Changes to Loss Provisions
Geoff Kayton, CPA
01.09.2019 | Client Alert
Among the sweeping changes to the U.S. tax system made by the Tax Cuts and Jobs Act (TCJA) were modifications relating to the treatment of net operating losses (NOLs) and certain business losses.
The TCJA included two significant provisions affecting business losses. Specifically:
- Newly-generated NOLs are now limited to 80% of taxable income and, for taxable years ending after December 31, 2017, may no longer be carried back. They are, however, now carried forward indefinitely. Existing, pre-TCJA NOLs continue to offset 100% of taxable income.
- Aggregate active business losses of noncorporate taxpayers in excess of $250,000 ($500,000 for married filing jointly) – termed “excess business losses” – are disallowed. Disallowed amounts are carried forward as part of the taxpayer’s NOL (and subject to the new limitations). The excess business loss provision applies after the passive loss and at-risk rules.
The following examines these changes to the loss provisions, as well as their practical application.
Net Operating Losses
An NOL results when, in a tax year, a taxpayer’s business deductions exceed gross business income. Pre-TCJA law generally allowed NOLs to offset 100% of taxable income1 and provided for two-year carryback and 20-year carryforward periods, to the extent not utilized. NOLs not used at the end of the 20-year carryforward period expire. NOLs are generally utilized in the order incurred; thus, earlier NOLs are utilized first. Individual, trust, and corporate taxpayers can have NOLs.
The TCJA, however, imposed an 80% of taxable income limitation on using NOLs arising in taxable years beginning after December 31, 2017. It also eliminated carrybacks and provided an indefinite carryforward period for taxable years ending after December 31, 2017.2 The table below summarizes these changes:
|Pre TCJA (Old)||Post TCJA (New)|
What this means for taxpayers is that the use of post-2017 NOLs will allow at least 20% of pre-NOL current year income to be subject to tax:
Example: In 2018, ABC Corporation realizes a loss of $10 million, which gets carried forward to 2019 as an NOL. In 2019, ABC earns taxable income of $10 million. While prior to the TCJA, the full $10 million NOL could be utilized to fully offset the $10 million taxable income. Following the TCJA, the 2018 NOL carryforward is limited to 80% of taxable income, or $8 million.3 Thus, ABC will have taxable income of $2 million and an NOL carryforward to 2020 of $2 million.
Existing Net Operating Losses
The new 80% limitation applies to taxable years beginning after December 31, 2017; pre-2018 NOLs are, therefore, not subject to the 80% limitation and can offset 100% of taxable income:
Example: XYZ Corporation has pre-2018 NOL carryforwards of $5 million and earns taxable income in 2019 of $4 million. The pre-2018 NOLs of $5 million are not subject to limitation, however, and can be used to fully offset the $4 million of taxable income.
This means taxpayers will need to segregate pre-TCJA NOLs and post-TCJA NOLs since each is treated differently. Presumably, the earlier NOLs – the pre-TCJA NOLs – will be utilized first:
Example: XYZ Corporation has pre-2018 NOL carryforwards of $13 million and generates a $14 million NOL in 2018. It earns taxable income in 2019 of $15 million. The 80% limitation is, therefore, $12 million. The pre-2018 NOLs of $13 million are not subject to limitation and could be used in full against the $15 million of taxable income, leaving $2 million of taxable income. The $14 million of 2018 NOLs are, however, limited to, 80% of taxable income, or $12 million, and it is doubtful that any may be utilized since the 80% limitation has been surpassed with the pre-TCJA NOLs.
Effective Dates and Fiscal Year Taxpayers
Congress chose different effective dates for the NOL carryback and the 80% NOL limitation provisions. The 80% NOL limitation applies to tax years beginning after December 31, 2017, whereas the carryforward/carryback provision applies to tax years ending after December 31, 2017. For calendar basis taxpayers, this difference is irrelevant.
