What is the excess business loss limitation under code section 461 (I)?
In its simplest form, it is a fourth disallowance provision behind the three that we already have in order for a taxpayer to deduct business losses:
- Tax basis
- At-risk basis
- Passive activity rules
If those three are met, all of your business income is added together and any net losses in excess of $250,000 ($500,000 for joint returns) are disallowed and carried-forward to the next year. This disallowed amount is now an “excess business loss” treated as a net operating loss (NOL).
Looking at an example, taxpayer and spouse file joint returns for tax year 2018. Taxpayer incurs an $800,000 ordinary loss from an S-corporation and spouse earns $150,000 income from a schedule C.
Due to the new limitation, $150,000 would be carried forward to 2019 and they can only deduct $500,000 of losses in the current year.
Keep in mind, under The Tax Cuts and Jobs Act, NOLs created after the tax year ending 12/31/2017 can only offset 80% of taxable income in a following year.
Without regulations and guidance from the IRS, CPAs are left wondering what exactly Congress meant when they wrote this provision. One very basic question is, “What is business income?” This has a direct impact on the calculation because we need to understand what is aggregated to arrive at the total net business loss.
What is included in business income?
We know ordinary income and loss from schedule Cs, partnerships, and S corporations will be included, assuming they meet the basis and passive activity rules. Beyond that, we cannot say for certain what the IRS will include. Here are the questions we have:
Are wages and guaranteed payments considered business income? If so, they would be included in the calculation to offset business losses. If they were not allowed in total, maybe they would be allowed to offset the business loss in which the wages were earned. For example, if a taxpayer was a W-2 employee of a Fortune 500 company and nothing more, those wages may not be included. Conversely, if the taxpayer owned 100% of an S corporation that generated a $250,000 loss, but paid themselves a salary of $120,000, then the net loss from that business could be viewed as $130,000.
Is interest generated from a business considered business income? Let’s assume the taxpayer is an active owner in a real estate partnership. The net rental real estate income or loss reported in box 2 of the K-1 would certainly be included in business income. The same would be true if any amount was reported in box 1, ordinary business income or loss. What about box 5, interest income? If the partnership was holding a large amount of cash, generating interest within the business, the partner would include that income on their personal 1040 on schedule B. Would it also be included in the net business loss calculation?
Are the gains and losses from the sale of business assets included? Assume the same situation as above, but instead of interest income, the partnership sold a building and reported a 1231 gain in box 10. Would the gain be included in business income?
What are the ordering rules for the limitation?
Once we understand what the IRS intended to be included as business income for this limitation, we then need to know how to aggregate the amounts.
Is all ordinary business income added together? The way the law reads, the aggregate trade or business deductions is added to the aggregate trade or business gross income, to calculate the net business loss. It makes sense that ordinary business income, whether from a schedule C, schedule E, schedule F, form 4797, schedule K-1, etc. would be added together. Once all the business income is summed, if there is a loss greater than $250,000 ($500,000 MFJ), that is the excess business loss.
Is all capital business income added together? Do you net ordinary and capital business income? Taking that one step further, how are capital gains or losses from a trade or business used in the calculation. Specifically, assume a taxpayer files as single and receives a K-1 from an S corporation reporting $600,000 ordinary loss and $400,000 capital gain. Would the taxpayer have a $200,000 net business loss, therefore no excess business loss since it was less than $250,000? What if the $400,000 was a short-term capital loss? With no other capital gains to offset the capital loss, the taxpayer would be allowed a $3,000 capital loss on their 1040. Does that mean the taxpayer has a $1,000,000 net business loss (adding the $600,000 and $400,000) or is it a $603,000 net business loss (adding the $600,000 and $3,000)?
This makes it obvious Congress did not go into great depth writing this provision. We expect the IRS to release proposed guidance by late summer. Until then, we will not know for certain how this limitation will be calculated. Please watch for updates in the coming months and contact your Blue & Co. tax advisor with questions in the meantime.