Excess Business Losses – Where We Stand Today
Berdon Tax Team
1.20.22 | Client Alert
The Tax Cuts and Jobs Act (TCJA), enacted in 2017, reformed the income tax treatment of business losses for individual taxpayers and those treated like individuals for income tax purposes (i.e., trusts and estates). Initially effective for tax years beginning after 2017, §461(l) of the Internal Revenue Code limited the ability of noncorporate taxpayers to offset net business losses to $250,000 of nonbusiness income for single filers, including trusts, and $500,000 for joint filers. These amounts are indexed for inflation such that for 2021, the threshold amounts are $262,000 and $524,000 for single and joint filers, respectively. A business loss in excess of this allowance (excess business loss or EBL) is treated as a net operating loss (NOL) in subsequent years, deductible against any type of income (subject to an 80% of taxable income limitation). As a result of the CARES Act, enacted during the pandemic in 2020, the EBL rules were suspended retroactively from 2018 through 2020. Beginning in 2021 they are back in play.
Anne is a real estate professional and materially participates in partnerships A, B, and C that she owns an interest in. For the tax year 2021, her share of partnership income from A is $1 million and from B $500,000. From C, she is allocated a net loss of $3 million. Accordingly, her net taxable income from her business interests for 2021 is a loss of $1.5 million. From her portfolio of stocks and bonds, Anne has $200,000 of qualified dividends, $100,000 of taxable interest income, and $500,000 of long-term capital gain in 2021. Anne is single.
For 2021, Anne has a net business loss of $1.5 million and nonbusiness income of $800,000. Thus, she has an excess business loss (EBL) of $1,238,000 ($1.5 million minus the $262,000 allowance). The EBL will be treated as an NOL carryover to 2022, which may be used to offset 80% of taxable income in future years and carried forward indefinitely to the extent not absorbed. Her taxable income before itemized deductions is $538,000 ($800,000 of nonbusiness income less the 2021 business loss allowance of $262,000), all taxed at long-term capital gains rates, since the allowed business loss first offsets ordinary income.
Examples of business income and loss include:
- Business and rental real estate income from pass-thru entity K-1s
- Schedule C businesses and Schedule E rental activities
- Gain or loss from the sale of business assets used in Schedule C and Schedule E business activities
- Gain or loss from the sale of business assets from pass-thru entity K-1s (e.g., Section 1231 gains and losses)
- Gain or loss on the sale of interests in pass-thru entities (S corporation stock or partnership interests) that generate business income or loss
Examples of nonbusiness income and loss include:
- Interest and dividends
- Capital gain and loss from stocks and bonds, including non-pass-thru private companies
- Retirement plan distributions
- Social security
Business losses are taken into account only after the at-risk and passive loss limitations, to the extent applicable. There continues to be uncertainty with respect to the treatment of common items such as income or loss from hedge funds and partnership guaranteed payments for services, which would seem reasonable to include within the ambit of business income.
The EBL limitations for 2022 are $270,000 and $540,000 for single and joint filers, respectively. The EBL rules were originally scheduled to expire at the end of 2025 but the American Rescue Plan Act extended the application to expire beginning after December 31, 2026. However, the current administration’s legislative proposals would significantly alter the EBL rules in two ways; first, they would make them permanent, and second, an EBL would not become an NOL but would be treated as a business loss in subsequent years.
State Income Tax Treatment
Certain states, such as New York State, opted out of the CARES Act’s income tax provisions. For New York taxpayers, this, in effect, has required them to maintain two sets of tax records. The EBL rules have applied to New Yorkers since 2018, potentially causing additional tax liabilities and different NOL carryover schedules. Moreover, items that are impacted by adjusted gross income, such as charitable contributions, need to be recomputed and may result in different deduction amounts and carryovers.
The EBL rules are part of an array of provisions from the TCJA that have increased complexity in tax compliance and planning exponentially. State opt outs have only compounded these undertakings. Regular communication and strategizing with your tax advisor is paramount in order to optimize outcomes under the current tax landscape.
Questions: Please reach out to your Berdon advisor.
This alert is for general information purposes only and is not intended, and should not be construed, as legal or tax advice.