The CARES Act Includes Many Tax Incentives for Businesses – Expands Ability to Take Losses and Deductions

By Bahar Schippel and William Kastin

On March 27, 2020 the President signed into law a historic $2 trillion stimulus package known as the Coronavirus Aid, Relief, and Economic Security ("CARES") Act to provide economic stimulus for the devastation resulting from the spread of COVID-19.  Below are some of the business-related tax relief measures included in the CARES Act.

Modification of Rules Relating to Net Operating Losses Carrybacks

Under prior law, net operating losses could not be carried back to prior years and could only be carried forward (other than in certain very limited circumstances).  The CARES Act permits a five-year carryback of net operating losses.  That is, net operating losses arising in a tax year beginning in 2018 and before 2021 can be carried back to each of the five tax years preceding the tax year of such loss.  

One of the practical implications of this change is that businesses that suffer a loss in 2020 as a result of the COVID-19 pandemic but were profitable in the prior five years can carryback the 2020 losses to such prior years and obtain a refund of those previously paid taxes. 

Removal of 80% Limitation

Under prior law, a taxpayer could only offset 80% of its taxable income with its net operating losses.  For example, if a taxpayer had (i) $100 of operating losses in 2018 that were carried forward to 2019, and (ii) $100 of taxable income in 2019, then the taxpayer could offset only $80 of its 2019 taxable income with the 2018 net operating losses carryforward.  The CARES Act temporarily removes this limitation such that the net operating loss carryforwards may offset 100% of a taxpayer’s taxable income.  This temporary change generally applies to tax years beginning in 2018 through 2021.  The change also applies to tax years beginning before 2018 to which net operating losses arising in tax years beginning in 2018 are carried back.

One of the practical implications of this change is that businesses can make full utilization of their 2020 COVID-19 epidemic related losses, either by carrying those losses back to prior years or forward to future years, without being limited by the 80% cap.

Modification of Limitation on Losses for Non-Corporate Taxpayers

Under prior law, for the years 2018 through 2025, a non-corporate taxpayer could only offset non-business income with up to $250,000 ($500,000 for married individuals filing jointly) of business losses.  For example, if, in 2018, a single individual had (i) business losses of $300,000, and (ii) non-business income of $400,000, then the taxpayer could only use $250,000 of its $300,000 business loses to offset its $400,000 of non-business income; and as a result, the taxpayer would have $150,000 of non-business income for 2018.  The CARES Act removes this limitation for the years 2018 through 2020.   

One of the practical implications of this change is that if a non-corporate taxpayer paid taxes on non-business income in 2018 or 2019, but had business losses that were subject to this limitation, the taxpayer maybe able to file an amended return and seek a refund of those taxes. 

In terms of the example above, the taxpayer could file an amended return for 2018, applying the full $300,000 of business losses against its $400,000 of non-business income; and as a result, the taxpayer would have only $100,000 of non-business income for 2018, resulting in a $50,000 refund.   

Deductibility of Interest Expense Increased

Under prior law, a taxpayer's business interest deductions were generally limited to 30% of the taxpayer’s adjusted taxable income (with certain exceptions). The CARES Act temporarily and retroactively increases the limitation on the deductibility of interest expense from 30% to 50% for tax years beginning in 2019 and 2020. In addition, taxpayers can elect to calculate the interest limitation for their tax year beginning in 2020 using the adjusted taxable income for their last tax year beginning in 2019 as the relevant base. For partnerships, this election must be made by the partnership.

The CARES Act contains a special rule for partnerships with respect to the interest deduction limitation for partners for 2019, presumably because many partnerships have already filed their 2019 tax returns, which were due on March 15, 2020 (unless the partnership filed for an extension).  For partners whose interest expenses in 2019 exceeded 30% of their adjusted taxable income and were otherwise subject to the 30% limitation, they are allowed to deduct 50% of the 2019 interest expense that was disallowed in 2020.  That is, 50% of the excess business interest that was disallowed in 2019 will be treated as paid or accrued by the partner in the partner's first tax year beginning in 2020 and isn't subject to any limits in 2020.

The following examples illustrate how the interest expense limitation rules apply under the CARES Act:  If a partner had $100 of adjusted taxable income and $50 of interest expense in 2019, then if the partner was subject to the 30% business interest limitation rules, the partner would be required to carry over $20 (the excess above 30% of $100) to 2020.  As provided for in the CARES Act, the partner can now deduct $10 (50% of the $20 of the excess 2019 interest expense that was carried forward) in 2020 without any interest expense limitation.  If the same partner has $100 of adjusted taxable income and $50 of interest expenses in 2020, then that partner can deduct $60 in 2020 (50% of $100 for 2020 plus 50% of the $20 the interest expense carryover from 2019).  Also, if the partnership makes an election to apply the 2019 adjusted taxable income as the relevant base, then the 50% limitation will apply based off the higher 2019 income amount.  Thus, in the example above if the partner’s 2020 income is $60 instead of $100, the partner can still take a full $60 deduction against such income (50% of $100 — i.e., the 2019 income amount– for 2020 plus 50% of the $20 the interest expense carryover from 2019).    

