Business-owning clients need to keep one word in mind this year concerning their losses: limitations.
Internal Revenue Code Section 461 imposes a new cap on the non-passive business losses an individual taxpayer can deduct. Before tax reform, taxpayers had greater use of business losses to offset other income.
Most business owners and investors are familiar with the 461 limitation “but are less certain about its application,” said Nate Smith, director in the CBIZ MHM national tax office in Clearwater, Fla. “It’s been over a year and a half since the enactment of the new tax law, and while the Treasury and the IRS have done a tremendous job in publishing regulations for many parts of the law, we still don’t have any guidance for excess business losses.”
“I suspect that an individual who truly has a business and invested their own capital that resulted in expenses that exceed income will be greatly disappointed,” added Craig Richards, managing director and director of tax services at Fiduciary Trust Company International in New York.
Section 461 defines an excess business loss as “the excess (if any) of the aggregate deductions of the taxpayer for the taxable year ... over the sum of the aggregate gross income or gain of such taxpayer for the taxable year which is attributable to such trades or businesses plus $250,000.” The base amount is doubled to $500,000 for married filing jointly returns; the amounts are also indexed for inflation and are $255,000/$510,000 for 2019.
Prior to the tax reform act, less-severe limitations prevented taxpayers from deducting more than their investment. “The TCJA made losses much less valuable to taxpayers,” said Perry H. McGowan, a CPA and director in the construction and real estate group in the Minneapolis office of CliftonLarsonAllen.
Richards offers the example of a single taxpayer with his or her own business who will have $100,000 of business income and $300,000 of business expenses this year. “The $200,000 business loss can be used against other 2019 income on her return,” Richards said. “But she’s considering incurring an additional $150,000 in expenses, which would put the business at a net $350,000 loss for the year. Only $255,000 would be available against other income on her 2019 return.”
These excess losses carry forward to the next taxable year in the form of a net operating loss (NOL)—but tax reform also made it more difficult to use NOLs. “Under [tax reform's] revisions, these business losses ... may offset no more than 80% of income in the future year,” McGowan said.
The section also uses the phrase “noncorporate taxpayers,” which indicates that “C corporations are not impacted by this limit, but other types of taxpayers—individuals, trusts and estates, for example—generally are,” McGowan said.
Despite some uncertain language in 461, there are some ways to plan an efficient tax strategy with the limitation in mind. “Planning revolves around projecting income and expenses over multiple years,” Richards said. “Expenses are typically more controllable than income. If the limitations might be an issue for a taxpayer, they need to decide about incurring expenses in a year that might trigger a loss that is not deductible in that year.”