The Tax Cuts and Jobs Act (TCJA) expanded the current limitation on excess farm losses to apply to noncorporate taxpayers engaged in all types of trades or businesses for taxable years starting after December 31, 2017.
The new excess business loss (EBL) rules create a limitation on the amount a noncorporate taxpayer can deduct from a pass-through entity, such as an S corporation or partnership, or a sole proprietorship. Any EBL will carryforward under the net operating loss (NOL) rules, subject to the limitations such rules place on the utilization of NOL carryforwards.
Because losses incurred in 2017 won’t generally be subject to these same limitations, taxpayers may want to consider the following strategies to increase deductions for the 2017 tax year:
- Use expanded bonus depreciation provisions available for 2017
- Request accounting method changes to accelerate deductions or defer income
The following is an overview of the new rules, effective for losses generated in tax years beginning after December 31, 2017.
Excess Business Loss Disallowance
For taxable year beginning after December 31, 2017, and ending before January 1, 2026, a noncorporate taxpayer is no longer allowed to take a loss exceeding their EBL. An EBL exists if the aggregate losses and deductions from a taxpayer’s trades or businesses exceed the sum of:
- Aggregate gross receipts from such trades or businesses
- $500,000 for married filing joint taxpayers or $250,000 for other taxpayers
Because the EBL rule is applied by aggregating a taxpayer’s business income and deductions, it doesn’t prevent taxpayers from offsetting losses of one business against the income of another business. The EBL rule effectively prevents net losses from a taxpayer’s trades or businesses from offsetting nonbusiness income beyond the $500,000 or $250,000 limitation.
Because the EBL rule doesn’t affect a taxpayer’s ability to offset income and losses from separate businesses, it provides incentive for taxpayers to classify their activities as trades or businesses to the extent possible.
Losses Carried Forward
Any loss disallowed under the EBL rule becomes an NOL and is carried forward to future taxable years where the loss can be utilized to offset income under the NOL rules of section 172. The net effect of the EBL rule, subject to the NOL limitations described below, is that it forces a taxpayer to wait at least one year to utilize an EBL to offset nonbusiness income.
It’s important to note that this mechanism is unlike other loss disallowance rules that effectively require a disallowed loss to be tested against the same loss disallowance rule in succeeding taxable years. Instead, with a disallowed EBL, the statute requires the EBL to be treated as an NOL in succeeding taxable years.
The Order of Disallowance Rules
The EBL rule is applied after the application of the passive loss rules. An individual taxpayer holding a business through a pass-through entity would need to consider the various loss disallowance rules in the following order:
- Limitations based on the taxpayer’s tax basis in the entity
- At-risk limitation
- Passive activity loss limitation
- EBL limitation
Although the basic ordering of the various loss limitation rules is clear, the exact manner in which these rules should be coordinated is uncertain.
For instance, assume a taxpayer operates two businesses, business A and business B, both of which operate at a loss. Further assume that the loss from business A is subject to the passive activity loss limitation, but the loss from business B isn’t limited prior to considering the EBL limitation.
While the taxpayer can’t deduct the loss from business A, it isn’t entirely clear whether or not the taxpayer should take into account the suspended deductions from business A in determining if an EBL exists for the taxable year that could affect the taxpayer’s ability to use the loss from business B. The ordering rules noted above would suggest that the suspended losses from business A aren’t taken into account for this purpose. Additional guidance from the Treasury or Congress on this issue could help to clarify it.
Modified Net Operating Loss Rules
Previous law generally permitted a taxpayer a two-year carryback and a 20-year carryforward of an NOL. The taxpayer could elect to forgo the two-year carryback through an election attached to the return for the year the NOL arose. Special rules also applied to extend the carryback periods for specified liability losses, farming losses, and casualty and disaster losses for individuals.
The TCJA generally eliminates the NOL carryback provisions and provides that NOLs can be carried forward indefinitely—this applies to NOLs incurred in taxable years ending after December 31, 2017. The change doesn’t apply to NOLs arising in taxable years ending prior to January 1, 2018. This change will require calendar-year taxpayers to separately track pre-2018 NOLs, which will continue to be subject to the two-year carryback and 20-year carryforward rules, and post-2017 NOLs, which won’t be eligible for carryback but will have an indefinite carryforward.
Post-2017 NOL Limits
The TCJA generally limits the amount of post-2017 NOLs that can be utilized in a taxable year to only 80% of the taxable income of such year without regard to the NOL carryforward. This restriction may significantly limit a taxpayer’s utilization of NOLs in subsequent years.
This change is effective for losses arising in tax years beginning after December 31, 2017. Accordingly, for fiscal-year taxpayers, the 80% limitation and change to the carryover rules will first affect them in different tax years.
Exception for Farming Losses
Although NOLs arising in taxable years ending after December 31, 2017, generally can’t be carried back, farming losses continue to be eligible for a reduced two-year carryback.
Farming losses for any taxable year are treated as separate NOLs for that taxable year and are only taken into account after the remaining portion of the regular NOL, if any, for that taxable year. This will require taxpayers to separately track farming losses to avoid commingling with regular NOLs.
A farming loss is defined as the lesser of:
- The amount that would be the NOL for the taxable year if only income and deductions attributable to farming businesses are taken into account
- The amount of the NOL for the taxable year
Tax Planning Strategies
Understanding the interaction between the modified NOL rules and the EBL rules will be relevant for tax planning for taxable years after 2017.
For instance, once the new rules are applicable beginning in 2018, taxpayers planning a large capital asset acquisition eligible for immediate expensing under the new rules should evaluate the benefits of purchasing that property in years with higher income.
If an acquisition results in an NOL, or an EBL that will be treated as an NOL, for a partner or shareholder, the NOL carryforward deduction related to such expensing will effectively become limited to 80% of the pre-NOL taxable income in any succeeding taxable year.
In contrast, timing the acquisition of assets eligible for immediate expensing to taxable years with enough taxable income to absorb the deduction may result in a full cost-recovery deduction in that year—rather than an NOL carryover limited to 80% of the taxable income in a later year.
We’re Here to Help
If you’d like more information about how the new modified NOL and EBL rules could affect you or your business, contact your Moss Adams professional or email firstname.lastname@example.org. You can also visit our tax reform webpage for more information.