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Classroom Examples: Excess Business Losses (New § 461(l))
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Contributing Author James C Young

Since the Tax Reform Act of 1986, we’ve been used to limitations on losses when someone is a passive owner.  But under the Tax Cuts and Jobs Act of 2017, now even a nonpassive owner can be subject to loss limitations.  The new rules – contained in § 461(l) – caught just about everyone by surprise.  When coupled with the new 80% limit on the use of net operating losses, it effectively means that almost everyone will pay taxes every year.  Here is a summary of these new rules, along with some examples to use in your classes this semester.

Overview.  If a non-corporate taxpayer has an excess business loss for the year, it is not allowed.[1]  Instead, it is carried forward and treated as part of the taxpayer’s net operating loss (NOL) carryforward in subsequent years.

Excess Business Loss Defined.  An “excess business loss” is defined as:[2]

                        The aggregate deductions for the year attributable to the taxpayer’s businesses

            Less:    The sum of aggregate gross income or gain of the taxpayer

            Less:    A threshold amount ($500,000 for married taxpayers filing a joint return,

 $250,000 for all other taxpayers).

Beginning in 2019, the threshold amounts are adjusted for inflation each year.

At its core, the purpose of the excess business loss limitation is to limit the amount of non-business income (e.g., salaries, interest, dividends, and capital gains) that can be “sheltered” from tax as a result of business losses. 

EXAMPLE 1.   In 2018, Tonya, a single taxpayer, operates a sole proprietorship in which she materially participates.  Her proprietorship generates gross income of $320,000 and deductions of $600,000, resulting is a loss of $280,000.  The large deductions are due to the acquisition of equipment and the use of immediate expense and additional first-year depreciation to deduct all of the acquisitions.  Tonya’s excess business loss is $30,000 computed as follows:

                        Aggregate business deductions                                              $600,000

            Less:    Aggregate business gross income and gains                           (320,000)

            Less:    Threshold amount                                                                   (250,000)

                                    Excess business loss                                                   $ 30,000

So, of Tonya’s $280,000 proprietorship loss, $250,000 can be used to offset non-business income.  The $30,000 excess business loss is treated as part of Tonya’s net operating loss carryfoward in subsequent years.

EXAMPLE 2.   Assume the same facts as Example 1, except that Tonya is married and files a joint return.  In this case, Tonya does not have an excess business loss due to the increased threshold amount.

                        Aggregate business deductions                                              $600,000

            Less:    Aggregate business gross income and gains                           (320,000)

            Less:    Threshold amount                                                                   (500,000)

                                    Excess business loss                                                   $  None  x

As a result, Tonya’s $280,000 sole proprietorship loss is fully deductible and can be used to offset non-business income (e.g., her spouse’s wages or their interest and dividend income).

The excess business loss limitation applies to the aggregate gross income and deductions from all of a taxpayer’s trades or businesses.[3]  So if a married couple files a joint return, information from all of the couple’s trades or businesses must be consolidated.  Further as noted in Example 2, if married taxpayers file a joint return, the losses of one spouse can be used to offset the other spouse’s non-business income (up to the $500,000 limit in 2018). 

Losses from Partnerships or S Corporations.  For a partnership or S corporation, this rule applies at the partner or shareholder level.[4]  Each partner’s or S corporation shareholder’s share of items of income, gain, deduction, or loss of the partnership or S corporation is taken into account in applying the limitation for the tax year of the partner or S corporation shareholder.

EXAMPLE 3.   Jayson, a single taxpayer, is an S corporation shareholder and materially participates in the grocery store business.  During 2018, the store had a large depreciation deduction causing a substantial loss.  Jayson has a flowthrough loss of $345,000 from the S corporation.  He also received a $78,000 salary from the corporation.  At the beginning of the year, Jayson had a $520,000 basis in his S corporation shares – enough to absorb the S corporation loss.  Because he materially participates in the business, it is not a passive activity.

However, Jayson’s flowthrough loss exceeds the $250,000 excess business loss threshold by $95,000 ($345,000 – $250,000).  So Jayson can deduct $250,000 (and use it to offset his salary and other non-business income).  The $95,000 excess is not deductible in 2018, but carries forward as a net operating loss.

            Assume that in 2019, the grocery store business generates a profit and flows-though $210,000 of income to Jayson.  Jayson can deduct the 2018 “excess business loss” of $95,000 against this flowthrough income.

The excess business loss rules also treat similarly-situated owners differently (based on their filing status).

EXAMPLE 4.   Margie Opal leaves her job in 2018 to pursue her dream, a technology start-up.  Margie is single and invests $500,000 of capital, and so does her business partner Janice French, who is married.  Together they form TechStart LLC (which reports as a partnership for Federal tax purposes); both materially participate in the business.  In 2018, the LLC reports a net loss of $700,000.  Each LLC member receives a Schedule K-1 from the LLC indicating a $350,000 ordinary loss; each will report this loss on their 2018 individual income tax return (on Form 1040 (Schedule E)).

            Margie has an excess business loss of $100,000 ($350,000 minus the $250,000 threshold for single taxpayers). This excess business loss is an NOL carryforward for Margie.[5]  Janice can use the full $350,000 loss in 2018 since it is less than the $500,000 threshold that applies to married taxpayers.

Other Items.  The excess business loss limitation is applied after the application of the § 469 passive loss rules.[6]  Given this requirement, losses from passive trades or businesses (e.g., a business where the taxpayer is not materially participating) are limited first by the § 469 passive loss rules, and once the losses are allowed under § 469, they would be subject to these rules.

            The Treasury Department and IRS are to specify reporting requirements necessary to implement these rules.[7]

[1] § 461(l).

[2] § 461(l)(3).

[3] § 461(l)(3)(A)(i).

[4] § 461(l)(4)(A).

[5] Under prior law, NOLs could be carried back two years and used to offset income in those years.  This carryback allowed taxpayers to immediately “monetize” a NOL by using the NOL to generate an income tax refund in those years.  Under the TCJA of 2017, NOL carrybacks are no longer allowed; NOLs can only be carried forward.  So in addition to treating similarly-situated owners differently based on filing status, the inability to carryback these losses also is detrimental to business owners.

[6] § 461(l)(6).

[7] § 461(l)(5).

 

SWFT Chapters

SWFT Individuals Chapter 7

SWFT Comprehensive Chapter 7 

SWFT Essentials Chapter 6 

 

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James C. Young is the Crowe Horwath Professor of Accountancy at Northern Illinois University. A graduate of Ferris State University (B.S.) and Michigan State University (M.B.A. and Ph.D.), Jim’s research focuses on taxpayer responses to the income tax using archival data. His dissertation received the PricewaterhouseCoopers/American TaxationmAssociation Dissertation Award and his subsequent research has received funding from a number of organizations, including the Ernst & Young Foundation Tax Research Grant Program. His work has been published in a variety of academic and professional journals, including the National Tax Journal, The Journal of the American Taxation Association, and Tax Notes. Jim is a Northern Illinois University Distinguished Professor, received the Illinois CPA Society Outstanding Accounting Educator Award in 2012, and has received university teaching awards from Northern Illinois University, George Mason University, and Michigan State University.