The COVID-19 pandemic has had wide-ranging effects. The Coronavirus Aid, Relief, and Economic Security (CARES) Act legislation, signed into law on March 27 in response to COVID-19, has reshaped the tax landscape as we know it. Gone, for example, are the restrictions imposed on carrying back certain tax attributes, including net operating losses (NOLs), for certain tax years following the enactment of the Tax Cuts and Jobs Act (TCJA). The CARES Act also provides liquidity to taxpayers in great need of that liquidity. Yet this provision of liquidity has raised many questions.
Will carrying back certain tax attributes to years that are otherwise closed for assessment of tax “reopen” those years to tax assessment? If so, to what extent? What is the likelihood of an Internal Revenue Service audit if a taxpayer carries back an NOL that exceeds the threshold for review by the Joint Committee on Taxation (JCT)? Will the IRS be more likely to audit and identify issues that may arise in a carryback year? How long does the JCT take to review a claim for refund, whether a tentative claim or otherwise? Can taxpayers rely on IRS guidance in the form of FAQs (frequently asked questions) related to the provisions of the CARES Act so as to protect themselves against penalties, among other purposes?
These questions, both timely and relevant, are of course particularly crucial to taxpayers that have sought to leverage the benefits afforded by the CARES Act. This article attempts to address these and other questions that have emerged in the wake of the CARES Act.
The Challenge: Reducing Audit Risk While Enhancing Loss Utilization
Prior to the enactment of the TCJA in 2017, Section 172 generally allowed taxpayers to carry back NOLs up to two years and to carry NOLs forward up to twenty years to offset taxable income in the carryback and carryforward years. The TCJA, however, amended Section 172(b)(1)(A)(i) by, in part, prohibiting taxpayers from carrying back their losses to prior years for tax years beginning after 2017. Taxpayers were, however, allowed to carry forward NOLs indefinitely. Amended Section 172(a) of the TCJA further capped a taxpayer’s NOL deduction at the lesser of 1) the aggregate of NOL carryovers to the tax year, plus NOL carrybacks to the tax year, or 2) eighty percent of taxable income computed for the tax year without regard to the NOL deduction allowed for the tax year.
In an effort to boost taxpayers’ liquidity, the CARES Act changed these provisions with respect to NOLs arising in tax years beginning after December 31, 2017, and before January 1, 2021. Specifically, Section 172(b)(1)(D)(i) of the CARES Act generally permits taxpayers to carry back NOLs arising in these years to each of the five tax years preceding the tax year of the loss. This provision is particularly valuable given that taxpayers can carry back NOLs from a twenty-one percent tax year to a thirty-five percent tax year, thus reducing the applicable tax rate in the carryback year by fourteen percent. The CARES Act further eliminated the eighty percent of taxable income limitation on deductibility for NOLs carried over or carried back to tax years beginning before January 1, 2021.
Many taxpayers have either applied or plan to apply these new NOL provisions of the CARES Act. Specifically, many taxpayers filed Forms 1139 (Corporation Application for Tentative Refund) and Forms 1045 (Application for Tentative Refund) by the July 15, 2020, deadline with respect to their 2018 tax years. Many taxpayers have already received the refunds requested in those claims. The story, of course, does not end with the IRS’ issuance of a tentative refund. Despite the fact that the IRS is obligated to issue the tentative refund provided there are no significant computational errors—and is obligated to do so even with respect to refunds that exceed the threshold for JCT review, pursuant to Section 6405(a), $2 million for individual taxpayers and $5 million for C corporations—the IRS may later examine the propriety of the claimed refund. While such an examination is more likely where claimed refunds exceed the JCT review thresholds, nothing prevents the IRS from examining refunds that fall below those thresholds as well. That examination process, including the likelihood of audit of those tentative refunds, the timing of the JCT review, and the timing of examinations, are front and center in many taxpayers’ minds. Furthermore, many taxpayers that have carried back an NOL to an otherwise closed year may have questions about the IRS’ ability to “reopen” a closed year.
