On December 22, 2017, the Tax Cuts and Jobs Act (TCJA), brought sweeping tax law changes. Many of these changes, e.g., lower corporate tax rates, expanded and enhanced cost recovery, the new pass-through deduction, etc., have been widely publicized. However, other changes also may significantly affect individuals and businesses, such as changes to net operating loss (NOL) rules and the introduction of a new limitation on excess business losses.
New NOL Rules & Limitations
An NOL is the excess of business deductions over gross income. Prior to the TCJA, an NOL generally was required to be carried back to the two preceding tax years, with any excess NOL then carried over to the 20 succeeding tax years. For regular tax purposes, the NOL was eligible to offset up to 100 percent of taxable income of a tax year (90 percent for alternative minimum tax purposes) within the carryback and carryforward periods. After 20 years, any unused portion of the NOL expired.
The TCJA brought an important change in how NOLs may be used going forward. For NOLs arising in tax years beginning after December 31, 2017, the TCJA limits the NOL deduction to 80 percent of taxable income. Also, for years ending after December 31, 2017, the TCJA eliminated the two-year carryback period but allows for an indefinite carryforward. For NOLs generated in tax years ending on or prior to December 31, 2017, prior tax law still applies—the 80 percent limitation on NOLs wouldn’t apply, and the NOLs could be carried forward 20 years.
To illustrate the effect of these changes, let’s assume a calendar-year corporation generates a $200,000 NOL in 2018 followed by $100,000 of taxable income in 2019. Under the TCJA’s provisions, the corporation only would be eligible to offset 80 percent of the 2019 taxable income with the 2018 NOL, leaving $20,000 of taxable income. The remaining $120,000 of 2018 NOL could be carried forward indefinitely.
Now let’s modify the above scenario by assuming the same corporation also had a $100,000 NOL carryforward from 2017. As this NOL was generated by December 31, 2017, the TCJA NOL provisions don’t apply and its use isn’t limited. Therefore, the $100,000 of taxable income in 2019 could be fully offset by the $100,000 NOL from 2017. The $200,000 NOL from 2018 would carry forward indefinitely to offset up to 80 percent of future taxable income in a given year.
As can be seen in the above illustrations, taxpayers may find themselves in future profitable years paying income tax despite having NOL carryforwards that would’ve been sufficient to fully cover taxable income under prior law without regard to alternative minimum tax (AMT) provisions. It should be noted that corporate AMT has been eliminated for tax years beginning after December 31, 2017; however, individual taxpayers may still be subject to AMT. Taxpayers still have the opportunity to fully use any NOLs generated in tax years beginning prior to 2018. Thus, consideration should be given to any opportunities—such as changes in tax accounting methods—to generate or expand NOLs for 2017 tax years.
Excess Business Loss Limitation
Another significant change in the TCJA is the limitation of excess losses for taxpayers other than corporations. For purposes of the excess business loss limitation, a nonpassive activity is a trade or business activity in which the taxpayer owns an interest and materially participates in the activity. Internal Revenue Code (IRC) Section 469 defines “material participation” as an activity in which the taxpayer is involved in the operation on a regular, continuous and substantial basis.
Prior to the TCJA’s passage, there were no limitations on the amount of excess business losses an individual taxpayer could deduct in a tax year. This allowed individual taxpayers to directly offset other sources of income, including wages, interest, dividends and capital gains with losses generated from nonpassive business activities, regardless of the size of the loss generated.
Effective for tax years beginning after December 31, 2017, the TCJA disallows excess business losses for taxpayers other than corporations. This limitation is calculated as the excess of the taxpayer’s aggregate deductions attributable to trades or businesses, over the sum of the aggregate gross income or gain attributable to trades or businesses plus a threshold amount ($500,000 for married filing jointly and $250,000 for all other taxpayers). The excess loss becomes an NOL carried forward indefinitely. This limitation applies at the partner or S corporation shareholder level and expires December 31, 2025, absent future legislation.
To illustrate the potential effect of these changes, let’s assume a single taxpayer owns a construction company. The company was formed as an S corp with the individual taxpayer as the sole owner. In 2018, the taxpayer suffers a $500,000 loss on operations. Let’s also assume the taxpayer has the following income from other sources for the 2018 tax year:
In this scenario under prior tax law, disregarding adjustments for other deductions, the taxpayer would report adjusted gross income (AGI) equal to the sum of these income and loss items for a net loss of $40,000. This loss would be reported on the taxpayer’s 2018 federal income tax return, creating an NOL that—under prior tax law—would be eligible for a two-year carryback or 20-year carryforward.
The same facts and circumstances prepared under the TCJA’s provisions yield quite a different result. Under the TCJA, the taxpayer’s loss generated from the business would be limited to a total of $250,000, with any excess loss treated as part of the taxpayer’s NOL carryforward to subsequent years. Therefore, in this scenario, the taxpayer would report AGI of $210,000 ($300,000 + $10,000 + $150,000 - $250,000) on the 2018 federal income tax return and may be required to pay income tax, depending on other personal deduction items.
The $250,000 excess business loss is treated as an NOL under the new tax law and carried forward indefinitely, subject to the 80 percent of taxable income limitation mentioned above.
The TCJA made significant changes to the NOL rules and created a new limitation on excess business losses that may affect your personal situation. Check out BKD’s Tax Reform Resource Center for more information on the new law or contact your trusted BKD advisor.