The COVID-19 disaster has caused significant financial losses for many businesses and their owners. Whether a business is owned by a sole proprietor, or by a Limited Liability Company, Partnership, or S Corporation treated as pass-through entity for income tax purposes, or by an entity taxable as a C Corporation, there are opportunities for the business and/or its owner(s) to use current year business and investment losses to obtain refunds of taxes paid in prior years.
A taxpayer who suffers a current year loss normally must wait until the end of the year before such loss may be carried back to obtain a refund of prior years’ taxes. However, there is a special provision in the tax code allowing a taxpayer to elect to claim a loss occurring in a federally declared disaster area in either the tax year in which the loss occurred or the immediately preceding year. Accordingly, COVID-19 disaster losses that otherwise would be reported on 2020 income tax returns may be reported on 2019 tax returns, when it is more likely that the taxpayer had income and can obtain a refund. Moreover, if the COVID-19 disaster loss creates a net operating loss for 2019, under a separate provision in the tax code, that loss may potentially be carried back to obtain refunds from the 2014-2018 tax years.
Electing to deduct the loss in 2019 rather than 2020 will potentially increase the tax savings from the loss and, perhaps most significantly for a business owner in serious financial distress, it will enable the taxpayer to obtain a tax refund before the end of the 2020 tax year. However, before advising a client to make such an election, a tax professional should carefully evaluate the taxpayer’s current year tax situation and tax returns for prior years to determine:
- whether the disaster loss qualifies as a business or investment loss;
- whether the disaster loss is deductible on an individual or entity tax return;
- whether, if net income exists before deducting the disaster loss in 2019 or 2020, there are differences in the taxpayer’s marginal tax rates for those years;
- whether, if the loss will create a net operating loss for 2019 and/or 2020, how such loss may be carried back to produce tax refunds from 2014 through 2018; and
- whether, if the loss is taken in 2019 and carried back to 2014, the taxpayer will be subject to the alternative minimum tax in 2014.
These are just some of the many aspects of a taxpayer’s situation that will have to be examined for the past six years in order to make an informed decision as to when and how to claim tax refunds for a COVID-19 disaster loss.