Return to main report card

5-YEAR CARRYBACK OF NET OPERATING LOSSES

Key Points

·        Current law allows businesses to carry net operating losses back for two years to offset past taxable income. This proposal would allow small businesses the option of carrying back losses an additional three years. The provision would allow businesses to redo prior-year tax returns and get immediate cash refunds for previously unusable losses.

·        The proposal would make temporary investment incentives such as bonus depreciation and expensing more effective, but only for some small businesses.

·        The proposal would increase cash flow to some small businesses that are constrained in borrowing, enabling them to increase investment

·        The increase in the carry-back period would benefit some previously profitable small businesses that face large losses now. Given the state of the economy, this may be insufficient to induce those businesses to invest more now. Large businesses, start-ups, small businesses that have large losses relative to past gains, and small businesses organized as partnerships or S-corporations whose owners have sufficient other income to offset business losses would receive no benefit from the provision.

·        JCT estimates that the proposal will cost $0.9 billion over 10 years.

Current Law

Businesses calculate taxable income by subtracting expenses from revenues. While net income is taxed immediately, net operating losses do not qualify for immediate refunds on current tax returns. However, businesses may effectively receive a refund to the extent that they can be “carried back” against income taxed in previous years. Under current law, businesses may use current losses to offset only the past two years of profits. Losses that exceed the sum of the previous two years of positive income may be “carried forward” and used to offset taxable income earned in future years. Losses can currently be carried forward for twenty years (without interest, so their present value is lower than if they could be claimed immediately).

The net operating loss limitations apply both to corporations and to businesses organized as flow through enterprises (partnerships, subchapter S corporations, and small proprietorships).  While businesses subject to corporate tax may offset losses only against profits, partners or shareholders in a flow-through enterprise may deduct their losses from the business against income from earnings, investments, and profits of other businesses they own.  Most small businesses accounting for most of the revenue among small businesses are organized as flow-through enterprises.

Stimulus Proposal

The provision would increase the net operating loss (NOL) carry-back period from two years to five years in the case of an NOL for any taxable year either beginning or ending in 2008. The benefit would apply to small businesses only. For the purpose of the provision, a business qualifies as “small” if its annual gross receipts is $15 million or less.

Discussion

Businesses that are unable to absorb their current losses with past tax payments do not receive immediate benefits from investment tax incentives such as expensing or bonus depreciation. Unused deductions can’t be used until future years. Because this blunts any stimulus provided by investment tax incentives, extending the carry-back period would enhance these incentives. The more generous carry-back period could allow a business to benefit immediately from temporary investment incentives.

The provision would also give an infusion of cash to some businesses that are running losses, which may promote investment. This might be especially important if those businesses have trouble borrowing because of financial market problems. The carry-back provision acts like an interest-free loan to these businesses. The Congressional Budget Office (2008) has concluded, however, that “effects of taxes on investment that stem from their impact on cash-flow are generally believed to be weaker, dollar for dollar, than those that stem from the direct effects of taxes on the cost of capital.” But this relationship might be reversed when businesses are having difficulty obtaining external finance.

The provision would also help small businesses that were relatively healthy in the past but now have losses that are larger than recent profits or, for flow-through businesses, larger than the sum of recent profits and other income of owners. The provision would benefit old capital held by these businesses, but it is not clear whether it would induce them to undertake new investment. Large businesses, start-ups businesses that have large losses relative to past gains, and small businesses whose owners can offset their losses from the business with other income would receive no benefit from the provision.

The Job Creation and Worker Assistance Act of 2002 applied a five-year carry back to losses from 2001 and 2002. In 2003, the carry-back period reverted to two years. We are not aware of any research evaluating the effects of that tax law change on business investment.

Increasing the carry-back period is not necessarily bad tax policy. By not providing full refunds for losses, the government discriminates against risky investments relative to safe ones. Allowing full and immediate refunds of losses would level the playing field. But not all losses claimed by businesses are “real”. Some are generated by differences between income measured for tax and accounting purposes. Other losses may not be genuine and are taken to reduce taxable income in an attempt to evade taxation. Limiting the carry-back period can be viewed as a compromise between discouraging tax evasion and not discouraging risk-taking. Extending the carry-back period reduces the penalty on risk-taking and provides for more neutral treatment between risky and safe investments.

The proposal would cost an estimated $947 million over 10 years. Revenue would fall by more than 4.7 billion in fiscal year 2009.  The resulting reduction in the stock of losses that firms could deduct from future profits would yield revenue gains in later years, recouping most of the early revenue loss. As a result, the short-term stimulus effect is likely greater than the 10-year costs suggest, although still very modest.

Grade: C

Increases effectiveness of temporary investment incentives such as bonus depreciation and expensing but only for some small businesses. By increasing cash flow to some small businesses that cannot borrow, it could also stimulate new investment but the effect would be modest at best given current economic downturn and the limited amount of investment that benefits. 

 Return to main report card