The Tax Cuts and Jobs Act (TCJA) brought sweeping changes to tax law. Many of these changes, such as lower corporate tax rates, expanded cost recovery and the new pass-through deduction, have been widely discussed; however, these are not the only changes enacted by the TCJA.
Consider the limitation on excess business losses introduced by Internal Revenue Code Sec. 461. Prior to the TCJA, there was no limitation on the amount of non-passive business losses an individual (non-corporate) taxpayer could deduct in a given tax year. This allowed individual taxpayers to offset other sources of income, including, but not limited to, wages, investment income and even capital gains, regardless of the amount of business loss generated.
For tax years beginning after Dec. 31, 2017, this will no longer be true. IRC Sec. 461(l)(1)(A) and (B) states: “In the case of taxable year of a taxpayer other than a corporation … after Dec. 31, 2017, […] any excess business loss of the taxpayer for the taxable year shall not be allowed.”
IRC Sec. 461(l)(3)(A) defines an excess business loss as: “[…] the excess (if any) of the aggregate deductions of the taxpayer for the taxable year which are attributable to trades or businesses of such taxpayer […], over the sum of the aggregate gross income or gain of such taxpayer for the taxable year which is attributable to such trades or businesses plus $250,000 (200 percent of such amount in the case of a joint return).”
Effectively, this limits the business loss individuals may utilize equal to their total business income, plus an additional $250,000 ($500,000 for taxpayers filing jointly).
For example, John and his spouse filed a joint return for 2019 and have $750,000 in investment income. John earned $250,000 in wages and incurred an $800,000 ordinary loss from his S corporation. His spouse earned $40,000 in wages and $50,000 from Schedule C. The table below shows the impact to John’s adjusted gross income (AGI) before and after the TCJA.
|Gross non-business income (loss):||1,040,000||1,040,000|
|Business income (loss):|
|Net business loss||(750,000)||(750,000)|
|Allowed business loss||500,000||750,000|
|Disallowed business loss||(250,000)|
|Adjusted gross income||540,000||290,000|
If the same facts and circumstances applied to John except that he filed as a single taxpayer in 2019, John’s AGI would differ due to the reduced excess business loss allowed.
|Gross non-business income (loss):||1,000,000||1,000,000|
|Business income (loss):|
|Net business loss||(800,000)||(800,000)|
|Allowed business loss||250,000||800,000|
|Disallowed business loss||(550,000)|
|Adjusted gross income||750,000||200,000|
IRC Sec. 461 also explains what happens to the disallowed business loss for John above. Per IRC Sec. 461(l)(2): “Any loss which is disallowed […] shall be treated as a net operating loss carryover for the following taxable year under Sec. 172.” For John and his spouse, the $250,000 excess business loss they incurred in 2019 would become a net operating loss carryforward per IRC Sec. 172.
An important point to remember for this new provision is that these excess business losses are utilized only after all passive loss and at-risk limitations have been applied. IRC Sec. 461 has, in effect, created a new category of loss for non-corporate taxpayers.
Before the next filing season, it will be critical for all tax preparers to determine if any clients are in a potential business loss situation. For a client with a potential business loss, the tax preparer will want to advise them about the impact IRC Sec. 461 may have to avoid any unpleasant surprises at deadline time.