Sole proprietorships and pass-through entity structures, which include partnerships, S corporations and certain limited liability companies (LLCs), provide owners with valuable tax benefits, such as avoidance of double taxation and the potential ability to deduct losses from the business on their individual tax returns. However, the Tax Cuts and Jobs Act (TCJA) of 2017 placed new limitations on deducting business losses. Here’s a look at the changes in the rules and how they might affect you.
Before the TCJA, a taxpayer’s business losses could generally be fully deducted in the tax year when they arose. That is, business losses could offset non-business income, such as interest, dividends or capital gains, without limitation. That was the result unless the basis or at-risk basis limitations, passive activity loss (PAL) rules or some other provision of tax law limited that favorable outcome, or the business loss was so large that it exceeded taxable income from other sources, creating a net operating loss (NOL).
Under prior law, taxpayers could carry back an NOL to the two preceding tax years or could carry it forward for up to 20 tax years.
For tax years 2018 through 2025, the TCJA made changes that limit the deductibility of business losses for noncorporate taxpayers – that is, any taxpayer other than a C corporation. Before looking at these changes, it is important to review how the PAL rules work, as they may apply to any business that is a rental operation or where the owner does not actively participate in the business.
In general, the PAL rules allow for passive losses to be deducted only to the extent of passive income from other sources, such as positive income from other business or rental activities or gains from selling passive activities. Passive losses that cannot be currently deducted are carried forward to future years until sufficient passive income is generated to absorb the losses, or the underlying activity is sold.
If a business loss is deductible under the PAL rules, it is now subject to a new limitation created by the TCJA: under Section 461(l) of the Internal Revenue Code, for tax years beginning in 2018 through 2025, a noncorporate taxpayer cannot deduct an “excess business loss” in the current year. For 2019, an excess business loss is the excess of aggregate business deductions for the tax year over the sum of aggregate business income and gains for the tax year and $255,000 (or $510,000 for married individuals filing jointly). This threshold amount is increased each year by a cost-of-living adjustment to account for inflation.
Any excess business loss is carried forward to the following tax year and can be deducted under the rules for NOL carryforwards. For NOLs that arise in tax years ending after December 31, 2017, taxpayers generally cannot use an NOL carryforward to shelter more than 80% of taxable income in the carryforward year. (Under prior law, an NOL could offset up to 100% of taxable income.) In addition, NOLs that arise in tax years beginning after December 31, 2017 cannot be carried back to an earlier tax year. Instead, they can be carried forward indefinitely.
Example: Paul, a single taxpayer, has $400,000 of net business losses in 2019 from a trade or business in which he materially participates and $500,000 of investment income. Before the TCJA, the $400,000 of losses could be fully deducted. Under the new excess business loss rules, the $400,000 net business loss only offsets $255,000 of his 2019 investment income. The remaining $145,000 excess business loss is treated as an NOL carryover to 2020, a year in which he has taxable income of $160,000. Paul’s 2020 NOL deduction is limited to $128,000 ($160,000 x 80%). The remaining NOL of $17,000 cannot be deducted in 2020 but can be carried forward indefinitely.
To date, no regulations have been promulgated under Section 461(l), leaving uncertainty in how to comply with this new loss limitation provision. For example, it is not entirely clear how taxpayers should treat wage income for purposes of the excess business loss rules. However, the treatment of wages as income attributable to a trade or business is consistent with other provisions under the Internal Revenue Code, and the IRS has indicated on its website that a “trade or business” can include “the activity of being an employee.” The newly created Form 461, which is used to calculate the excess business loss of a taxpayer, also provides for the inclusion of wage income on Part 1, Line 1. Therefore, it appears reasonable to treat wages as business income that can be offset by business losses.
Other areas of uncertainty include the treatment of business-related capital losses; whether gains from the disposition of partnership or S corporation stock should be included as business income; and how deductions such as self-employed health insurance and unreimbursed partner expenses affect the excess business loss calculations. A clarifying amendment or interpretive guidance is needed to address these questions.
As noted, the new loss limitation rules apply after applying the PAL rules. If the PAL rules disallow a business or rental activity loss, most practitioners agree that the loss is not considered in determining whether a taxpayer has an excess business loss (although the statute is not entirely clear). Further, the PAL rules apply after the basis and at-risk basis limitations. A full discussion of these limitations is beyond the scope of this article. Generally, a taxpayer is at risk in an activity to the extent of money or property contributed to the activity in excess of distributions taken, net income and gain from the activity, and borrowed funds for use in the activity for which the taxpayer has personal liability.
For business losses passed through from S corporations, partnerships and LLCs that are treated as partnerships for tax purposes, the new loss limitation rules apply at the owner level. In other words, each owner’s allocable share of business income, gain, deduction or loss from the entity is taken into account by the owner in applying the excess business loss rules to the owner’s tax year that includes the end of the entity’s tax year.
The rationale underlying the new loss limitation rules is to further restrict the ability of noncorporate taxpayers to use current-year business losses (including losses from rental activities) to offset income from other sources, such as interest, dividends and capital gain. The practical impact is that, if a taxpayer has excess business losses, the requirement that such losses must be carried forward as an NOL delays any tax benefits from those excess losses for at least one year.
The existence of this limitation may also affect the choice of entity decision for a new business. Under prior law, a start-up business that was expected to generate significant losses in its early years of operation may have chosen a partnership or S corporation structure so that those losses could flow through immediately to the shareholders. With the excess business loss rules now in place, such losses could be limited at the owner level. Because of the lower corporate income tax rate and the availability of benefits such as the Section 1202 gain exclusion on an eventual sale, additional consideration should be given to operating as a C corporation. Many provisions of the TCJA will affect this decision, and all relevant factors should be considered in the context of entity choice.
While the intent behind the new excess business loss provision is clear, there remain areas of ambiguity in its application because of the continued absence of regulatory guidance. If you have questions about the excess business loss rules and how they might affect your tax situation, contact your Bennett Thrasher tax advisor by calling 770.396.2200.