Tax Reform: The New Overall Loss Limitation

With the many significant changes made by the Tax Cuts and Jobs Act of 2017, one provision that may have gone relatively unnoticed is the new limitation on excess trade or business losses imposed on individual taxpayers. This new limitation has been dubbed an “anti-tax-shelter” measure, although it impacts taxpayers who would never consider their business losses to be some sort of tax shelter. The limitation is intended to restrict the ability of taxpayers (other than C corporations) to use trade or business losses to offset other sources of income, such as investment income. Trade or business losses have historically been subject to a variety of limitations at the individual level, such as the passive activity loss limitations and the at-risk basis limitations. The new overall loss limitation adds yet another restriction on top of the other limitations that continue to apply.

Under new Internal Revenue Code Section 461(l), an “excess business loss” is the excess of aggregate trade or business deductions over the taxpayer’s aggregate trade or business gross income or gain plus a threshold amount. For 2018, the threshold amount will be $500,000 for married filing jointly taxpayers and $250,000 for all other taxpayers (these amounts are indexed for inflation). To the extent a taxpayer has an “excess business loss” for the tax year, that portion of the loss is disallowed and will become a net operating loss (NOL) that will be carried forward to future tax years.

Effectively, the new law limits a taxpayer’s deductible net business losses to the threshold amount for the tax year incurred. Further, the limitation forces taxpayers to wait at least one year before utilizing those losses in excess of the threshold.

Example: In 2018, a married taxpayer filing jointly has investment income of $750,000. In addition, he has aggregate business losses of $1.2 million. The taxpayer’s excess business loss is $700,000 ($1.2 million aggregate loss – $500,000 threshold). The excess business loss is disallowed in 2018 and treated as part of his NOL carryforward to later years. As a result, the taxpayer’s gross income for 2018 is $250,000 ($750,000 investment income – $500,000 limited business loss).

This example illustrates how the new law could severely limit a taxpayer’s ability to offset his other income with his business losses and could result in a tax liability for 2018 where, under prior law, the taxpayer’s business losses would have been fully utilized. For taxpayers that anticipate aggregate business losses above the threshold amount, they may need to engage in some additional tax planning and potentially prepare to pay tax liabilities where they previously would not have had a tax payment due.

As mentioned above, a taxpayer’s excess business loss will become an NOL and carried to future tax years. Although it is not free from doubt, pending further guidance on the issue, we do not believe the excess will be subject to a further threshold limitation in the carryforward years. However, the new tax law also imposed a new limitation on the use of NOLs generated after Dec. 31, 2017. These NOLs can only offset 80 percent of taxable income in the carryforward years. Therefore, carryover excess business losses will be subject to the new NOL limitations as they are carried forward.

As with other aspects of the new tax law, we have not yet received guidance about some of the technical aspects of this new provision. One open question concerns whether wages as an employee will be considered “trade or business” income for purposes of calculating aggregate business income or loss. For other purposes of the Code, employment is sometimes treated as a trade or business. However, to treat wages in this way would seem to reduce the effect of the limitation and negate some of the intended impact of the new law. It remains to be seen whether and when we might receive guidance on this point.