By Diane Tinney
During economic growth, many corporate tax departments naturally look for ways to preserve cash flow and reduce tax liabilities. One key strategy is to take advantage of net operating losses (NOLs). But even in a down economy, the strategic use of NOLs does not go away. On average, recessions occur every 2-5 years. In other words, economic downturns are a natural part of economic cycles, making NOLs a continual and natural part of the corporate tax function.
As of June 2016, the U.S. economy was experiencing GDP growth of 1.4 percent, with an unemployment rate of 4.9 percent. In line with this, in a Q1 2016 Bloomberg BNA software group poll of 100 financial executives across a wide range of industries, an overwhelming number of survey respondents (88 percent) expect to move into profitable years in the near future, which means NOLs will likely be an increasingly important focus for corporate tax teams moving forward.
The same poll found the majority of respondents (74 percent) have used losses to cover tax liabilities in the past. And almost half of respondents have 4-21+ years before all of their state NOLs expire or need to be used fully. This does not mean that after 21 years or in an economic downturn, the state NOL challenge goes away.
In fact, during an economic downturn, the need to organize, track and report on losses, as well as to apply strategies to maximize future NOL carryovers is just as important as actually applying losses during profitable years.
While many companies may be tempted to focus solely on budget cuts during an economic depression, this is actually the ideal time to strategize ways to maximize NOL carryovers. With the right tools, tax teams can easily model out impacts of apportionment changes, elections, and state tax planning to increase the NOL carryover and better protect cash flow when the economy recovers and they once again experience profitable years.
The Biggest NOL Challenges
Whether in a thriving or down economy, most tax departments agree the management of state NOLs is no easy task. But what makes it so difficult?
The previously mentioned poll also explored the challenges associated with NOLs. Over one-third of survey respondents cited state “carryback/forward rules” as their biggest potential obstacle, with “keeping up with state NOL tax law changes” as a close second. State limitations came in third.
The findings are not surprising. States differ on rules around modifications and apportionment. Moreover, they have two sets of rules: one to control how the taxable income/loss is computed for a given year, and a second set of rules to control how any loss is computed and utilized. On top of this, states have specific rules regarding carrybacks/carryovers, post-apportionment, pre-apportionment, group reporting, suspensions, and limitations. With each state having varying NOL rules and regulations, the management of NOLs at the state level quickly becomes complex and unruly.
Manual Spreadsheets for Managing State NOLs Risky
Despite the best efforts of corporate tax departments to manage and track state NOLs effectively, they continue to use risky manual processes, including spreadsheets and databases as their primary methods. According to European Spreadsheet Risks Interest Group, half of the operational spreadsheet models used in large businesses have material defects. In other words, spreadsheet mistakes are making their way onto financial statements.
Underscoring the perils associated with spreadsheet usage, survey findings from Bloomberg BNA’s software group revealed “manual data entry error,” followed by “missed tax rule or rate,” and “a spreadsheet formula error” were the top risks associated with the use of spreadsheets and manually managed databases. “An incorrect amount in tax provision (material misstatement in financials),” was another top risk of spreadsheets.
These findings indicate the far-reaching implications associated with decentralized state tax workpapers, in which tax teams have to create and maintain separate spreadsheets for provision, compliance, tax audits and planning.
Automation is Key to State NOL Success
So what is the solution to the state NOL conundrum? Bloomberg BNA asked tax departments this same question. The majority of respondents indicated they would find value in the automation of state NOLs. Specifically, a solution that accurately computes allowable state NOL and utilization for compliance/provision, provides state NOL forecasting, and allows what-if analysis.
The reality is that the management of state NOLs by multistate corporations, with multiple entities, is far too complex to navigate and manage manually.
As state income tax and specific NOL laws continue to change and grow in complexity, so will the management of state NOLs. As a result, spreadsheets can no longer be the solution of choice as there is far too much at risk. Only by implementing best practices that automate the tracking, computation and forecasting of state NOLs can companies know with certainty they are leveraging their valuable state NOLs to the fullest extent.
Diane Tinney is Director Product Management, Bloomberg BNA Software.
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NOLs Defined
In their simplest form, NOL calculations are similar to a Schedule C in an individual tax return. But, whereas the Schedule C of the 1040 impacts only a single tax year, NOL schedules can go back and forward many years according to state rules. The foundation of any corporate state income tax return is the federal form 1120 tax return. Any change at the federal level, such as an IRS audit, tax notice, or taxpayer filing an amended return, affects the state tax returns. Once federal NOLs are calculated, states apply modifications to arrive at their fair share – the state income or loss that will be subject to apportionment. For state corporate income tax purposes “apportionment” is the process used to assign to a particular state that portion of a multistate corporation’s income a state may tax.
Traditionally, apportionment has been based on three-factors: sales, property, and payroll. States continue to abandon the traditional 3-factor formula in favor of the single sales factor, but that can differ across industries, where industry-specific apportionment adds additional complexity to computing the loss and utilization of a loss.