Many businesses generate tax losses, especially in the first few years of operation or under unfavorable conditions. It is important for businesses to understand the new rules set for by the Tax Cuts & Jobs Act (TCJA) that specify when losses can be deducted, and how much they can deduct in any given year. This article explains new limitations on the ability of individual taxpayers to deduct losses from pass-through business entities, including sole proprietorships, partnerships, limited liability companies (LLCs) treated as sole proprietorships or partnerships for tax purposes, and S corporations.
Prior to the TCJA, an individual taxpayer’s business losses could usually be fully deducted in the tax year when they were derived. That was the result unless:
The passive loss 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 so-called “net operating loss” (NOL).
Also prior to the TCJA, you could carry back an NOL to the two preceding tax years or carry it forward for up to 20 tax years.
For tax years beginning January 1, 2018 and before January 1, 2026, the TCJA changes the rules for deducting an individual taxpayer’s business losses. If your business or rental activity generates a tax loss, things get complicated. First, the passive activity loss (PAL) rules may apply if it’s a rental operation or you don’t actively participate in the activity. In general, the PAL rules only allow you to deduct passive losses to the extent you have passive income from other sources, such as positive income from other business or rental activities or gains from selling them.
Passive losses that can’t be currently deducted are suspended. That is, they’re carried forward to future years until you either have sufficient passive income or sell the activity that produced the losses. To complicate matters, after you’ve successfully cleared the hurdles imposed by the PAL rules, the TCJA says: beginning in 2018 and through 2025, you can’t deduct an “excess business loss” (EBL) in the current year.
An EBL is the excess of your aggregate business deductions for the tax year over the sum of:
Your aggregate business income and gains for the tax year, and
$250,000 for single filers, or $500,000 for married/joint-filers.
The EBL is carried over to the following tax year and can be deducted under the rules for NOL carryforwards. The EBL rule effectively prevents net losses from a taxpayer’s trades or businesses from offsetting nonbusiness income beyond the 250,000 or $500,000 limitation.
Losses Carried Forward
Any loss disallowed under the EBL rule becomes an NOL and is carried forward to future taxable years where the loss can be utilized to offset income under the NOL rules. The TCJA also modified certain rules with respect to NOLs. First, an NOL can no longer be carried back two years. In addition, they can now be carried forward indefinitely as opposed to being limited to 20 years. Finally, NOLs can only be used to offset 80% (instead of 100%) of a taxpayer’s taxable income in a carryforward tax year.
Exception for Farming Losses
Although NOLs arising in taxable years ending after December 31, 2017, generally can’t be carried back, farming losses continue to be eligible for a reduced two-year carryback. Farming losses for any taxable year are treated as separate NOLs for that taxable year and are only taken into account after the remaining portion of the regular NOL, if any, for that taxable year. This will require taxpayers to separately track farming losses to avoid commingling with regular NOLs. A farming loss is defined as the lesser of:
The amount that would be the NOL for the taxable year if only income and deductions attributable to farming businesses are taken into account
The amount of the NOL for the taxable year
Rules for S Corporations, Partnerships and LLCs
For business losses passed through to individuals from S corporations, partnerships and LLCs that are treated as partnerships for tax purposes, the new excess business loss limitation rules apply at the owner level. In other words, each owner’s allocable share of business income, gain, deduction or loss is passed through to the owner and reported on the owner’s personal federal income tax return for the owner’s tax year that includes the end of the entity’s tax year.
Summary & Impact of New Loss Disallowance Rule
The rationale presumably is to further restrict the ability of individual taxpayers to use current-year business losses (including losses from rental activities) to offset income from other sources, such as salary, self-employment income, interest, dividends and capital gains.
The practical impact is that your allowable current-year business losses can’t offset more than $250,000 of income from such other sources for single filers (or more than $500,000 for married/joint-filers).
The requirement that excess business losses must be carried forward as an NOL forces you to wait at least one year to get any tax benefit from those excess losses.
Understanding the modified NOL rules and the EBL rules is important for tax planning purposes and could result in adjustments to your Tax strategy. Please contact Restivo Monacelli as soon as possible to discuss your particular situation. We will determine if you can take advantage of any of the allowed exceptions, as well as provide other strategic planning moves to help minimize your tax liabilities under the new tax laws.