Reference no: EM131457108

Question: Firms that incur a tax loss are allowed to carry back the tax loss to obtain a refund of taxes previously paid. To the extent the losses cannot be carried back to obtain a refund (because past taxable income is less than the current tax loss), the losses can be carried forward to be deducted against future taxable income. The Taxpayer Relief Act of 1997 reduced the carryback period to 2 years from 3 years and extended the carryforward period to 20 years from 15 years beginning in 1998. Thus, a firm with tax losses in 1997 could elect to carry back the losses to obtain a refund of 1994 taxes paid, then of 1995 taxes paid, and then of 1996 taxes paid (up to the point that the losses are fully offset).

a. In general, what effect will the shortening (lengthening) of the carryback (carryforward) period have on firms that incur a tax loss?
Assume a firm in November 1997 expects to report a tax loss of $250,000 for the tax year 1997. The CFO argues that the firm should defer recognition of $50,000 of income until 1998, thus increasing the tax loss to be carried back to $300,000. The firm reported an annual taxable income of $100,000 in each of the past 5 years. The firm expects to earn $500,000 in 1998 (before any shifting of income). The firm uses an after-tax discount rate of 6% to discount cash flows. The statutory tax rate is expected to remain unchanged at 35%.

b. Evaluate the CFO's plan. How much in taxes will the firm save if the CFO's plan is implemented?

c. How much in taxes would the firm save if the statutory tax rate in the carryback period were 45% rather than 35%?

d. Under what conditions would you advise a firm to carry forward a tax loss rather than carry back the tax loss to obtain an immediate tax refund.