Many taxpayers may also intend to carry back NOLs via a Form 1120X or Form 1040X. These taxpayers have many of the same questions but are often even more interested in the review process in light of the fact that refunds claimed through formal refund claims that exceed the JCT review thresholds must first undergo JCT review prior to issuance. The nature and duration of the JCT’s review process thus are similarly of great interest to these taxpayers, particularly given the liquidity shortfall that many taxpayers currently face.
Assessment Statute With Respect to NOL Carrybacks and Carryforwards
The operation of Section 6501s assessment statute of limitations can be confusing. Whereas applying the general assessment statute period of three years set forth in the Section 6501(a) is relatively straightforward, things may be less clear with respect to NOL carrybacks, in that Section 6501(h) establishes an exception to the general three-year limitations period with respect to NOL and capital loss carryback claims. (Note that Section 6501(k) performs a similar function with respect to tentative refunds.)
Section 6501(h) makes clear that a deficiency attributable to the reduction of an NOL carryback may be assessed at any time before the expiration of the limitations period for assessing a deficiency for the year of the loss. Thus, under the right circumstances, it is irrelevant that the assessment statute has run with respect to the carryback year. What controls, rather, is whether the assessment statute is open for the year of the loss itself. If the statute is open with respect to the loss year, the IRS can assess a deficiency attributable to the reduction of the NOL carryback in the carryback year.
Importantly, however, the IRS can assess only a deficiency attributable to the NOL carryback. In the context of Section 6501(h), the IRS can examine items in the closed year that are unrelated to the NOL to offset (reduce) the amount of the NOL carryback, but the IRS cannot assess tax unrelated to the NOL carryback. In the context of Section 6501(k), the IRS can examine items and assess deficiencies in the closed year that are unrelated to the NOL, but those assessed deficiencies cannot exceed the amount of the NOL carryback. This may alleviate some taxpayer concerns regarding NOL carrybacks to otherwise closed years. On the other hand, if the assessment statute of limitations on the loss year has run, but the carryback year is still open by agreement, the IRS may still issue a notice of deficiency for the carryback year. See, for example, Calumet Indus., Inc. v. Commissioner, 95 T.C. 257 (1990).
Consideration. One way to remember the above rule is to keep in mind that the year controlling the assessment statute is the year in which the loss arose. For example, suppose that a taxpayer has a $10 million loss that arose in 2019 and carries that loss back on a Form 1120X to 2015. The IRS may assess a deficiency in 2015 attributable to the $10 million loss at any time before the expiration of the statute of limitations for 2019 has run. If the IRS, though, wants to assess any amount of deficiency unrelated to the NOL carryback in excess of $10 million, the assessment statute for 2015 must be open. Taxpayers may want to consider whether or not to extend the assessment statute as well for years in which they have generated and carried back large NOLs for just this reason.
With respect to carryforwards, in contrast, the IRS can generally examine a closed loss year, as well as any intervening or subsequent year, to determine the correct amount of the loss available for carryover purposes. The IRS cannot, however, make any assessment in a closed year if the loss year is already closed. Indeed, the IRS may adjust items in any closed year and any year between the closed year and the open year to compute the tax correctly in an open year.
Consideration. Revenue Rulings 81-88 and 56-285 also allow a taxpayer to affirmatively adjust items in a closed year to compute tax correctly in an open year. Thus, for example, if a taxpayer believes it incorrectly understated the amount of an NOL in its 2012 tax year, and the taxpayer has carried a portion of that NOL forward for use in 2017, an open tax year, the taxpayer may recalculate the amount of the NOL in the loss year to correctly compute its tax in 2017. Thus, taxpayers should be mindful of the fact that a miscalculated and understated NOL is not necessarily “lost” forever.
A question presents itself with respect to the filing of superseding returns. Taxpayers typically file superseding returns to correct errors, including missing forms or elections. Until recently, the IRS took the position that the superseding return, and not the originally filed return, started the statute of limitations on assessment. See, for example, ILM 200645019 (June 20, 2006).
The IRS recently reversed this position, however. In CCA 202026002, released June 26, 2020, the IRS made clear that its current position is that the original return, and not a superseding return, constitutes “the return” for purposes of Section 6501 and starts the three-year statutory assessment period. Thus, taxpayers that file superseding returns should consider filing refund claims within three years of the filing of the initial return if their refund statute of limitations is not otherwise extended.
