To maximize the economic stimulus afforded by the Coronavirus Aid, Relief and Economic Security (CARES) Act, many of its tax provisions are retroactive. The economic impact of the pandemic on many businesses meant that their income – and their tax bills – would decline sharply from 2019 to 2020. Having a tax cut take effect for a year in which the tax bill is lower has much less effect than when the cut comes in a year with a greater tax bill. Thus, many provisions of the CARES Act are retroactive to the effect date of the Tax Cuts and Jobs Act (TCJA), i.e., to the 2018 calendar year. Taxpayers can file amended returns for 2018 and 2019, and as described below, special considerations apply to partnerships, S corporations, and trusts and estates.

Bonus Depreciation for Qualified Improvement Property (QIP)

Qualified improvement property (QIP) is

• Improvement made by taxpayer to an interior portion of a building
• Nonresidential real property
• Placed in service after the date the building was first placed in service (Code Section 168(e)(6)(A))

Prior to the TCJA of 2017, qualified improvement property (QIP) had a 15-year recovery period; QIP qualified for bonus depreciation. Due to TCJA’s rushed nature and the absence of input from practitioners, it contained a number of drafting errors, one of which was classifying QIP as 39-year property. This erroneous classification prevented bonus depreciation from applying to QIP.

A technical correction to the TCJA added QIP to the list of 15-year property in Code Section 168(e)(3)(E)(vii) (CARES Act Section 2307). Technical corrections are generally retroactive to the enactment date of the underlying law, and the CARES Act explicitly made this provision retroactive (CARES Act Section 2307(b). Thus, QIP is eligible for bonus depreciation, retroactive to calendar years 2018 and 2019.

For individuals, claiming the retroactive deduction is a simple matter of filing an amended return. As discussed below, the process is more difficult for partnerships and trusts.

Net Operating Loss

The TCJA limited the net operating loss deduction to 80% of taxable income computed without regard to net operating loss, qualified business income deduction, and the deduction related to global intangible low-taxed income (GILTI) (Code Section 172(a)(2)(B)). There is a precedent for a similar limitation because the alternative minimum tax limits the net operating loss deduction to 90% of alternative minimum taxable income (Code §56(d)(1)(A)(i)(II)).

The CARES Act repealed the net operating loss limit for tax years beginning before 2021 (CARES Act Section 2303(a)(1)). In addition, it allows a five-year carryback (Code Section 172(b)(1)(D)). Normally, an election to waive the net operating loss carryback must be made on a timely filed return; however, because the carryback was enacted after the due date for 2018 and 2019 returns, there is a special election to waive the carryback for 2018, 2019, or 2020 (Code Section 172(b)(3)). (The IRS explained the special election in Revenue Procedure 2020-24.) The date to waive the carryback is extended to the due date (including extensions) for the tax return for the first year ending after 03/27/2020; for calendar-year taxpayers, this is the 2020 return. Taxpayer should attach a separate statement each year, 2018 or 2019, for which taxpayer makes the election. The election must state that taxpayer elects to apply Code Section 172(b)(3) under Rev. Proc. 2020-24.

Rev. Proc. 2020-24 is silent on what statement, if any, should be attached to the amended 2018 or amended 2019 returns. I recommend that a copy of the statement be included with the amended returns.

Excess Business Loss Limitation

The TCJA imposed the excess business loss limitation (Code Section 461(l)). In brief, business losses may only offset nonbusiness income up to $250,000 ($500,000 for joint returns). This applies to a “taxpayer other than a corporation” (Code Section 461(l)(1)). Originally effective for the years 2018 through 2025, the CARES Act suspended the rule for 2018 through 2020. This provision replaced the provision on excess farm losses under Code Section 461(j), which becomes effective once again in 2026 (Code Section 461(l)(1)(A)). Note that while the CARES Act suspended the excess business loss limitation for 2018 through 2020, it did not reinstate the excess farm loss provision for those years. The excess business loss provision was not aimed at a particular tax abuse, but instead was enacted to plug a revenue hole.

