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New Limits on Excess Business Losses and Net Operating Losses

November 1, 2018

Heather Green-Kirk, CPA
Autumn Eschmann

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While there has been much attention paid to the favorable 20% pass-through deduction for qualified business income, there are other less favorable rules in The Tax Cut and Jobs Act of 2017 (“TCJA”) with respect to the utilization of business losses and net operating loss carryforwards by non-corporate taxpayers that should not be overlooked. The impact to owners and investors in pass-through entities could be significant. The excess business loss (“EBL”) and net operating loss (“NOL”) rules were put into place to help mitigate some of the revenue loss caused by the 20% pass-through deduction and the reduction of corporate tax rates. According to the IRS, the new limits to EBL are also an attempt to restrict the use of tax sheltering (financial arrangements made to minimize or avoid taxes altogether). The question you should be asking yourself now is “How will these new rules affect me and my business”?

Before the TCJA, business losses incurred by non-corporate taxpayers could reduce their non-business income, (such as W-2 wages, interest, dividends, and capital gains), without limitations. This assumes that the taxpayer has sufficient tax basis and amounts “at-risk” in order to deduct the loss and that the loss is not suspended under the passive activity loss rules. The new rules change that, for years beginning in 2018 through the year 2025, by placing limitations on the amount of non-business income that can be offset by EBLs that are incurred.

As defined by the TCJA, a non-corporate taxpayer’s EBL is the excess amount of the aggregate trade or business deductions over the aggregate trade or business income or gain of the taxpayer plus a threshold amount (discussed later on). This includes losses and income passed through from a partnership or S corporation to their owners.

All of a non-corporate taxpayer’s trade or business deductions and trade or business income are netted in order to determine if there is an EBL. If there is an EBL, the new rule limits the amount of the EBL that a non-corporate taxpayer can deduct. For tax years beginning after December 31, 2017, EBLs are now limited to $250,000 (or $500,000 if filing a joint return). The EBLs in excess of the new limitations are suspended and carried forward as an NOL for potential use in subsequent years.

To illustrate how the added limitations could impact an individual taxpayer filing single, let us assume that the taxpayer has an EBL of $400,000 and does not have any basis, at-risk or passive loss limitations. Prior to 2018, a taxpayer with an EBL of $400,000 and a non-business capital gain of $300,000 would have been able to reduce their taxable income to zero and have an NOL carryforward of $100,000 to a subsequent year (assuming that they elected to forego the carryback period). Now, however, that same taxpayer will only be able to deduct $250,000 because of the new limitation, resulting in taxable income of $50,000 ($300,000 - $250,000). As a result, under the new law an additional $50,000 loss will be deferred to subsequent years by increasing the NOL carryforward to $150,000.

As if that was not enough of a disadvantage, the TCJA also restricts the future usage of NOL carryforwards. Prior to 2018, a taxpayer’s NOL carryforward could be used to reduce 100% of their taxable income. NOLs created in years beginning after December 31, 2017 may only reduce 80% of taxable income (with certain modifications, including adding back any pass-through deduction that reduced the taxable income). However, unlike prior years, the NOL can now be carried forward indefinitely instead of being limited to 20 years. The option to carry the NOL back two years has been eliminated.

The new law only effects the NOLs that are 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.

The new limits on EBLs and NOLs may come as a surprise to taxpayers who expected little or no tax liability by utilizing their EBLs to offset their non-business income and utilizing newly-created NOLs in the future. Please contact your Citrin Cooperman adviser or a member of our Federal Tax Policy Team to discuss how these new rules apply to you and how you can adjust your estimated tax payments accordingly to avoid surprises when filing your 2018 and future tax returns.