The Tax Cuts and Jobs Act added Section 461(l) to the Internal Revenue Code (“the Code”), which limits the excess business losses of noncorporate taxpayers. The limitation applies to sole proprietors, partnerships, S Corporations, limited liability companies, estates and trusts for years beginning after December 31, 2017 and before January 1, 2026.
Excess business loss means the excess of the aggregate deductions of the taxpayer, attributable to trades and business, over the aggregate gross income or gain of such taxpayer, attributable to those trades or business plus $250,000 ($500,000 for a joint return). These two thresholds are adjusted for inflation for taxable years beginning after December 31, 2018. For 2019, inflation adjusted amounts are $255,000 and $520,000, respectively.
Any disallowed loss under this provision is treated as a net operating loss (“NOL”) carryover to the following taxable year under §172. The excess business loss is determined after the application of passive loss provisions of §469 and the at-risk rules of §465. The IRS has issued Form 461, Limitation on Business Losses, to compute any excess business loss. The instructions indicate that it must be filed for noncorporate taxpayers if its net losses from all trades and businesses are more than $250,000 ($500,000 for a joint return).
A trade or business is an activity if the taxpayer’s primary purpose is income or profit and the taxpayer is involved in the activity with continuity and regularity. While facts and circumstances of each case determine if the activity is a trade or business, regularity of activities and transactions and the production of income are important elements. The activity does not have to make a profit in a particular year, if there is a profit motive. Based on the Form, salaries and wages can be used to offset business losses, which decrease a taxpayer’s excess business loss that must be carried forward as an NOL. While Congress indicated that an excess business loss does not take into account the gross income and deductions attributable to the trade or business of performance of services as an employee, neither the Code nor the instructions indicate this exclusion. Therefore, a technical correction may be necessary to achieve this result.
The operation of the excess business loss provisions can best be understood by the following examples:
- In 2018, T, a single taxpayer, has deductions of $500,000 and gross income of $200,000 from a business. T’s excess business loss is $50,000 ($500,000 – ($200,000 + $250,000)). The $50,000 excess business loss is treated as part of the taxpayer’s NOL carryforward in later years;
- Facts are the same as Example 1, except that T is married and files a joint return. T does not have an excess business loss because the aggregate business deductions ($500,000) does not exceed the $200,000 of business income, plus the $500,000 threshold for joint filers;
- Same facts as Example 2, except that T’s spouse (S) also has a business that has deductions of $500,000 and gross income of $200,000. S and T’s excess business loss is $100,000 ($1,000,000 – ($400,000 + $500,000));
- Same facts as Example 2, except that S earns a salary of $150,000. Since T’s business deductions ($500,000 do not exceed $700,000 (T’s $200,000 business income plus the $500,000 threshold). T does not have an excess business loss. Therefore, T&S can use T’s business loss to offset S’s $150,000 salary.
Because an excess business loss applies to the aggregate income and deductions from all taxpayer’s trades or businesses, it is likely that if a husband and wife have separate trades or businesses and they file a joint return, §461(l) applies to the couple’s trade or business. Because §461(l) limits the ability of noncorporate taxpayers to use trade or business losses against other sources of income, the practical result is that these losses can offset no more than $500,000 (for married individuals filing jointly) or $250,000 (for other individuals), as adjusted for inflation, of taxpayer’s non-business income for the year.
For partnerships or S Corporations, the excess business loss limitation applies at the partner or shareholder level (§461(l)(4)(A)). Each partner’s or shareholder’s allocable share of each item of income, gain, deduction or loss of the entity is taken into account by the partner or shareholder in applying §461(l) to their taxable income for the year.
- In 2018, X and Y start a business as equal partners. X is single and Y is married. The 2018 partnership reports a net loss of $700,000. X’s and Y’s allocable share of the partnership’s loss is $350,000 each, which they report on their respective 2018 individual tax returns. Since the excess loss limitation applies at the partner level, X has an excess business loss of $100,000 ($350,000 less the $250,000 threshold) and Y has no excess business loss, because his allocable share of $350,000 is less than $500,000;
- Same facts as Example 5. Except, X received a salary of $300,000 and had other income of $50,000. Since salaries and wages are business income, X's $300,000 salary is offset by X's partnership loss. X can use $50,000 of the $250,000 threshold amount to offset his other income.
There are still several unanswered questions regarding excess business losses, while proposed regulations have not been issued, The Tax Warriors® at Drucker & Scaccetti are guiding their clients through these complex provisions. Contact us if you believe you may be impacted by this new part of the Code.