The tax reform act (formerly known as the Tax Cuts and Jobs Act or the "Act") makes extensive changes to numerous aspects of the Internal Revenue Code and will have a substantial impact on tax planning for many taxpayers. Financially troubled corporations, which face unique tax-planning challenges and opportunities, are no exception. This update summarizes certain changes relating to deductions for net operating losses (NOLs) and interest expense that are particularly relevant to financially distressed corporations. This update also addresses the Act’s treatment of capital contributions, which differs significantly from the capital contribution provisions proposed by the House bill.
Changes to NOL Rules
Financially distressed corporations commonly have significant NOLs, which can be of great value for tax planning purposes. The Act makes two changes to the use of NOLs by C corporations that may have a substantial impact on tax planning for troubled corporations.
First, the Act changes the rules for carrying NOLs to other taxable years. Under current law, with some exceptions, corporations can carry NOLs back for two years and forward for twenty years. Under the Act, NOLs arising in taxable years ending after December 31, 2017, generally cannot be carried back at all but can be carried forward indefinitely. Special rules apply to NOLs of a farming business or property and casualty insurance company.
The elimination of the NOL carryback period may be significant for many troubled corporations. The ability to carry back NOLs under current law is extremely valuable to some financially distressed corporations, allowing the corporations to receive immediate refunds of taxes paid in prior years. On the other hand, the extension of the carryforward period beyond twenty years may be of little benefit to a corporation that is struggling to survive.
Second, the Act imposes a new limit on NOL deductions. Under current law, there is no general limit on the amount of NOLs that can be used to offset regular taxable income, although the amount of alternative minimum tax NOLs that can be used in a particular taxable year is generally limited to 90% of the alternative minimum taxable income for such year (subject to certain adjustments and exceptions). The Act limits the deduction for NOLs arising in any taxable year beginning after December 31, 2017, to 80% of taxable income in the carryforward year. The Act also eliminates the corporate alternative minimum tax.
This new NOL limitation potentially exposes financially troubled corporations to increased tax liability in connection with any taxable restructuring transactions (at an effective tax rate of 4.2%, based on the corporate tax rate under the Act of 21%) and generally reduces the future usefulness of their NOLs.
Limit on Deduction for Interest Expense
Under current law, there is no general limit on the amount of taxable income that can be offset by interest deductions, although the deductibility of interest may be limited in certain specific situations. Under the Act, the amount of business interest expense that a taxpayer may deduct in any taxable year beginning after December 31, 2017, is generally limited to the sum of (i) the business interest income of the taxpayer for such year, (ii) 30% of the taxpayer's "adjusted taxable income" for such year, and (iii) the amount of the taxpayer's interest expense for such year on certain debt used to finance the acquisition of motor vehicles held for sale or lease. "Adjusted taxable income" for this purpose generally means the taxable income of the taxpayer computed without regard to (1) any item of income, gain, deduction, or loss which is not properly allocable to a trade or business, (2) any business interest expense or business interest income, (3) the amount of any NOL deduction, (4) the new 20% deduction for certain pass-through income, and (5) for taxable years beginning before January 1, 2022, any deduction allowable for depreciation, amortization, or depletion.
The amount of any interest deductions in excess of the limit may generally be carried forward indefinitely. Any interest deduction that is carried forward will generally be treated as a loss for purposes of Internal Revenue Code section 382, which imposes limitations on the use of NOL carryforwards after certain ownership changes.
The limit on interest deductions under the Act does not apply to interest allocable to certain specified trades or businesses, including certain regulated utility businesses and certain electing real property trades or businesses. The limit also does not apply to certain low-revenue taxpayers. Special rules apply with respect to partnerships and S corporations and owners thereof.
Interest expense can be an important source of deductions for financially troubled corporations, which are often highly leveraged. Consequently, the interest limitation under the Act could have a significant impact on the tax liability of such corporations and should be considered when determining financing strategy. Furthermore, because the amount of the limit is based on adjusted taxable income, the impact of the limit will be exacerbated in the case of a distressed corporation whose income is declining while its interest obligations are stable or increasing.
Treatment of Capital Contributions
The House bill would have required a corporation to recognize income from its receipt of a capital contribution of money or property to the extent the fair market value of such capital contribution exceeded the fair market value of any stock issued by the corporation in exchange therefor. The House bill also would have repealed Internal Revenue Code section 108(e)(6), under which a debtor corporation acquiring its indebtedness from a shareholder as a contribution to capital is treated as having satisfied the indebtedness with an amount of money equal to the shareholder’s adjusted basis in the indebtedness. These changes proposed by the House bill, if enacted, could have significantly impacted a financially distressed corporation’s ability to restructure in a tax-efficient manner.
The Act did not adopt these capital contribution provisions from the House bill. The Act does amend Internal Revenue Code section 118, which generally excludes contributions to capital from the income of a corporation, so that it will not apply to contributions by any governmental entity or civic group (other than any such contributions made by a shareholder as such), to contributions in aid of construction, or to contributions as a customer or potential customer. However, this provision of the Act is much more narrowly tailored than the capital contribution provisions of the House bill and does not raise the same general issues with respect to the restructuring of financially troubled corporations as were raised by the capital contribution provisions of the House bill.