Are you up to speed on Tax Cuts and Jobs Act (TCJA) changes that impact your business? One change that may still be an area of confusion is Section 461, or the excess business loss limitation. Let’s delve into this provision.

What is the excess business loss limitation?

As part of the 2017 TCJA, Congress amended Section 461 of the Internal Revenue Code (IRC) to add Sub-Section L which eliminates the ability of individuals, trusts, and estates to deduct trade or business losses greater than $250,000 in any tax year that begins after December 31, 2017. For married individuals filing jointly this limitation is doubled to $500,000. The limitation is indexed for inflation and will be $255,000 ($510,000 for joint filers) for the 2019 tax year and $259,000 ($518,000 for joint filers) for 2020.

This provision received very little fanfare when the law was passed. While the number of taxpayers affected by this change is relatively small, those taxpayers that are impacted may find that their tax liability is significantly increased due to the limitation.

What did the law change?

Prior to the change, a taxpayer could offset any investment income or other nonbusiness income by losses sustained from a business. For example, Taxpayer A (who is single) had $1 million of income from interest, dividends, and capital gains and a $1 million loss from a business they owned and operated. Under the old law, Taxpayer A could use the $1 million business loss to effectively zero-out their income for the year.

Using the same fact pattern under the new law, Taxpayer A would only be able to deduct $250,000 of the business loss. This would leave Taxpayer A with having to pay a tax on $750,000 of income.

What taxpayers will likely be affected?

It is important to note that the limitation under Section 461(l) is applied only after other loss limitations have been tested. These limitations pre-date the TCJA and include the loss limitation for passive activities. Because of this, a taxpayer is only likely to be affected by Section 461(l) if they have losses from a business in which they participate or have previously suspended passive business losses that are released upon disposition of a passive activity.

How is excess business loss calculated?

After other loss limitations are applied, losses from a trade or business are then netted against trade or business income. If the remaining losses exceed income by more the $250,000 (or $500,000) limitation, the excess losses are disallowed.

But what is considered a trade or business?

Typically these are activities carried on by taxpayers looking to generate income or profit (ie. a profit motive) where the taxpayers are involved regularly and continuously. It is important to note for taxpayers invested in partnerships or s-corporations that this determination is made at the entity level and not based on the individual taxpayer’s circumstances. For example, if a taxpayer owns 10% of a trade or business, but does not otherwise participate throughout the year, the activity is still considered to be a trade or business for the purposes of this limitation.

Typically trade or business activities do not include rental real estate activities. It also does not include other investment income such as interest, dividends, and capital gains that are not otherwise related to a business.

It does however include wages paid to a taxpayer. Even if the taxpayer has no ownership of the entity paying the wages.

What happens to the excess losses after they are limited?

While the losses are limited the year they occur, any unused excess business loss becomes a Net Operating Loss (NOL). Under new rules established under the TCJA, NOL’s for tax years beginning after December 31, 2017 are only carried forward indefinitely to future tax returns and can be used to offset up to 80% of a taxpayer’s taxable income. This means that the Section 461(l) limitation is really just a mechanism for delaying a taxpayer’s ability to use business losses to offset other nonbusiness income. Losses are only tested for the Section 461(l) limitation in the year they would otherwise be deductible, after which they can be deducted against up to 80% business and nonbusiness income.

How does this impact future tax planning?

Owner/operators of pass-through businesses may find less of an incentive to make capital investments than they would without the excess business loss limitation. Even though the TCJA expanded a business’s ability to immediately expense or accelerate depreciation of assets, the excess business loss limitation may inhibit the taxpayer’s ability to immediately reap a tax benefit from the expenditure.

To illustrate, Taxpayer B has $500,000 of investment income and is a 100% owner/operator of a business that usually generates $1 million of income a year. The business is seeking to expand and is expected to spend $2 million on new property, all of which can be immediately depreciated. This will result in $1 million of business losses of which $250,000 can be deducted in the current year.

This will also affect owner/operators whose pass-through businesses regularly incur losses. While partnerships and s-corporations have traditionally been very tax-efficient, the introduction of the excess business loss limitation for individuals and trusts in addition to other incentives for c-corporations such as a lower tax rate may warrant another look at organizing a business as a c-corporation.

Businesses that pay rent to related entities may also be affected. Since real estate is typically not considered a trade or business, income generated by the rental company might not be able to offset losses sustained by a related business.

Contact usfor advice on your particular business situation.