OK, So I Carried Back an NOL. Will I Get Audited?
As discussed above, many taxpayers already had large NOLs from their 2018 and 2019 tax years or anticipate generating large NOLs in 2020 due, in part, to COVID-19. These taxpayers can now carry back those NOLs to years that had been closed for carryback prior to the enactment of the CARES Act. This benefit, however, may come with an associated risk. For one thing, if a taxpayer is already under audit, the Exam team may well review the refund claim and even, potentially, add additional tax years to the audit cycle. This decision may prolong the audit.
Then there is also the issue of JCT review. Specifically, Section 6405 requires that the IRS submit reports to JCT with respect to refunds or credits in excess of $2 million for individuals and $5 million for C corporations.
Section 6405(a) applies to an examination of an original return, a refund claim, or an affirmative adjustment raised during an examination. Section 6405(a) states that no refund or credit over $2 million or $5 million will be issued until after the expiration of thirty days from the date the IRS submits a report to the JCT. Section 6405(b), in contrast, governs tentative adjustments, including tentative carryback adjustments claimed on Forms 1139 and 1045. As noted above, the IRS will issue the refund or credit with respect to tentative carryback claims before reporting those refunds to the JCT. The IRS, however, often conducts examinations of tentative refunds quickly and proactively, since these refunds may pose collection risks to the IRS if the IRS cannot recover the incorrectly issued tentative refund.
Taxpayers, therefore, need to be cognizant of the additional level of scrutiny that JCT involvement brings to the review process. (See below for more on that topic.) It is further more likely that refund claims exceeding the applicable dollar thresholds will result in examination than those that do not exceed those thresholds due, in part, to the required review by the JCT.
Taxpayers should take notice, too, of the TCJA campaign that the IRS’ Large Business & International (LB&I) Division issued on May 1, 2020. Although the campaign primarily focuses on issues arising from changes the TCJA brought about, the campaign “is also considering the impact of the CARES Act on these returns as well as any others examined.” Thus, Exam teams may well include a rigorous examination of NOL carrybacks (and other aspects of the CARES Act, such as the employee retention credit) in addition to a heavy focus on bread-and-butter TCJA issues, such as Section 965 calculations and GILTI.
So, JCT Will Review My NOL Carryback or Refund Claim—Why Does This Matter?
Questions frequently arise regarding, for example, the nature of the JCT’s review of refunds, the level of rigor the JCT brings to its review, how the JCT process works, and how long the process takes. Here, we address some of those questions.
First, a bit of history. Congress enacted legislation providing for a Congressional Joint Committee on Internal Revenue Taxation in 1926. Congress changed the name of this committee to the Joint Committee on Taxation in 1976. The JCT is a nonpartisan congressional committee consisting of five members from the Senate Committee on Finance and five members from the House Committee on Ways and Means. The JCT operates with an experienced professional staff of attorneys, Ph.D.-holding economists, and accountants.
The JCT’s duties are set forth in Section 8022. At a high level, the JCT monitors the operation of the IRS and its administration of tax laws. The JCT’s duties include considering possible changes in tax law to prevent undue hardships or to eliminate the granting of unintended benefits. Another duty—and one of immediate interest to many taxpayers—involves the JCT’s oversight authority over refunds of income, estate, gift, and certain excise taxes over statutorily prescribed amounts. As stated above, these amounts are $5 million for C corporations and $2 million for all other taxpayers.
Note the distinction between the IRS’ Joint Committee Specialist groups and the JCT itself. The Joint Committee Specialist groups sit within the LB&I Division. These specialists review and approve JCT reports for all examined or surveyed cases involving amounts that exceed the statutorily prescribed thresholds. Once the specialists have reviewed and approved reports prepared by field agents assigned to the case, they forward them to the Joint Committee Program Analyst in LB&I for submission to the JCT itself. In certain cases, including those involving substantial error, corrections favorable to a taxpayer, or fraud or malfeasance, specialists may return a case to the Exam team for further development.
