Sole proprietorships and pass-through entity structures, which include partnerships, S corporations and certain limited liability companies (LLCs), can provide owners with some valuable tax benefits. Any of the above entities had been able to deduct losses and avoid double taxation, but that is changing. The Tax Cuts and Jobs Act (TCJA) has placed some 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 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 or forward 20 years, whatever you decided worked best.
The Way it is Now
Through 2025, the TCJA changes the rules for deducting an individual taxpayer’s business losses. Unfortunately, the changes don’t look good for affected taxpayers.
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 that year. For 2019, an excess business loss is the excess of your total business deductions over $255,000 (or $510,000 if you’re a married joint-filer) for that tax year, and your total business income and gains.
The excess business loss is carried forward to the following tax year and can be deducted under the rules for NOL carryforwards. Previously, NOLs could shelter up to 100 percent of taxable income. After Dec. 31, 2017, they can only be used to shelter 80 percent of income and NOLs can be carried forward indefinitely but not backward anymore.
As noted, the new loss limitation rules apply after applying the PAL rules. So, if the PAL rules disallow your business or rental activity loss, the loss limitation rules don’t apply.
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 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.
The rationale underlying the new loss limitation rules is to further restrict the ability of individual taxpayers to use current-year business losses to offset income from other sources. The practical impact is that, if you have excess business losses for 2019, making a business carry forward an NOL makes sure the tax break can’t be used for this year.
If it looks like your business may generate a loss in 2019, contact Froehling Anderson to get legal help on how excess business loss operates under the new TCJA laws.