In years past, taxpayers safely operated under the assumption that qualifying business losses could be fully deducted, up to the limit of their taxable income. The new rules imposed by the Tax Cuts and Jobs Act (TCJA) will require business owners to adjust when and how they use business losses to offset their income. This article explores the ways that the TCJA business loss provisions will affect pass-thru business entities.
Pass-Thru Business Entities
Pass-thru businesses flow income and expenses through to the owners, rather than pay corporate income tax at the entity level. The owners then report those expenses on their own tax return and pay any resulting tax at their individual income tax rates. Pass-thru businesses can include:
- Sole proprietorships
- Partnerships
- Limited Liability Companies (LLCs)
- Trusts
- S Corporations
Old Rules
Prior to the TCJA, a taxpayer’s business losses could generally be fully deducted in the tax year when the losses arose, unless:
- The passive activity loss (PAL) rules or some other provision of tax law limited that favorable outcome, or
- The business loss was so large that it exceed taxable income from other sources, creating a net operating loss.
New Rules – Passive Activity Loss Rules
The TCJA’s new loss limitation rules are applied after the application of the PAL rules. As a result, if the PAL rules disallow your business or rental activity loss, your loss will not be subjected to the new loss limitation rule or included in the calculation of any excess business loss.
The PAL rules come into effect when a taxpayer doesn’t actively participate in their business or rental operation. Their purpose is to prevent the use of passive losses as a means to offset earned (ex. waged, salaried) income. Generally, in order to deduct passive losses, the taxpayer must be able to match those losses against passive income from other sources – such as income from other activities or the sale of other activities. If there is no passive income, then no loss can be deducted.
Any disallowed passive losses are suspended and carried forward until the taxpayer has sufficient passive income to match the losses or sells the activity that produces the losses.
New Rules – Excess Business Losses
From now until 2025, businesses are no longer permitted to deduct an “excess business loss” in the current year. An excess business loss is characterized as the excess of your aggregate business deductions for the tax year over the sum of:
- Your aggregate business income and gains for the tax year, and
- $250,000 ($500,000 if filing jointly).
Any excess business loss is carried over to the following tax year as a net operating loss and will be governed by the rules for net operating losses in the carryforward years.
The loss limitation rule hampers a taxpayer’s ability to use current-year business losses to offset income from other sources, like self-employment income or salary. Additionally, forcing taxpayers to carry over any excess business loss as a net operating loss requires them to wait a year before benefiting from that loss.
If you are expecting your pass-thru business entity to generate a tax loss this year, consult with a tax professional at Naden/Lean to understand how the loss rules imposed by TCJA will affect your taxable income.