Excess business loss limitation effective for 2021

The excess business loss (EBL) limitation, codified in Internal Revenue Code section 461(l), was originally created by the Tax Cuts and Jobs Act of 2017 (TCJA). Appling to taxpayers other than corporations, this provision limits the amount of trade or business deductions that can offset nonbusiness income. The limitation for the 2018 tax year was $250,000 (or $500,000 in the case of a joint return), with these threshold amounts indexed for inflation in subsequent years.

Section 461(l) went into effect for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026, making 2018 through 2025 filings subject to the limitation. However, the Coronavirus Aid, Relief, and Economic Security (CARES) Act retroactively delayed the implementation of section 461(l) from tax years beginning after Dec. 31, 2017, to tax years beginning after Dec. 31, 2020. Taxpayers who had already filed 2018 or 2019 returns with the EBL limitation, received an opportunity to amend returns, fully claiming business losses.

As 2021 comes to a close, remember, the EBL limitation is now in effect and should be incorporated into annual tax planning going forward (through 2025). For the current year, the indexed limitation amount is $262,000 (or $524,000 in the case of a joint return). Net business losses in excess of this amount will be disallowed on 2021 return filings and carried forward.

Applying the excess business loss limit

 EBLs are defined as the excess of a taxpayer’s aggregate trade or business deductions (determined without regard to the limitation of the provision), over the sum of the taxpayer’s aggregate gross trade or business income or gain, plus the threshold amount (as described above).

The limit is applied at the partner or S corporation shareholder level and calculated after application of the passive activity loss and at-risk limitations. Net trade or business losses that exceed the threshold amount are carried forward as part of the taxpayers’ net operating loss (NOL) carryforward to subsequent taxable years. (See our article  on expiring provisions for a discussion of NOL treatment.)

To illustrate, consider a taxpayer that is a sole proprietor, whose trade or business deductions in 2021 totaled $1 million. The taxpayer’s gross receipts from the business and dividend income from their brokerage account each totaled $500,000. The taxpayer’s 2021 EBL is $238,000 (the taxpayer’s $1 million trade or business deductions, minus the sum of their $500,000 of trade or business income and the $262,000 threshold amount for 2021). As a result, even though the taxpayer’s total gross income and deductions net to $0, the taxpayer’s 2021 taxable income after the application of section 461(l) is $262,000. The $238,000 EBL carries forward to 2022.

CARES Act clarifications

In addition to delaying the implementation of section 461(l), the CARES Act provided much-needed clarification on several items affecting the EBL calculation, that were previously areas of uncertainty:

• Performing services as an employee is not considered a trade or business under section 461(l): While the TCJA Blue Book indicated this was congressional intent, a technical correction was needed to make it effective. The CARES Act explains that employee wages are excluded from gross trade or business income when computing an EBL.
• NOLs are excluded from a taxpayer’s EBL computation: A technical correction included in the CARES Act stipulates an EBL is only limited once, in the year incurred, and then allowed as an NOL without additional testing in the subsequent year. However, see below discussion on the NOL treatment.
• Only trade or business capital gains are included in EBL computations, not capital losses: The CARES Act clarified that when calculating the EBL limitation, taxpayers take into account the lesser of: (1) capital gain net income from business sources, or (2) capital gain net income. Capital losses are not taken into account when calculating the limitation.

Outstanding issues

While the EBL limitation is in effect for current-year filings, several unresolved issues remain:

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

To date, there is no direct guidance or clear congressional intent available with respect to these questions. Since the CARES Act retroactively delayed the implementation of section 461(l), we may see additional guidance from Treasury on these outstanding issues in the coming months. In the meantime, we encourage you to reach out to your Baker Tilly advisor if the EBL limitation rules apply to your tax situation.

Future of the excess business loss limitation

While the section 461(l) limitation is in effect through tax years beginning before Jan. 1, 2026, a provision included in the House reconciliation bill would make the limitation permanent. Additionally, the House bill would change the treatment of carryover EBLs, treating them as an aggregate deduction subject to testing again in all subsequent years, rather than as an NOL, effectively undoing the CARES Act technical correction mentioned above. The final text of the legislation, if it passes, will shape future tax planning surrounding the EBL limitation.

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.