The pass-through entity structure, which includes sole proprietorship, partnerships, S corporations and certain limited liability companies (LLCs), provides owners with some valuable tax benefits, such as avoidance of double taxation and the potential ability to deduct losses from the business on their individual tax returns. But under the Tax Cuts and Jobs Act (TCJA), there are some new limitations on deducting business losses. This article looks at the changes in the rules and how they might affect owners of pass-throughs.
How to deduct business losses after the TCJA
The pass-through entity structure, which includes sole proprietorship’s, partnerships, S corporations and certain limited liability companies (LLCs), provides owners with some valuable tax benefits, such as avoidance of double taxation and the potential ability to deduct losses from the business on their individual tax returns. But under the Tax Cuts and Jobs Act (TCJA), there are some new limitations on deducting business losses. Here’s a look at the changes in the rules and how they might affect you.
The way it was
Before the TCJA, an individual taxpayer’s business losses could usually be fully deducted in the tax year when they arose. That was the result unless the passive activity loss (PAL) rules or some other provision of tax law limited that favorable outcome, or the business loss was so large that it exceeded taxable income from other sources, creating a net operating loss (NOL)
Under prior law, you could carry back an NOL to the two preceding tax years, You also could carry it forward for up to 20 tax years.
The way it is now
For 2018 through 2025, the TCJA changes the rules for deducting an individual taxpayer’s business losses. Unfortunately, the changes are unfavorable to affected taxpayers.
Before we look at the changes, it’s important to review how the PAL rules work. They may apply if your pass-through entity is a rental operation or you don’t actively participate in the activity. In general, the PAL rules allow you to deduct passive losses only to the extent you have passive income from other sources, such as positive income from other business or rental activities or gains from selling the,. Passive losses that can’t be currently deducted are carried forward to future years until you either have sufficient passive income to absorb them or you sell the activity that produced the losses.
If you successfully cleared the hurdles imposed by the PAL rules, the TCJA places a new hurdle in front of you: For tax years beginning in 2018 through 2025, you can’t deduct an “excess business loss” in the current year. An excess business loss is the excess of your aggregate business deductions for the tax year over the sum of $250,000 (or $500,00 if you are a married joint-filer) and your aggregate business income and gains for the tax year.
The excess business loss is carried forward to the following tax year and can be deducted under the rules for NOL carry forwards. For NOLs that arise in tax years after December 31, 2017 you generally can’t use an NOL carry forward to shelter more than 80% of your taxable income in the carry forward year. (under prior law, you could usually shelter up to 100%.)
In addition, NOLs that arise in tax years beginning after December 31, 2017, can’t be carried back to an earlier tax year. Instead, they can be carried forward indefinitely.
As noted, the new loss limitations rules apply after applying the PAL rules. So, if the PAL rules disallow your business or rental activity loss, the loss limitation rules are irrelevant.
For business losses passed through to individuals from S corporations, partnerships and LLCs that are treated as partnerships for tax purposes, the new loss limitation rules apply at the owner level. In other words, each owner’s allocable share of business income, gain, deduction or loss is passed through to the owner and reported on the owner’s personal federal income tax return for the owner’s tax year that includes the end of the entity’s tax year.
The rationale underlying the new loss limitation rules is to further restrict the ability of individual taxpayers to use current-year business losses (including losses from rental activities) to offset income from other sources, such as salary, self-employment income, interest, dividends and capital gains.
The practical impact is that your allowable current-year business losses can’t offset more than $250,000 ($500,000 for a married couple filing jointly) of income for such other sources. The requirement that excess business losses must be carried forward as an NOL forces you to wait at least one year to get any tax benefit from those excess losses.
If your business generated a loss in 2018, it’s important to get the best advice to help you determine whether your tax situation will change based on the new rule.
Janet L. Osborn, CPA
As a Partner at Hancock & Dana with more than 30 years of experience, Janet provides insight for clients in the retail, manufacturing, non-profit and service industries. She specializes in tax research and planning, and IRS problem resolution.Prior to joining Hancock & Dana, she was employed with Coopers and Lybrand (now PricewaterhouseCoopers) and Arthur Andersen.