New Limitation on Losses Could Impact Your Tax Strategy

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.

Old Rules

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.

New Rules

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 di