The JCT reports contain information including the taxpayer’s history; the amount and nature of the proposed refunds and deficiencies; the reasons for the refund; the taxpayer’s prior examination history and any current examination activity of the refunds; and information on statutes of limitations for each refund and source year. Once the IRS has drafted and approved a report, it is sent to the JCT for review by the JCT Refund Counsel. JCT Refund Counsel review the IRS’ report and pay particular attention to cases in which taxpayers claim tax benefits that do not appear to have been intended by the relevant statute. Following their review, JCT Refund Counsel may either issue a clearance letter approving the refund or a staff review memorandum sharing concerns regarding the refund with the IRS. Although JCT Refund Counsel may recommend adjustments to the amount of the refund, the IRS is not bound to accept its recommendations, although in practical terms the IRS will work with JCT Refund Counsel and taxpayers to resolve any concerns raised by JCT Refund Counsel.
So how long does the entire JCT review process last? It varies. The bulk of any “delay” in processing a refund typically lies on the IRS’ side of the wall. Before the passage of the CARES Act, in our experience, the IRS’ Joint Committee Specialist groups typically took approximately two to four months to review and approve a report for submission to the JCT. Prior to the passage of the CARES Act, the JCT’s Refund Counsel would typically review and approve (or disapprove) a given refund in thirty days or less. Thus, in a pre-CARES Act environment, in our experience, the total review time averaged approximately four to six months. Following passage of the CARES Act, we’ve seen examples indicating that the review and approval process is moving more slowly than usual. The IRS and JCT are, however, working to streamline the review process in light of the deluge of tentative refund claims and amended returns filed following the CARES Act.
Reliance on IRS-Issued Guidance Regarding the CARES Act
Guidance issued regarding the CARES Act has created questions about the level of support provided for the positions many taxpayers are taking on their tax returns. Establishing “reasonable cause and good faith” for a return position is a near-universal defense against penalties. Penalties assessed for “substantial understatements” of income tax, however, may also generally be reduced by the portion of any understatements that are attributable to the taxpayer’s tax treatment of any item, provided that the taxpayer either 1) has “substantial authority” for that tax treatment or 2) has adequately disclosed the tax treatment of the item and has reasonable basis for that tax treatment.
The challenge here is that the IRS has issued myriad FAQs regarding the provisions contained in the CARES Act and, in many instances, has not provided any other sub-regulatory guidance interpreting those provisions. As of June 10, 2020, for example, the IRS had issued ninety-four FAQs with respect to the Employee Retention Credit, ninety-three FAQs with respect to the Families First Coronavirus Response Act, sixty-nine FAQs with respect to CARES Act economic impact payments, sixty-seven FAQs with respect to COVID-19-related tax credits, and forty FAQs with respect to payment and filing deadlines. While helpful, FAQs cannot be relied upon by taxpayers in demonstrating substantial authority, and the IRS has indicated further that many of these FAQs will not be converted to Notices, let alone full-blown Treasury regulations. In light of the risk taxpayers face in supporting return positions based solely on FAQs, taxpayers should consider, at a minimum, taking screenshots of or printing FAQs (which may not stay on the IRS website indefinitely) to demonstrate that they had reasonable cause for the positions they took on a tax return, even if the FAQs themselves cannot be relied upon to demonstrate substantial authority for return positions.
Although taxpayers have often wrestled with issues regarding the assessment statute of limitations with respect to NOL carrybacks and carryovers, JCT review, and penalty protection, the CARES Act’s passage has placed these issues front and center for many taxpayers. Whereas the TCJA had removed the use of NOL carrybacks, the CARES Act has brought it back, at least for taxpayers’ 2018 through 2020 tax years. The raft of refund claims requiring JCT review following the CARES Act’s passage, and the profusion of informal guidance interpreting the applicable statutes has only amplified taxpayers’ concerns. With appropriate foresight and analysis, however, taxpayers can enhance the use of their tax attributes and reduce their uncertainty regarding the JCT review process and penalty protection.
Jason Dimopoulos is a principal at Deloitte Tax LLP.
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