For taxpayers with fiscal year ends, however, the new law could impact a 2017 tax return. A taxpayer with a fiscal year beginning in 2017 and ending in 2018 will not be allowed to carryback losses:
Example: ABC Corporation is a March 31st year end, fiscal year taxpayer. For its taxable year, April 1, 2017 through March 31, 2018, ABC incurs a $10 million NOL. Based on the wording of the statute’s effective dates, ABC will not be able to carry back any of the 2017 loss because the rule against NOL carrybacks applies to taxable years ending after December 31, 2017.
This creates an inequity between calendar year and fiscal year taxpayers for 2017 return years, and commentators have urged Congress for a technical correction.
Excess Business Losses
The second significant TCJA loss provision, found in new section 461(l), applies to noncorporate taxpayers and the use of trade or business losses to offset non-business income.
For tax years ending after December 31, 2017, only a certain amount of business losses are allowed to offset nonbusiness income. The limitation amounts are $250,000 for individuals and $500,000 for joint returns, and the statute provides for inflation adjustments. Losses in excess of these limitations – excess business losses – are carried forward to later years as additional NOLs and subject to the new limitations. Unlike the NOL provisions, which are permanent, the excess business loss provision expires in 2025.
It is important to note that the rules do not prevent aggregation of business income with other business income or loss; it only limits business losses from offsetting non-business income:
Example: The facts in this example have been selected to generate zero taxable income under pre-TCJA law. In Year 1, a single taxpayer earns $1,000,000 of interest and $200,000 from passive businesses, but has a $1,200,000 loss from a business in which the taxpayer materially participates. These facts generate a net business loss of $1,000,000 and non-business portfolio income of $1,000,000. The business loss in excess of $250,000 of non-business income (an “excess business loss”) – will be limited and carried forward to year 2 as an NOL. This results in $750,000 of taxable income in a year when actual net income is zero.
In Year 2, assume the same facts. The taxpayer will have the same $750,000 of taxable income flowing thru the first step of the calculation, but will also get to include the excess business loss from Year 1. Under the new rules governing NOL utilization, the taxpayer is allowed a deduction of up to 80% of taxable income. The NOL deduction is $600,000 (80% of $750,000), resulting in taxable income in Year 2 of $150,000.
To reiterate, this fact pattern generates $900,000 (Year 1-$750,000 and Year 2-$150,000) of taxable income, which under pre-TCJA law would have been zero.
The excess loss limitation provision is applied after the passive activity and at-risk rules, and at the partner or shareholder level in the case of partnerships and S corporations.4 Therefore, a disallowed loss from a passive activity won’t factor into the determination of a taxpayers excess business loss:
Example: A single taxpayer engages in business activity A, a passive activity, as he/she does not materially participate, and business activity B. Activity A generates a $150,000 loss in 2018, and activity B generates a $200,000 non-passive loss. The $150,000 loss from activity A would be suspended under the passive loss rules, leaving only the $200,000 loss from activity B. Since this falls below the statutory threshold for an excess business loss, the full amount could be used to offset non-business income and/or carry forward as an NOL.
Key questions remain regarding the utilization and application of this new excess business loss rule. Will regulations adopt the rules governing NOLs for determining what is business income (e.g. wages are included) and deductions? Will NOL carryforwards be considered a business deduction for this computation, thereby exacerbating its adverse effect on taxpayers? How will the income of securities traders (i.e. hedge funds) be clarified for this purpose?
Your Berdon tax advisors remain singularly focused on the continuing developments regarding the TCJA, so that we may help clients maximize available benefits and minimize the effect of its provisions that can do economic harm.
Berdon LLP New York Accountants.
1 NOLs are also limited for alternative minimum tax (AMT) purposes. The TCJA repealed the AMT for corporations.
2 The effect of the different effective dates on fiscal year taxpayers is discussed below.
3 As mentioned, following the TCJA’s changes, the NOL must be carried forward; it can no longer be carried back.
4 The passive activity loss rules are additional loss limitation provisions and generally prevent taxpayers from recognizing losses with respect to activities in which they do not “materially participate.”