By now, most people are very familiar with the new tax provision under Sec. 199A that generally allows a taxpayer with net flow-through trade or business income from a sole proprietorship, single member LLC, an S corporation or any entity taxed as a partnership to claim a tax deduction equal to 20% of such income. But what happens if the taxpayer has an overall net loss from those flow-through entities?
Under pre-TCJA tax law, the ability of any taxpayer other than a C corporation to deduct tax losses from a flow-through business activity (sole proprietorship, single member LLC, S Corporation or any entity taxed as a partnership) was subject to three limitations:
- The taxpayer’s tax basis in the activity.
- The taxpayer’s amount at-risk in the activity.
- The application of the passive loss rules.
Losses that were limited by any of these three hurdles in a given tax year were suspended and carried forward to subsequent years, where they were once again subject to the same three limitations. The previously suspended losses could become deductible to the extent that the taxpayer’s basis or at-risk amount increased, or the taxpayer had passive income or disposed of the interest in the passive activity in a taxable transaction.
Taxpayers with losses that can overcome these three hurdles will now be confronted with a surprising fourth limitation. For tax years beginning after December 31, 2017, and before January 1, 2026, excess business losses will no longer be allowed to be deducted in the current tax year. Instead, those losses must be carried forward and treated as part of the taxpayer’s net operating loss (“NOL”) in the subsequent tax year.
An excess business loss is defined as the excess of the taxpayer’s total trade or business deductions and losses over the sum of (a) their total trade or business income and gains and (b) $250,000 (single) or $500,000 (joint).
So, what does this new rule really mean? Well, taxpayers who could previously deduct all of their otherwise allowable trade or business losses from sole proprietorships, single member LLCs, S corporations and entities taxed as partnerships against their other non-business sources of income (such as wages, interest, dividends, capital gains, other investment income and retirement plan income) will now only be able to offset these other sources of income with $250,000 (single) or $500,000 (joint) of their trade or business losses in the current tax year.
Well then, what happens with the net loss that exceeds that maximum $250,000 or $500,000 deductible amount, if the taxpayer cannot deduct it in the current tax year? Surprisingly, any excess loss beyond that $250,000 or $500,000 is recharacterized as an NOL carryover to the taxpayer’s subsequent tax year. This recharacterization as an NOL is at least beneficial for taxpayers from the standpoint that the carryover will not be added to the subsequent year’s business losses where it would again be subject to the $250,000 or $500,000 maximum loss limitation. However, the recharacterization as an NOL carryover does also have a potential downside, given the changes the TCJA made to the NOL rules.
Because of this new limitation on the ability to utilize business losses to offset other sources of income, it will be important for taxpayers to project and control their annual business losses in order to maximize the tax benefits of those losses. Control of losses can potentially be achieved through various tax elections, methods of accounting, asset acquisition timing, depreciation choices, decisions regarding the 30% business interest limitation, etc.
- For partnerships and S corporations, the limit on excess business losses is applied at the partner or shareholder level, not at the entity level.
- If the taxpayer is a noncorporate farmer who was subject to the limitation on excess farm losses that applied prior to the TCJA, they will not be subject to that limitation for tax years beginning after December 31, 2017, and before January 1, 2026. Instead, the broader excess business loss limitation discussed above will apply to them the same as it applies to all taxpayers.