New York State and New York City’s corporate net operating loss carryover rules have always been an area of confusion, and they have been made even more complicated by the enactment of recent corporate income tax reform legislation. The state and city corporate tax reforms, which took effect for years beginning on or after January 1, 2015, made significant changes to corporation tax law. One of the most confusing revisions is the manner in which the deduction for unutilized prior net operating loss (PNOL) carryovers is determined. This article will provide an overview of these recent changes and what CPAs need to be aware of when computing PNOL for the 2015 tax year and forward.
New York State and City Prior Net Operating Loss Conversion
Effective January 1, 2015, corporations are required to convert their net operating loss carried over to 2015, also known as the prior net operating loss conversion (PNOLC), before they can utilize the PNOL. The information used to compute the PNOLC is based on information the corporation reported in its 2014 tax return, also known as the base year for the PNOLC computation. To compute the PNOLC, the corporation will multiply its unutilized PNOL by its base year business allocation percentage, multiply the result by its base year tax rate, and divide the result by 6.5% (5.7% for New York State qualified manufacturers). The city PNOLC formula is the same, except the final divisor is 8.85%, the current corporate tax rate (9% for financial corporations).
PNOLC Subtraction Limitations
New York State also enacted limitations on the allowable deduction for the PNOLC, as follows:
- Taxpayers are only allowed to deduct 10% of the PNOLC from the pool in one tax period. If the 10% is not fully utilized in the tax period in question, the remainder can be carried forward to the following tax period and used alongside that period’s allowed 10%. This continues for the first 10 tax periods. After the 10th tax period, the 10% limitation no longer applies, and corporations can deduct all of their unutilized PNOLC.
- A PNOLC can be carried forward for 20 tax periods.
- A small business corporation—which is defined as a corporation that is not part of an affiliated group and that has less than $390,000 of net income in the taxable year and less than $1 million of assets—is not subject to the 10% limitation. A small business corporation can deduct 100% of its PNOLC in its first tax period succeeding its base year. Any unused amount is eligible for carry forward for no longer than 20 tax periods following the base year.
- In lieu of the 10% per tax period PNOLC deduction, corporations can make a revocable election, by checking the box on their timely filed 2015 tax return, to utilize their PNOLC subtraction pool by claiming not more than 50% of the PNOLC pool in each of the tax periods beginning on or after January 1, 2015, and before January 1, 2017. Any unused amount is lost after 2016.
- The 50% election is revocable within three years from the date the 2015 return is filed, taking valid extensions into account. If the corporation decides to revoke this election before January 1, 2017, it must amend its 2015 and 2016 tax returns to adjust the PNOLC deduction to comply with the 10% limitation instead of taking the 50% deduction.
New York City passed its own reforms, which conform to all of the above New York State provisions except for the 100% small business corporation deduction, which the city does not allow.
PNOLC Computation for a Combined Group
If a combined return was filed for 2014, the PNOLC must be separately computed for each corporation in the combined group, and such separate PNOLCs are then aggregated to determine the PNOLC of the combined group. If there were changes in the corporations included in the combined group during the 2015 tax year, the PNOLC of the corporations either entering or leaving the combined group would have to be added (or subtracted, as the case may be) from the PNOLC of the combined group to determine the combined group’s overall PNOLC deduction. For example, Company X and Company Y filed a combined return in 2014, and each corporation incurred a net operating loss of $1 million for the year. The results of the computation of Company X and Company Y’s PNOLC, on a stand-alone basis, were $250,000 and $500,000, respectively. For the 2015 tax year, the corporations will not be filing a combined return; as a result, Company X and Company Y will each have their own PNOLC subtraction pool, as computed above, of $250,000 and $500,000, respectively, instead of a combined subtraction pool of $750,000.
In addition, even though New York State and City have not provided clear guidance regarding their conformity to IRC section 382, which governs NOL carryovers where certain ownership changes occur, it is likely that both will continue to follow the section 382 limitations.
One of the major challenges faced by corporations is whether to make the 50% deduction election in their 2015 tax return. Needless to say, this business decision should be based on income projections for 2016. If the corporation believes it will generate enough income to use 50% of the PNOLC pool as a deduction in 2016, it should consider making this election on its timely filed 2015 return. If not, then the corporation should use the 10% limitation deduction.
In their guidance, both New York State and City emphasize that the deduction for PNOLC is based on tax periods instead of tax years. This is because a corporation can have more than one tax period in a year. For example, Company A combined with Company B in May 2015, and Company B is the new reporting entity. Prior to filing a combined return, Company A had a NOL carryforward of $1 million and had to file a shortyear tax return. Company A, after computing its PNOLC, can deduct 10% of its PNOLC in its short-year return; this is considered one tax period. When Company B files its annual return with Company A in the combined group, Company B can deduct another 10% from the original PNOLC pool in determining the taxable income of the combined group, since this is considered another tax period for purposes of the PNOLC deduction.
Lastly, the PNOLC computed for the 2015 tax return is a set number, meaning that if there is an error in the computation, an amended return will have to be filed to correct the error.
The overview provided above relates to the New York State and City prior-year NOL provisions as a result of the recently enacted legislation. It does not address all fact patterns. CPAs should be aware of these new rules and how they impact clients’ specific circumstances.