By Stephanie M. Casey, CPA, Tax Senior Manager | Family, Executive & Entrepreneur Advisory Services Team
For many taxpayers the Tax Cuts and Jobs Act (the Act) passed in December 2017 will be considered a win as it will provide for increased deductions. These include increased depreciation expense through Section 179, 100 percent bonus depreciation through the end of 2022 and a new pass through income deduction. The question is, will taxpayers be able to make use of all of these deductions?
New IRS Code Section 461(I) limits the ability of non-corporate taxpayers to use trade or business losses against other sources of income (such as salaries, fees, interest, dividends and capital gains). Prior to 2018, if you generated a large non-passive loss from a pass through business, that loss could offset all other forms of income on your individual tax return (1040). That loss will now be limited to $500,000 (Married Filiing Jointly “MFJ”) or $250,000 (Single). Any loss over and above those amounts are now considered an excess business loss.
So the question becomes, what exactly is an excess business loss and how is it calculated? The new Code Section 461(l)(3)(A) defines it as:
(i) the aggregate deductions of the taxpayer for the taxable year which are attributable to trades or businesses of such taxpayer (determined without regard to whether or not such deductions are disallowed for such taxable year under paragraph (1)), over
(ii) the sum of—(I)the aggregate gross income or gain of such taxpayer for the taxable year which is attributable to such trades or businesses, plus (II)$250,000 or 200 percent of such amount in the case of a joint return i.e., $500,000.
It may be easiest to look at two examples:
- In 2018, T, a single taxpayer, has deductions of $500,000 from a business. T's gross income from the business is $200,000. This results is a current year loss of $300,000. Assuming no other business income or loss, T can deduct only $250,000 on his current year form 1040. T's excess business loss is $50,000 ($500,000 – ($200,000 + $250,000)).
- The facts are the same above except that T's spouse (S) also has a business that has deductions of $500,000 and gross income of $200,000. S’s business has a current year loss of $300,000. T & S combined have business losses of $600,000. Assuming no other business income or loss, they are able to deduct only $500,000 on their current year 1040. S and T's excess business loss is $100,000 ($1,000,000 − ($400,000 + $500,000).
One further complication. According to this Code Section, you first need to apply the passive activity loss and at risk limitation rules. Once you apply those rules, any loss is eligible must be netted with your income according to the examples above.
What happens to the excess business losses?
There is some good news. Any excess business loss generated is carried forward to the next tax year as a Net Operating Loss (NOL). An NOL can offset any type of income, up to 80 percent of your taxable income. Any amount of NOL not used is then carried forward indefinitely to the next tax period until you are able to use it.
The Excess Business Loss rules are in effect January 1, 2018 through December 31, 2025.
If you have a large non-passive loss from a pass-through entity that would normally (pre 2018) have offset all of your other income – regardless of the size of the loss – that loss is now limited to $250,000 (Single) or $500,000 (MFJ). You may have some residual tax due in the year of the loss as the excess business loss is limited and converted to an NOL for use in a future year.
As with many of the new tax changes, the IRS will provide interpretive guidance as well as examples relating to application of this code section. Keiter is monitoring all activity related to the tax law and will keep you informed regarding how it will affect you and your business.