, and S corporations), the NOL is taken at the owner level because losses pass through to them.
The CARES Act changed the rules for NOLs for 2018, 2019, and 2020 to revert to pre-Tax Cuts and Jobs Act (TCJA) rules. TCJA had ended any carrybacks (other than for farming businesses) and limited offsets against taxable income to 80%. What does the CARES Act changes mean? NOLs arising in any of these years can be carried back for 5 years to offset 100% of taxable income. Unused amounts can then be carried forward. The carrybacks can be waived, but by using NOLs to offset income in earlier years, you can receive an immediate tax refund (i.e., cash that you can use to put back into your business now). (There’s IRS guidance on these new rules.)
You probably didn’t have a NOL in 2018 or 2019—the boom years. But if you did, the IRS has granted a 6-month extension to file Form 1139 for C corporations or Form 1045 for individuals for an NOL that arose in a taxable year that began during calendar year 2018 and ended on or before June 30, 2019. You can even fax the forms to the IRS for a quicker response. And, due to new IRS permission, partnerships that have losses to pass through to partners can do so on amended returns and revised Schedule K-1s (used Form 1065, check the box to indicate an amended return, and write “FILED PURSUANT TO REV PROC 2020-23” at the top).
For many businesses, 2020 may very well produce a NOL. You don’t have to wait until you file your 2020 tax return to take these carrybacks and get a refund. There is a procedure to obtain a quick/tentative refund by filing for it before you file your 2020 return and without filing amended returns for prior years.
Note: TCJA had created an additional limit on losses for noncorporate taxpayers. This limitation has been suspended for 2019 and 2020.
Impact on other tax provisions
There’s a domino effect from having a loss. It hits various tax rules. Here are some key rules to note:
Self-employment tax. If you are self-employed and don’t have a profit for 2020, you aren’t liable for self-employment tax. However, if you want to obtain Social Security credits, there’s an optional way of figuring self-employment tax (assuming you’re eligible to use this option).
Retirement plan savings. If you’re self-employed, contributions to your SEP or other qualified retirement plan is based on net earnings from self-employment. With no such income, no contributions can be made for the year. So, retirement savings is on hold for the year.
Section 179 deduction. If you buy equipment in a year where there are losses, it may not make sense to elect to use the Section 179 deduction (first-year expensing). This is because the deduction is subject to a taxable income limitation. The total cost you can deduct each year after you apply the dollar limit is limited to the taxable income from the active conduct of any trade or business during the year. For owners of partnerships and S corporations, the limitation applies at both the entity and owner levels. However, you can still use bonus depreciation for eligible property, even if this deduction increases a net operating loss.
QBI deduction. For owners of pass-through entities, understand how losses impact the qualified business income (QBI) deduction. If an owner has more than one business, QBI is figured separately for each. Then the amounts are combined, so that if one business has positive QBI while another has negative QBI, the loss reduces the income.
If QBI in total is negative, which can result for example if you own one business that isn’t profitable this year, then the loss is carried forward and treated as negative QBI in the carryforward year. In other words, you’ll need to have profits in the carryforward year in excess of the negative QBI in order to take any QBI deduction that year. For example, in 2020 you have a QBI loss of $10,000. In 2021, your QBI is $22,000. The QBI deduction for 2021 is based on $12,000 ($22,000 - $10,000).
If losses continue into 2021, then in figuring the QBI deduction after that, negative QBI is used on a first-in, first-out basis (use the oldest negative QBI first).
Note: I think this is a highly unfair result and that QBI should stand on its own year by year. If 2020 results in negative QBI, it should not have any effect on the deduction for 2021. I have been trying to make this point with key members of Congress. Let’s see what happens.
Because NOLs and negative QBI impact your tax results in future years and are used in specific ways, you need to keep track of these amounts. Work with a CPA to be sure that you’re applying proper limits for losses but are taking all the write-offs you’re entitled to.
Circling back to the opening notion that businesses are going to take a big hit this year, there’s more to it. The reality is that some businesses won’t survive the shutdown in the economy for March and April. Those that do survive are facing serious challenges. The U.S. is already in a recession.
But remember what Walt Disney said:
“I’ve heard there’s going to be a recession. I’ve decided not to participate.”