Emerging companies typically raise capital through the issuance of convertible debt and equity to finance start-up and growth initiatives. Historically investors in these early stage companies which were taxed as either S corporations, partnerships or LLCs needed to focus on two primary tax issues to determine if they could deduct losses allocated to them.The first issue involves the passive activity loss limitation rules, which in general specify that losses from activities in which the investor does not materially participate can only be deducted to the extent of passive activity income. Excess losses from passive activities are carried forward indefinitely, and can be deducted in the year in which the investor completely disposes of his interest in the activity.
The other tax issue involves the “at risk” rules, which limit the deductibility of losses allocated to the investors to the amount they personally have at risk related to their investment. The at risk amount includes the sum of the equity capital that the investor contributes to the company, any debt that the company issues to the investor, and any other company debt which the investor personally guarantees.
The Tax Cuts and Jobs Act which was passed in December 2017 added another provision called Excess Business Losses which investors in emerging companies will need to consider. The article, “Excess Business Loss: New Tax Law Not as Generous as Before”, by Stephanie Casey, a Tax Senior Manager, provides an overview of this new provision. Access Article.
“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.”
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