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| William Rohrer |
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| Maximilian Viski-Hanka |
The CARES Act made substantial changes to the Tax Cuts and Jobs Act's[1] net operating loss provisions, permitting taxpayers to utilize 100% of their current losses realized for tax years beginning before Jan. 1, 2021, and allowing businesses to carry back such losses for up to five years.
In addition, the CARES Act corrected a TCJA drafting error by permitting most businesses to claim 100% bonus depreciation for qualified improvement property, so long as certain requirements are met.[3]
The CARES Act also temporarily modified the TCJA's limitation on excess business losses for noncorporate taxpayers. For tax years beginning after Dec. 31, 2017, the TCJA added Internal Revenue Code Section 461(l),[4] thereby prohibiting noncorporate taxpayers from utilizing their excess business losses, which are then treated as NOLs in future tax years.
Under Section 461(l), the term "excess business losses" includes the amount equal to the taxpayer's business deductions over the sum of the taxpayer's business income plus $250,000 for single filers or $500,000 for married couples filing joint returns.
The CARES Act suspended the application of Section 461(l) for the 2018, 2019 and 2020 tax years. The suspension of Section 461(l) effectively permits noncorporate taxpayers — subject to the passive activity loss rules, the at-risk loss rules, etc. — to utilize their business deductions to reduce or eliminate their nonbusiness income in the same year.
The combination of the foregoing provisions have provided taxpayers the opportunity to utilize deductions and losses that were previously disallowed by the enactment of the TCJA. Particularly as it relates to the use of the recently permitted NOL carryback, taxpayers may be able to accelerate losses and obtain a tax-rate arbitrage as a result of the acceleration — due to the higher tax rates in the earlier carryback years, as further discussed below.
The question remains, however, what type of transactions may be utilized to trigger such NOLs.
One particular alternative that is worth exploring is the use of a sale-leaseback transaction of business property. In valid sale-leaseback transactions, the seller/lessee sells the business property to the buyer/lessor who immediately in turn enters into a lease agreement to lease the property back from the seller/lessee. Most importantly, for the sale-leaseback transaction to be valid, the buyer/lessor must be treated as the true tax owner of the property.
Particularly as it relates to the validity of sale-leaseback transactions between related-parties, it is important that: (1) the lease is negotiated at arm's length; (2) there is a business purpose behind the transaction; and (3) the lessee does not have an ownership interest in the property — i.e., the lessee doesn't have a reversionary interest, the lessor maintains some of the risk of ownership of the property, etc.
Upon the execution of a valid sale-leaseback, the seller/lessee either incurs a gain or loss on the sale — and if a loss, then a potential NOL carryback — and thereafter gets a deduction for all rental payments made. The buyer/lessor on the other hand will be permitted to obtain basis in the property equal to the purchase price and obtain depreciation deductions including, in some cases, the 100% bonus depreciation deductions as mentioned above.
Assuming the sale-leaseback transaction is valid, both the seller/lessee and the buyer/lessor could be subject to a host of positive tax and fiscal consequences.
First, with the CARES Act repeal of the TCJA's 80% NOL limitation and carryback restriction, corporate taxpayers who generate NOLs — as a result of the sale, the lease payments or the depreciation deductions (i.e., the 100% bonus depreciation deduction — will be able to carry back 100% of those NOLs for up to five years.
For pre-TCJA years, the corporate tax rate was as high as 35%, whereas the current corporate tax rate is 21%. Consequently, corporate taxpayers utilizing the NOL carryback could obtain a 14% rate arbitrate on the carryback.
For example, a corporate seller/lessee incurring a substantial loss on the sale could carry back the incurred NOL to obtain a refund for income on which such buyer/lessor paid a 35% tax rate, whereas, in future years they would obtain a 21% tax rate on income that would have otherwise been offset by carryforward — as opposed to carryback — of the NOLs.
In addition to the 14% rate arbitrage, the seller/lessee also gets the benefit of the time value of money, as they get an immediate NOL carryback and resulting tax refund, and no longer are required to wait to utilize the NOL deductions to offset future income.
The sale-leaseback structure provides many of the same benefits for individual taxpayers and partners/shareholders in pass-through entities, including a rate arbitrage and the time value of money.
For example, NOLs can be utilized to reduce prior years' income taxed at ordinary rates — potentially as high as 39.6% in the earlier carryback years — with current and future years' income potentially being subject to the TCJA's qualified business income deduction, potentially resulting in an effective tax rate as low as 29.6%.
In addition, unlike excess business losses incurred under the TCJA, the CARES Act permits individuals to offset their business losses against their nonbusiness income — subject to the passive activity loss rules, at-risk loss rules, etc. For example, an individual taxpayer that incurs a loss as a result of the 100% bonus depreciation deduction could offset the loss against their nonbusiness income.
Finally, another overlooked benefit of the sale-leaseback transaction is the seller/lessee's ability to fully deduct their rental payments under the Code notwithstanding the seller/lessee's adjusted gross income.
In more traditional financing structures — i.e., debt — a seller/lessee's deductible business interest expense is frequently limited, resulting in a substantially greater tax liability than if the payments were fully deductible. In comparison, assuming that the sale-leaseback is valid for tax purposes, the rental payments would likely be fully deductible.
Sale-leaseback transactions are given new life following the CARES Act's repeal of the TCJA's 80% NOL limitation and carryback restriction, technical correction of the TCJA's 100% bonus depreciation drafting error and modification of the limitation on excess business losses for noncorporate taxpayers.
Taxpayers able to accelerate and/or generate NOLs as a result of a sale-leaseback transaction may be able to obtain tax rate arbitrage — in some cases up to 14% — on the now-permitted NOL carryback and garner the benefit of the time value of money on the basis of the refund received pursuant such carryback.
Moreover, in some circumstances, taxpayers may be able to deduct 100% of their rental payments whereas in more traditional debt financing structures they would be limited to the Code's net business interest deduction limitation.
Taxpayers with the opportunity to utilize such sale-leaseback transactions and obtain the foregoing benefits should consider doing so before Dec. 31.
William D. Rohrer is a partner and Maximilian Viski-Hanka is an associate at Duane Morris LLP.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] TCJA
, 115 P.L. 97.[2] "COVID-19 Increases the Availability of Tax Refunds by Allowing Net Operating Losses to be Carried Back Five Years," Duane Morris T4: Tax Tips for Troubled Times, https://www.duanemorris.com/practices/tax.html#tab_TaxTipsforTroubledTimes.
[3] "Some Much-Needed Good Tax News for Real Estate Owners," Duane Morris T4: Tax Tips for Troubled Times, https://www.duanemorris.com/practices/tax.html#tab_TaxTipsforTroubledTimes.
[4] Internal Revenue Code Section 461(l)
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