For partnerships or S corporations, the excess business loss provisions apply at the level of the partner or shareholder, not the entity (Code Section 461(l)(4)(A)). The disallowed excess business loss becomes a net operating loss to be carried over. Because 2018 returns (and some 2019 returns) were completed before the CARES Act was signed, taxpayers had to amend their returns to increase their allowable losses for 2018 and 2019 and refigure their net operating loss carryovers.

A Brief Note on New York Nonconformance

New York tax law generally incorporates federal changes as they are made–so-called “rolling conformance.” The CARES Act, however, presented an issue to New York: the pandemic was (and at the time of this writing, still is) depressing important businesses in New York, particularly restaurants, theater, and tourism. The effect on businesses directly reduced tax collections at the same time an increased need for services developed. Unlike the federal government, which may engage in fiscal expansion (i.e., running a deficit), state governments cannot generally run a deficit. The CARES Act implemented a fiscal remedy, reducing tax revenues and increasing the federal deficit. New York could not afford to conform to the CARES Act changes. New York temporarily decoupled from conformity to the Internal Revenue Code, freezing its conformity to the Code as it existed on March 1, 2020 (New York 2021 Budget Act, L. 2020, S7508 (c. 58), 04/03/2020).

Areas where New York did not conform include the expansion of the net operating loss from 80% to 100% and the suspension of the excess business loss.

Example:  Taxpayer T is a single individual. Her original federal 2018 return shows $350,000 of interest and other portfolio income and a business loss of $375,000. She deducted $250,000 of the business loss, so her adjusted gross income (AGI) is $100,000. She has a disallowed excess business loss of $125,000 (excess loss amount, or ELA); the ELA carried over to 2019 as a net operating loss (NOL). T’s original New York return shows the same.

T’s original federal 2019 return shows portfolio income of $300,000 and business loss of $285,000, together with the 2018 NOL carryover of $125,000. Her AGI before the NOL is $300,000 minus $250,000 ($50,000), and the ELA is $35,000. Because her $125,000 NOL can offset up to 80% of her AGI, she can use $40,000. Her AGI is $50,000 minus $40,000 ($10,000), and the NOL carryover is $125,000 minus $40,000 ($85,000). The ELA becomes an additional NOL carryover, so the NOL carryover to 2020 equals $85,000 plus $35,000 ($120,000). T’s original New York return shows the same.

After the CARES Act, T filed amended returns for 2018 and 2019. The amended federal return for 2018 allows the current deduction of the entire business loss, so the return shows $350,000 minus $375,000 ( NOL $25,000). Assume taxpayer waives the carryback. her New York return is unchanged.

Her amended federal 2019 shows the NOL carryover from 2018 of $25,000 instead of the original $125,000. The return shows $300,000 minus $285,000 business loss ($15,000). The NOL carryover offsets the entire $15,000, leaving a remaining NOL carryover to 2020 equal to $10,000.

Normally, the New York NOL is limited to the federal NOL, so the New York return would not be able to deduct any more NOL than $15,000 (instead of the $40,000 as originally shown). But since New York did not conform to CARES Act changes, New York calculates its taxes according to a pro forma federal return that does not incorporate these changes, i.e., the original return. Since the original 2019 federal return showed an NOL of $40,000, the New York NOL may equal $40,000.

New York has issued Form IT-558 to report the adjustments due to nonconformance.

Business Interest Limit

Prior to the TCJA of 2017, Code Section 163(j) limited excess interest expense of corporations. It applied to corporations with a ratio of debt to equity exceeding 1.5 to 1 that paid interest to a tax-exempt related party (Prior Code Section163(j)(2)(A)). The purpose of the prior rule was to prevent corporations from increasing deductible interest paid to a foreign related entity that would be exempt from U.S. tax. This is called “earnings stripping.”

Example: X is a U.S. corporation whose sole shareholder is F, a U.K. corporation. X pays a $100K dividend to F. Under the U.S.-U.K. tax treaty, the dividend is subject to 5% U.S. tax (Treaty Article 10(2)(a)). Alternatively: suppose X pays $100K interest to F, and F does not have a permanent establishment in the United States. The interest is not taxable in the United States (Treaty Article 11(1)). Thus, by burdening the U.S. subsidiary with excess debt, the U.K. corporation can reduce the U.S. taxes paid by the subsidiary and escape U.S. taxes itself.

