Excess business loss limitation developments

The excess business loss (EBL) limitation is here to stay — at least through the 2028 tax year. The provision, codified in Internal Revenue Code section 461(l), limits the amount of trade or business losses noncorporate taxpayers can utilize to offset nonbusiness income. The EBL limitation took effect in the 2021 tax year and, due to the Inflation Reduction Act (IRA), will remain in effect for a minimum of eight years. Taxpayers who own pass-through entities, which include sole practitioners and their advisors, must understand and incorporate the EBL limitation into annual tax compliance and planning.

Excess business loss limitation history

In recent years, the EBL limitation has been on an implementation roller-coaster. First introduced as part of the Tax Cuts and Jobs Act (TCJA), the provision was originally effective for tax years 2018 through 2025. However, in response to significant pandemic-induced economic uncertainty and market declines, the Coronavirus Aid, Relief and Economic Security (CARES) Act retroactively delayed the provision’s implementation to 2021. This provided taxpayers who had already filed 2018 and 2019 returns incorporating the EBL limitation an opportunity to amend returns, fully claiming business losses.

After the CARES Act, two additional pieces of legislation changed the effective dates of the EBL limitation. The American Rescue Plan Act (ARPA) and, more recently, the IRA extended the EBL limitation for one and two additional years, respectively. Ultimately, this means the provision will be in effect for a minimum of eight tax years — 2021 through 2028.

Applying the excess business loss limitation

EBLs are calculated by determining the amount by which a taxpayer’s aggregate trade or business deductions or losses exceed their gross trade or business income or gain. The ability to deduct the losses, to the extent they exceed income, is limited to an annual threshold amount indexed for inflation. In 2021, the threshold was $262,000 for most taxpayers ($524,000 for joint filers). In 2022 and 2023, the amounts increased to $270,000 ($540,000 for joint filers) and $289,000 ($578,000 for joint filers), respectively.

The limitation is applied at the pass-through entity owner level for reporting on their individual income tax returns. The limitation applies after the outside basis, at-risk, and passive activity loss limitations. Net trade or business losses that exceed the annual threshold amount are carried forward as a net operating loss (NOL) which the taxpayer may use to offset taxable in a subsequent tax year, subject to NOL rules.

To illustrate the concept, consider a single taxpayer who owns an S corporation that generates $7 million in losses in 2022. In the same tax year, the taxpayer receives their regular $500,000 of annual compensation and sells securities for a total gain of $9 million. In this scenario, the taxpayer may only deduct $270,000 of the $7 million business loss in 2022. As a result, the taxpayer will have $9.23 million of taxable income ($500,000 of compensation plus $9 million gain on the sale of stock less $270,000 allowable business loss deduction). The taxpayer will have a $6.73 million NOL carryover to 2023 ($7 million in business loss less the $270,000 allowed in the current year).

Planning for the excess business loss limitation

Since the EBL limitation became effective in 2021, incorporating its application has become critical to tax planning for owners of pass-through entities. The timing of recognizing both business income and losses, as well as non-business income and losses, can have a drastic effect on a taxpayer’s ultimate tax liability. A lack of proper planning for the EBL limitation when making extension and estimated tax payments can also lead to significant penalties and interest. As interest rates increase, the cost of underpayment and failure to pay will become more burdensome.

To illustrate the need for planning, let’s return to our example above with the single taxpayer who has $7 million of business losses, $500,000 of regular annual compensation and $9 million in gains from the sale of stock in 2022. If the taxpayer does not have a regular and/or substantial source of income, it could be years or decades before the $6.73 million NOL is fully utilized. If the taxpayer only has $500,000 of compensation in 2023 and no other gains or losses, the taxpayer may only utilize $400,000 of the NOL (the NOL may only offset 80% of taxable income in any given year). At the end of 2023, the taxpayer will still have an NOL carryover of $6.33 million going into 2024.

Consider instead, the taxpayer understood and planned for the excess business loss limitation by deferring the sale of stock generating the $9 million gain until the following tax year. In that case, the taxpayer would have recognized $230,000 of taxable income in 2022 ($500,000 of compensation less $270,000 allowable business loss deduction) and an NOL carryover of $6.73 million to 2023. If the taxpayer then recognized the $9 million gain on the sale of stock in 2023, in addition to the taxpayer’s regular $500,000 in annual compensation, the taxpayer could fully utilize the EBL generated NOL in 2023. The taxpayer would only recognize $2.77 million of income and would have no remaining NOL going into 2024.

Outstanding questions

Several areas of uncertainty surrounding the EBL limitation remain outstanding, including:

• Is gain or loss from the disposition of an interest in a pass-through entity conducting an active trade or business considered trade or business income for purposes of section 461(l)?
• Are guaranteed payments considered trade or business income for purposes of section 461(l)?
• How do EBLs interact with self-employment and net investment income tax calculations?

Aside from several clarifications provided by Congress in the CARES Act, taxpayers and practitioners have not received any direct guidance on the EBL limitation. Furthermore, there is no clear congressional intent that speaks to the unresolved issues noted above. Though the IRS has given no indication that issuing guidance on the application of EBL limitations is a priority, practitioners are hopeful the recent extension of the limitation will highlight the need for additional direction from the IRS.

Applying the EBL limitation can be complex. It’s important to explore any outstanding questions and how the EBL limitation applies to your specific situation before it’s time to make extension and estimated payments and file your return. Some situations will require research and thoughtful planning or may require disclosure. We advise you to contact your Baker Tilly advisor on the application of the EBL limitation to your tax situation.

The future of the excess business loss limitation

The EBL limitation has been used as a revenue-raising provision on three occasions: in the TCJA of 2017, the ARPA of 2021 and the IRA of 2022. It’s important to note that these pieces of legislation were passed by Congresses of Republicans-only, a bipartisan group, and Democrats-only, respectively. Reports from Capitol Hill in response to the Democrat-passed IRA was that Republicans were upset with the EBL limitation extension, as they had unofficially earmarked an EBL extension as a revenue-raiser they intended to use in a future legislation.

Congressional Democrats did attempt to make significant changes to the EBL limitation as part of the Build Back Better (BBB) package. The proposal would have made the EBL permanent and, more importantly, would have changed how excess business losses are treated in subsequent years. Rather than converting disallowed EBLs into NOLs, the drafted provision would have treated EBLs as an aggregate deduction subject to testing in subsequent years. Ultimately, Democrats were unable to pass BBB, opting instead for the much-narrower IRA. Suffice it to say, making changes to the provision appears to be a go-to for lawmakers to fund both Democratic and Republican priorities.

At this point, there seems to be a possibility the EBL limitation will continue to be extended or become a permanent provision. The fact that it can be viewed as a revenue-raiser without actually having to raise rates makes it politically appealing. It is further possible that additional modifications will be made over the course of its life cycle, however long it may be. Again, we encourage you to reach out to your Baker Tilly tax advisor regarding how the EBL limitation may impact your situation, and we will continue to keep you apprised of any related developments.

For more information on this topic, contact our team.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.