With the significant changes made by the Tax Cuts and Jobs Act (TCJA) of 2017, one provision that has gone relatively unnoticed is the new limitation on excess trade or business losses (EBL) under Internal Revenue Code Section 461(l). Before the new law, when non-corporate taxpayers incurred business losses, they could reduce their non-business income (such as W-2 wages, interest, dividends and capital gain) without limitations. This assumes that the taxpayer had sufficient tax basis and amounts “at-risk” in order to deduct the loss, and the loss was not suspended under the passive activity loss rules. The new limitation on excess business loss is intended to restrict the ability of taxpayers to use business losses to offset other sources of income. The provision is effective for taxable years beginning after December 31, 2017, and before January 1, 2026.
In a sense, EBL is a fourth limitation provision. If the first three provisions above are met, all business income is added, and any net losses in excess of $500,000 (for joint returns and $250,000 for everyone else) are disallowed and carried forward as a net operating loss (NOL) in future tax years. The excess business loss threshold amounts will be indexed for inflation on an annual basis
Let’s consider an example to illustrate how EBL works:
Taxpayer and spouse file a joint return for 2018. They have $1 million of investment income. Taxpayer incurs a $750,000 ordinary loss from an S corporation and spouse earns a $100,000 income from a schedule C business. What is their 2018 adjusted gross income (AGI)? What would it have been under the old law?
|New Law||Old Law|
|Investment Income||$ 1,000,000||$ 1,000,000|
|Business income (loss):|
|Net business loss||(650,000)||(650,000)|
|Allowed business loss||500,000||650,000|
|Disallowed business loss||(150,000)||–|
|Adjusted Gross Income||$ 500,000||$ 350,000|
As a result of the new limitation, $150,000 of the disallowed business loss would be carried forward to 2019 as an additional NOL and the taxpayers can only deduct $500,000 of losses in the current year. Under the old law, they wouldn’t have been limited on their business loss deduction and their AGI would have been $150,000 lower, resulting in less tax.
Additionally, the TCJA restricts the future usage of NOL carryforwards. Prior to 2018, a taxpayer’s NOL carryforward could be used to reduce 100 percent of their taxable income.
NOLs created after December 31, 2017 may only reduce 80 percent of taxable income. Unlike in prior years, they can be carried forward indefinitely with the option to carry them back eliminated. The new law only affects NOLs created after 2017; previously created NOLs are still subject to the old rules. This means that taxpayers will now have to track NOLs that arose pre-2018 separately from newly generated NOLs.