August 21, 2019
In most contexts, the word "loss" has a negative connotation. But for American taxpayers, very often a "loss" is not such a bad thing. The general reason is that losses offset other items of income, and lower income leads to lower taxes. Losses have been so aggressively pursued by taxpayers that the Internal Revenue Code is loaded with a myriad of "loss limitation" rules to stymie many tax-sheltering and tax avoidance schemes.
Given how positive the 2017 Tax Cut and Jobs Act (TCJA) was for most taxpayers under many circumstances (for example, reducing the corporate tax rate, allowing immediate expensing of equipment, and providing a deduction against income for pass-through businesses), it is somewhat surprising the approach the TCJA took with respect to handling personal taxpayer losses. Among the changes the TCJA had on the Code's loss rules include (1) an annual limit on excess business losses; (2) changes to the net operating loss rules; and (3) the elimination of personal casualty losses.
Section 461(l) – Limitation on Excess Business Losses of Individual Taxpayers
For the 2018 through 2026 tax years, the annual "excess business loss" of individual taxpayers is now limited to $250,000 (or $500,000 for joint filers), with any suspended amounts becoming net operating loss (NOL) for subsequent tax years. An excess business loss is the amount by which a taxpayer's aggregate deductions attributable his or her business ventures exceed any aggregate income or gain attributable to those businesses, plus the $250,000 threshold amount. This new Section 461(l) language is specifically aimed at individuals and owners of pass-through entities. As the gains and losses of an LLC or S corporation flow directly through to their owners, the individual owners become subject to these new loss limitation rules.
The impact of this law change can be significant for taxpayers with active businesses that generate large losses and who also have considerable taxable income from other sources, such as passive activities or investments. Whereas in the past these active business losses could fully shelter and offset taxable income from other sources, now the usefulness of any large business loss in a given year to offset other sources of income is substantially limited by the $250,000 threshold.
There is some uncertainty as to what happens to these excess losses in later tax years. The issue is whether the resulting NOL gets treated again as a business loss in following tax year (resulting in a perpetual $250,000 annual loss limitation), or whether the resulting NOL is treated under the usual rules of Section 172. Though there is no clear guidance on the issue, the statutory language of Section 461(l) suggests that once an excess business loss becomes a NOL, it is no longer part of the excess business loss calculation for future years. In that case, a suspended excess business loss from Year 1 will become usable in Year 2 as a NOL (and able to offset other sources taxable income). This is the most taxpayer-friendly interpretation, as prior years' excess business losses would only be delayed for one year, and only a particular year's business losses would be subject to any annual limitation.
The above change is best demonstrated by the following hypothetical scenario. Assume that an unmarried taxpayer has an active business that generates a $300,000 loss and income from other investments equal to $300,000. Prior to the law change, the $300,000 business loss could entirely offset the same year's $300,000 income from other sources, resulting in zero tax liability for the year. However, as shown below, only $250,000 of the business loss is usable currently to offset other income. The result no is that the same taxpayer has $50,000 in taxable income (and a $10,000 tax liability). The "excess" $50,000 business loss is suspended and converts to a NOL for potential use in latter tax years.
|Active Business Loss||($300,000)|
|Section 461(1) Limitation||$250,000|
|Excess Business Loss||$50,000|
|Other Taxable Income||$300,000|
|Business Loss Allowed||($250,000)|
|Tax Liability (@20%)||($10,000)|
|Net After Taxes||$40,000|
Section 172 – Changes to Net Operating Losses (NOLs)
Beginning with 2018 tax years, taxpayers can no longer carry a NOL back to prior tax years and receive a tax refund. Instead, with limited exceptions, NOLs are now only allowed to be carried forward into future tax years and utilized to the extent a taxpayer has taxable income for those years. Another major change to the NOL rules is that the amount allowed as a deduction is now limited to 80% of a taxpayer's taxable income. Because of the 80% cap, the unfortunate effect of this rule change is that a significant portion of any loss is essentially disallowed (or "lost") forever.
Section 165(c)(3) – Personal Casualty Losses
Whereas (under certain conditions), taxpayers could generally deduct losses to personal property from casualty events like fires, storms, and theft, now, personal casualty losses are only allowed if they are suffered in a federally declared disaster area. But note, the TCJA affects only personal casualty losses, while keeping business casualty losses intact. The prior treatment of casualty losses to property used in a trade or business remains unchanged.
For all of the attention the TCJA received for its pro-taxpayer amendments, the more detrimental changes to the loss rules for individuals have gone relatively unnoticed. As the "old rules" for active business losses and NOLs are considerably altered, it is important for tax advisors to recognize these changes and incorporate them into their planning going forward.
This Insight is intended only to provide an overview of the matters addressed herein and does not constitute legal advice. If you have any questions regarding a specific issue, please seek appropriate legal counsel.
 IRC § 461(l)(1), (2).
 IRC § 461(l)(3).
 IRC § 172(b)(1)(A)(i)
 IRC § 172(b)(1)(A)(ii).
 IRC § 172(a)(2).
 IRC § 165(h)(5).