One of the practical implications of this change is that businesses that will be borrowing small business and other loans in 2020 to assist their business deal with the COVID-19 pandemic will be able to offset a larger portion of their 2020 taxable income with business interest expense deductions.  However, to the extent of interest paid after 2020, the lower 30% interest expense limitation will apply unless the taxpayer can qualify for one of the existing exception to the interest expense deduction limitation rules.

Making “Qualified Improvement Property” Eligible for Bonus Depreciation

The CARES Act includes a major incentive for the real estate industry, permitting them to write off the entire cost of certain interior building improvements in the year of purchase, which immediate write-off was not available under prior law for such property.  

By way of background, historically, improvements to non-residential real property have a 39-year depreciation recovery period.  Prior to the Tax Cuts and Jobs Act of 2017 (“TCJA”), an additional first-year bonus depreciation rule had three components which, when working together, significantly benefited taxpayers.  First, the rules established, among others, three categories of non-residential real property interior building improvements – (i) qualified leasehold improvement property, (ii) qualified restaurant property, and (iii) qualified retail improvement property.  Second, the rules provided that property falling within any of those three categories would be treated as having a 15-year depreciation recovery period.  And third, and most significantly, the rules provided that property with a depreciation recovery period of 20 years or less would be eligible for additional first year bonus depreciation.  As a result, interior building improvements previously subject to a 39-year depreciation recovery period were eligible for first year bonus depreciation.  The law has been modified over time, and prior to the TCJA, examples of improvements which qualified for bonus depreciation included lighting fixtures, flooring, and certain other internal building improvements. 

In 2017, the TCJA revised the bonus depreciation rules to replace the above three categories with a single more comprehensive category referred to as “Qualified Improvement Property” or QIP.  However, in making that revision, the TCJA did not provide that QIP would have a 15-year depreciation recovery period, and as a result, QIP would be treated as having a 39-year depreciation recovery period. Significantly, because bonus depreciation is only available for property with a depreciation recovery period of 20 years or less, QIP was not eligible for bonus depreciation.  As a result, the TCJA put real estate businesses in a worse position than they were in previously – eliminating bonus depreciation for interior building improvements that previously qualified for such treatment under one of the three categories.

And so, although prior to the CARES Act, QIP was not eligible for bonus depreciation, the CARES Act permanently and retroactively (i.e., effective for property placed in service after 2017) treats QIP as (i) 15-year property under the modified accelerated cost recovery system, (ii) 20-year property under the alternative depreciation system, and (iii) eligible for bonus depreciation.

One of the practical implications of this change is that businesses which previously made tax-related decisions based on the law as it applied prior to the CARES Act, may want to revisit those decisions. 

For example, as discussed above, prior to the CARES Act, a taxpayer’s business interest deductions were generally limited to 30% of the taxpayer’s adjusted taxable income, with certain exceptions.  One of those exceptions provided that certain real property businesses could make an irrevocable election to be excluded from this limitation – thereby allowing such businesses to deduct 100% of their business interest deductions (as opposed to deducting business interest deductions equal to only 30% of their adjusted taxable income).  However, the trade-off was that any taxpayer who made such an election could not be eligible for bonus depreciation.  In other words, such taxpayers would compare (i) the benefits of deducting 100% of their business interest deduction to (ii) the benefits of bonus depreciation.  Prior to the CARES Act, this comparison for real estate businesses was fairly easy because bonus depreciation wasn’t available for QIP.  However, after considering all of the changes in the CARES Act, real estate businesses may now want to consider (i) whether the election to be excluded from the business interest deduction limitation could be revoked (presumably the IRS will have to provide guidance with respect to whether a previously made election can be revoked), and (ii), if it can be revoked, whether it makes sense to do so.

Guidance in response to the COVID-19 pandemic is constantly being updated.  This article is merely intended to introduce you to the Notice and is not a substitute for careful tax planning.  If you have any questions, you are strongly encouraged to reach out to your tax advisor.

For other tax relief measures:

The CARES Act Includes Many Tax Incentives for Employers – Deferral of Payment of Employer Taxes and Employee Retention Credit

The CARES Act Includes Many Tax Incentives for Employers – Charitable Contribution Modifications

Families First Coronavirus Response Act: Summary of the Employment Provisions of the New Law

The IRS Moves Tax Day From April 15 to July 15, 2020

Arizona Postpones State Income Tax Filing and Payment Due Dates from April 15 to July 15

California COVID-19 Tax Relief

Tax and Estate Planning in the Current Environment

SW Benefits Update: Tax-Favorable COVID-19 Pandemic Relief for Employees and Employers Covered by Section 139 Programs