It’s no secret that most taxpayers work with financial professionals in order to lower their tax liability and maximize their profits. When it comes to leveraging tax advantages and benefits to help lower a business’s tax liability, what happens if tax relief is more than the taxes owed?
Our team discusses net operating losses and how R&D tax credits play into this outcome and future benefits if you find yourself in this position. We’ll review what exactly a net operating loss is, an overview of the R&D tax credit and eligibility requirements, and how these two tax terms work together to provide value for your business.
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Explanation of Net Operating Losses
A net operating loss (NOL) happens when a company's allowed tax deductions exceed its taxable income, resulting in a negative taxable income. NOLs offer a type of tax relief, as they can be used to offset income in other tax years, a process known as "carrying forward" or "carrying back" the net operating loss.
Historically, before 2017, NOLs could be carried back two years and carried forward 20 years. In 2017 the Tax Cuts and Jobs Act (TCJA) made significant changes to the treatment of NOLs, most notably eliminating the option to carry back an NOL for most taxpayers, but allowing NOLs to be carried forward indefinitely for tax years ending after 2020.
The Coronavirus Aid, Relief and Economic Security (CARES) Act introduced in 2020 also contained new changes with regards to the utilization of NOLs. The new provision allows businesses to carry back NOLs incurred in 2018, 2019, or 2020 for up to five years. A positive side of the NOL carryback provision is that it’s retroactive, meaning businesses can file amended returns for those years prior and receive their refund. This helps businesses recoup taxes paid in prior years, which can then be used to offset current expenses or fund future R&D projects.
The TCJA introduced other changes to the utilization of Net Operating Losses (NOLs). From 2018 to 2020, businesses could use NOL carryforwards to fully offset their tax liability, effectively reducing it to zero. NOLs generated before 2018 can still be carried forward to offset 100% of taxable income. However, for NOLs generated after January 1, 2018, a new rule applies: they are subject to an 80% limitation when used to offset income in any tax year starting from January 1, 2021 onwards.
To take advantage of the NOL carryback provision, businesses are required to file an amended tax return for any previous year where the carryback leads to a decrease in taxable income and a subsequent refund claim. This amended return should detail the NOL amount and provide an updated calculation demonstrating the decrease in taxable income and the resulting refund.
R&D Tax Credit Eligibility
The Research and Development (R&D) Tax Credit is a tax incentive designed to foster innovation within the United States. Yet each year countless qualifying businesses fail to claim this tax credit, missing out on potentially substantial returns on their R&D investments.
For businesses that have recently claimed the R&D tax credit, it's crucial to understand the net operating loss component of the CARES Act. Even if a business hasn't previously claimed the R&D tax credit, they may still be eligible to file for the benefit while applying relevant NOL carrybacks.
There are, however, important considerations for businesses regarding NOL carrybacks and the R&D tax credit. The R&D tax credit does not reduce taxable income, but instead offers a credit that offsets the income tax (regular tax liability) for a particular year. If a company is eligible for the R&D tax credit in a year where an NOL is being carried back to, the taxable income will be reduced or eliminated. Any R&D tax credits claimed that year would then be available to be carried back (1 year) or forward (up to 20 years) to be applied against income tax in those years.
The Value of these Opportunities
The R&D tax credit and NOLs can provide significant tax relief, helping businesses delay when they need to start paying taxes. For example, a business with $500,000 of taxable income in 2022 and $1,000,000 in carryforward NOL from 2021 could use up to $400,000 of the NOL to offset their taxable income. The taxpayer could then use R&D credits to offset the tax attributed to the remaining $100,000 of taxable income.
Utilizing an NOL carryback to lower taxable income in a previous year where the R&D tax credit was claimed may result in releasing the credit previously used in that year. The taxpayer may then carry back the released credit amount for one year and then carry it forward for as much as 20 years to apply against income tax.
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The interplay between the R&D tax credit and the net operating loss carryback provision can be complicated, and the changing laws can make it difficult for businesses to understand their eligibility. Businesses are encouraged to reach out to their financial advisors and Strike for guidance on how to maximize these opportunities.
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