Section 461(l), which limits the amount of business loss deductions from trade or businesses that noncorporate taxpayers can offset against other types of income, was enacted as part of the Tax Cuts and Jobs Act in 2017. Business losses in excess of the current-year deduction convert to net operating losses and are available to offset future year income.
These loss limitation rules were initially applicable to tax years beginning after December 31, 2017, but COVID-19 put the kibosh to that implantation date. As amended by the CARES Act, the limitation was retroactively postponed for tax years beginning in 2018, 2019 and 2020. The provision now applies to tax years beginning after December 31, 2020, with the limitation set to sunset for tax years beginning after December 31, 2026.
As background, an "excess business loss" is the excess, if any, of:
a taxpayer’s aggregate deductions for the tax year from the taxpayer’s trades or businesses, determined without regard to whether such deductions are disallowed for such tax year under the excess business loss limitation, minus
the sum of:
the taxpayer’s aggregate gross income or gain for the tax year from such trade or business, plus
$250,000 or $500,000 for a joint return (adjusted annually for inflation).
For example, if a married taxpayer incurs a $1,000,000 loss from a trade or business, their loss is limited to $500,000. The excess is carried over to future years and treated as a net operating loss carryover.
Losses from flow-through entities carry through to the owners and are combined. Excess loss limitation rules are not applied at the entity level.
The proposed legislation changes the current law in several ways:
It eliminates the sunset provision and makes the limitation permanent.
It retroactively applies the changes to taxable years beginning after December 31, 2020.
It modifies the carryover rules by eliminating its character as a net operating loss; it will remain a trade or business loss that’s included in the trade or business income or loss bucket in the following year for purposes of calculating the limitation. Therefore, the prior year loss may again be subject to the excess business loss rules in the following year, possibly postponing the deductibility of a loss for multiple years.
It repeals the limitation placed on excess farm losses.
Item 3 may be the most detrimental. As noted, treatment of the excess loss as a net operating loss carryover provided the ability to deduct a large portion of the loss in the following year. The modification may tend to extend the utilization of a sufficiently large loss over a longer period. Even worse, it appears that upon death, any unallowed loss may disappear; currently there appears to be no provision in the existing bill to treat otherwise.
The effective date of the legislation is also problematic in that it’s retroactive. Taxpayers may have already been planning on using the loss carryover under the existing net operating loss rules. With the recharacterization in the type of the loss, and depending on specific facts and circumstances, some portion of the loss may now not be available for 2021 or 2022, throwing wrenches into current planning scenarios.
Further, as with almost all tax legislation – proposed or enacted – there appear to be open issues that need further clarification in a final bill. The AICPA is recommending in a comment letter to members of the Senate Finance Committee and House Ways and Means Committee that:
Gains (and losses) from the disposition of partnership or S-corporation interest be included in the definition of business income used in the calculation;
Suspended Section 461(l) losses be allowed in full in the year of complete disposition; and
The issue of remaining losses at death, by either allowing losses in the final return or allowing a carryover of the loss to the estate, is addressed.
Taxpayers and advisors will need to monitor this provision closely. Possibly the Senate will change the effective date and address some of the other concerns with this portion of the proposed legislation.
We will continue to monitor developments as these proposed changes move through the legislative process. Additional articles and analyses will be provided in the coming weeks. In the meantime, if you have any questions, please reach out to your Schneider Downs tax consultant or contact us at [email protected].
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.