Update Nov. 24: The Senate Finance Committee posted the legislative text for the “Tax Cuts and Jobs Act” bill on Nov. 22 and this section, Limitation On Excess Business Losses Of Noncorporate Taxpayers, matches the modified mark language below.
A summary of the Senate Finance Committee’s “Tax Cut & Jobs Act” is now available, alarming owners of pass-through entities with a provision that serves to limit net business losses deducted on an active owner’s tax return.
The Senate’s bill summary extends the present law for “excess farm losses” to owners who are active in a trade or businesses operating as pass-throughs, including sole proprietors, partnerships, and S-Corps. (Apparently, it’s no longer just for certain farming businesses!)
The maximum allowed loss is the threshold amount of $500,000 married and $250,000 single, indexed each year for inflation. The summary lacks essential details, so it is not clear if the loss limitation is per tax return or investment.
The excess business loss becomes a net operating loss (NOL) carryforward, which a taxpayer may use against any income in the subsequent year. Both the Senate and House bills are proposing to repeal NOL carrybacks and limit NOL carryforwards to 90% of taxable income in the year applied. Both bills repeal the standard two-year NOL carryback, only allowing NOL carryforwards. The GOP Congress seems to be working hard to disenfranchise small business owners from tax benefits they have under present law. This one-two punch constitutes a massive tax hike on small businesses and will have a chilling effect on job creation.
The excess business loss rule is not as draconian as the passive activity loss rules. Losses from passive activities may only offset other passive activities with net income, until and unless the taxpayer sells the investment realizing the loss. The excess business loss rule for active businesses allows a reasonable loss amount, and the excess is a NOL carryover, which is more useful and valuable than a suspended passive loss.
Entrepreneurs with substantial capital investment may have losses that exceed the threshold, and the Senate is proposing to force them to wait at least one year to get a tax refund.
Here’s an example of how the Senate’s excess business loss provision would work:
Joe Smith leaves his job in 2017 to pursue his dream, a technology start-up. Joe is single and invests $500,000 of capital, and so does his partner Mary White, who is married. The 2018 LLC partnership tax return reports a net loss of $700,000. Each active partner shows a $350,000 loss on 2018 individual tax return Schedule E.
Joe has an excess business loss of $100,000 ($350,000 minus the $250,000 threshold for single). The loss is an NOL carryforward. Under present law, Joe has sufficient income in the two years preceding 2018 to fully deduct the 2018 business loss as an NOL carryback to maximize his tax refund. But, he does not have enough income in 2019 or 2020, so he cannot monetize the NOL carryforward. Mary can use the full loss in 2018 since it’s less than the $500,000 married threshold. Mary’s spouse has substantial income to utilize her loss and generate a 2018 tax refund. The Senate’s tax bill changes significantly hurt Joe; he is unable to replenish capital in the company with a tax refund to retain jobs.
The U.S. economy became the best in the world partially due to our tax code, which was favorable to entrepreneurs. The business loss and NOL carryback provisions give businesses the opportunity to spread income and taxes over several years. Why is a Republican Congress turning its back on small business job creators now?
SENATE COMMITTEE ON FINANCE DESCRIPTION OF THE CHAIRMAN’S MARK OF THE “TAX CUTS AND JOBS ACT”
1.B.2. Limitation on losses for taxpayers other than corporations
Description of Proposal:
The proposal expands the limitation on excess farm losses. Under the proposal, excess business losses of a taxpayer other than a C corporation are not allowed for the taxable year. Such losses are carried forward and treated as part of the taxpayer’s net operating loss (NOL) carryforward in subsequent taxable years. NOL carryovers are allowed for a taxable year up to the lesser of the carryover amount or 90 percent of taxable income determined without regard to the deduction for NOLs.
An excess business loss for the taxable year is the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer, over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount. The threshold amount for a taxable year is $500,000 for married individuals filing jointly, and $250,000 for other individuals. The $500,000 and $250,000 thresholds are indexed for inflation. In the case of a partnership or S corporation, the proposal applies at the partner or shareholder level. Each partner’s or S corporation shareholder’s share of items of income, gain, deduction, or loss of the partnership or S corporation are taken into account in applying the limitation under the proposal for the taxable year of the partner or S corporation. Regulatory authority is provided to apply the proposal to any other passthrough entity to the extent necessary to carry out the proposal. Regulatory authority is also provided to require any additional reporting as the Secretary determines is appropriate to carry out the purposes of the proposal.
5. Modification of net operating loss deduction
Description of Proposal:
The proposal limits the NOL deduction to 90 percent of taxable income (determined without regard to the deduction). Carryovers to other years are adjusted to take account of this limitation, and may be carried forward indefinitely.
The proposal repeals the two-year carryback and the special carryback provisions, but provides a two-year carryback in the case of certain losses incurred in the trade or business of farming.