The Code section was complex; the proposed regulations to implement it were voluminous and complicated, and there was political opposition. The TCJA substantially amended Code Section 163(j), eliminating earnings stripping provisions entirely (P.L. 115-97, Section 13301(a)). This rendered the proposed regulations moot, but left a revenue hole. Current Code Section 163(j) filled this hole by imposing new limits on interest deductions. (A full discussion of the business interest limit is beyond the scope of this memo.)

The TCJA limited business interest deductions to 30% of adjusted taxable income. The CARES Act increased that limit to 50% of ATI for tax years beginning in 2019 or 2020.

There is a special rule for partnerships:

• The limit increase from 30% to 50% applies to 2020, not 2019; and
• For 2019, 50% of excess business interest expense carries forward to 2020 and is allowed as business interest that is not subject to §163(j). (Code Section 163(j)(10)(A)(ii)(II)(aa))

See below in the section on partnership compliance for a discussion of the effect on an electing real property trade or business.

Compliance Issues Raised by the CARES Act

The usual rule is that if there is a retroactive change, taxpayer should file an amended return. However, it is not that simple when the retroactive change affects a partnership, an S corporation, or a trust or estate.

Partnerships and partners. The Centralized Partnership Audit Regime was enacted by the Bipartisan Budget Act of 2015 (BBA). Partnerships subject to the Centralized Partnership Audit Regime are called “BBA partnerships.” Continuing and expanding concepts introduced in the Tax Equity and Fiscal Responsibility Act (TEFRA), the BBA provided that all items would be determined at the partnership level (Code Section 6221(a)) and the tax would be paid at the partnership level (Code Section 6225). Partnerships with fewer than 100 partners may elect out of the Centralized Partnership Audit Regime; the election must be made separately for each year (Code Section 6221(b)). A partnership that elects out is called “a non-BBA partnership.”

Complying with retroactive changes to the Code differs between BBA and non-BBA partnerships.

• A non-BBA partnership files an amended return for the year involved, and each of the partners file amended returns for the same year.
• A BBA partnership files an Administrative Adjustment Request (AAR).

Understanding an AAR requires distinguishing between the reviewed year and the adjustment year.

• The reviewed year is the partnership taxable year being examined or to which the change applies. (Code Section 6225(d)(1)).
• The adjustment year is one of the following (Code section 6225(d)(2)):

1. If there is a court decision, the year the decision becomes final;
   
   
2. If the partnership initiated an AAR, the year it made the request; or
   
   
3. In any other case, the date the IRS mails the notice of final partnership adjustment.

The change is made for the adjustment year. The tax benefit of the change, if any, applies to the adjustment year, so then partners will not realize the benefit until they file their returns for the adjustment year, which could be four months or ten months later. There is the possibility that partnership interests will change hands between reviewed year and adjustment year. Thus, a partner who departed in the interim would not receive the tax benefit of the change.

A partnership may have chosen to be treated as “electing real property trade or business” for purposes of the business interest limit rule (Code Section 163(j)(7(B)). This election causes the entity to be excluded from trades or businesses that are subject to the business interest limitation (Code Section 163(j)(7)(A)(ii)), and thus the interest limitation thus won’t apply. The drawback to making the election is that the electing entity must use the alternative depreciation system under Code Section 168(g)(1)(F) for QIP (Code Section 168(g)(8)); therefore, it cannot take bonus depreciation.

The election is irrevocable, but the IRS offered relief in Rev. Proc. 2020-22. A non-BBA may file an amended return by October 15, 2021 and a BBA partnership may file its AAR no later than the earlier of October 15, 2021 or the statute of limitation for the reviewed year.

Special rules apply for the retroactive reinstatement of bonus depreciation for QIP. The IRS announced a simplified procedure that expired on September 29, 2020 (Rev. Proc. 2020-23). For partnerships fortunate enough to beat the deadline, they did not have to file an AAR nor would they have to file a Form 3115 (change of accounting method): they could simply file an amended return, as if they were all non-BBA partnerships. This simplified procedure also applied to the relief offered by Rev. Proc. 2020-22 to withdraw the electing real property trade or business election.

If the partnership missed the deadline of Rev. Proc. 2020-23, it may rely on Rev. Proc. 2020-25, which allows the partnership to file Form 3115 claiming an adjustment to the current year for bonus depreciation in lieu of filing an AAR. The designated automatic change number for Form 3115 is 244.

The rationale behind allowing Form 3115 is that for QIP placed in service after December 31, 2017, taxpayer was depreciating QIP over 39 years under the TCJA. Once the CARES Act made the retroactive amendment, depreciating QIP over 39 years became an impermissible method of depreciation. (Rev. Proc. 2020-25 Section 3.02(1)). The year of the change is 2020, and the Revenue Procedure offers taxpayers the option that applies to property placed in service one year before the change year (i.e., 2019): taxpayer may choose between filing Form 3115, filing an AAR, or filing an amended return. This effectively extends the procedure of Rev. Proc. 2020-23.

Statute of Limitations

For partnerships, note the difference between BBA and non-BBA partnerships in how to apply the statute of limitations: for a BBA partnership, it applies at the partnership level, and for a non-BBA partnership, it applies at the partner level.

For S corporations and shareholders, there is no statute of limitations at the corporate level for pass-through items to the shareholders; the statute only applies at the shareholder level (IRS Manual §25.6.22.6.3).

For beneficiaries of trusts and estate, the issue is noteworthy for net operating loss carrybacks. The CARES Act allowance of NOL carrybacks permits a trust or estate to file amended Forms 1041 for the carryback years (IRS Publication No. 536). The amended return could show lower distributable net income, which would affect the Schedules K-1 issued to beneficiaries.

Suppose a trust using the five-year carryback amended it returns and issued amended Schedules K-1 to its beneficiaries for the five-year prior return. Individuals normally can only amend returns within the three-year statute of limitations, and this situation raises the question: would the individual beneficiary lose the benefit of the NOL carryback? The answer to this question requires no new statute or revenue procedure, because for NOL carrybacks, the statute of limitations is counted from the year in which the NOL was incurred, not the year to which the NOL is carried (Code Section 6511(d)(2)(A)). For the beneficiary, the statute of limitations is computed from the year in which the trust incurred the NOL (Rev. Rul. 61-20).

Summary

Each of the topics I covered in this article have been the subjects of many articles and seminars. My intention here is to tie them together and show the interplay and ordering of these loss and deduction limitations. At the time of this writing, the Biden administration has just taken office, and it has announced plans, not yet solidified, to make significant changes to the TCJA. As the pandemic hopefully slackens its grip on the country, I expect to see modifications, adjustments, and even restructuring affecting the tax topics I covered in this writing. 

Dean L. Surkin, JD, LLM, is a tax director at Gettry Marcus CPA, P.C. He is a tax attorney with broad-based experience in tax planning and research, has litigated major cases in the fields of taxation, probate, and general commercial matters, and has been peer-reviewed by Martindale-Hubbell. Mr. Surkin received his BA from the University of Pennsylvania in 1973 (double major in mathematics and political science), his JD from New York University School of Law in 1976, and his LLM in taxation from New York University School of Law in 1985. He is admitted to the New York State Bar, the Federal District Courts of the Southern and Eastern Districts of New York, the Second Circuit Court of Appeals, and the U.S. Tax Court. Mr. Surkin holds the faculty appointment of Professor (Adjunct) at Pace University Graduate School of Business where he  teaches taxation of entities. He was recently honored for 35 years of service to Pace. He formerly served as Adjunct Associate Professor at the NYU School of Continuing and Professional Studies where he was program coordinator of the Estate and Gift Taxation and Planning Certificate Program. He has also served as Adjunct Assistant Professor at Hunter College, CUNY. He has presented seminars to  FAE, the New York State Bar Association, the Association of the Bar of the City of New York, the American Society of Women Accountants, and many private groups. His published articles on tax law have appeared in peer-reviewed journals, practitioners’ journals, and the popular press.