Excess business loss limitation reminders

The excess business loss (EBL) limitation currently applies to the 2021 through 2028 tax years, limiting the amount of trade or business losses noncorporate taxpayers can utilize to offset nonbusiness income. Failure to understand and incorporate the EBL limitation into annual tax compliance and planning can lead to unexpected and significant tax, penalties, and interest due when extending or filing a taxpayer’s return.

Applying the excess business loss limitation

EBLs are calculated by determining the amount by which a taxpayer’s aggregate trade or business deductions and losses exceed their gross trade or business income and gain. The ability to deduct the losses, to the extent they exceed income, is limited to an annual threshold amount indexed for inflation. For 2023, the amount is $289,000 ($578,000 for joint filers) and an estimated increase to $305,000 ($610,000 for joint filers) in 2024.

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

To illustrate, consider a single taxpayer that owns a business taxed as an S Corporation that generates an $8 million dollar loss in 2023. The taxpayer also receives in 2023 their regular $1,000,000 of annual wages and sells stock for a total gain of $10 million. Due to the EBL limitation, the taxpayer can only deduct $289,000 of the $8 million business loss in 2023; resulting in $10.711 million of taxable income ($1,000,000 of compensation plus $10 million gain on the sale of stock less $289,000 allowable business loss deduction). The taxpayer is left with a $7.711 million NOL carryover to 2024 ($8 million of business loss less the $289,000 allowed in the current year).

Planning for the excess business loss limitation

The timing of recognizing business and nonbusiness income and losses has a significant impact on a taxpayer’s ultimate tax liability. Failure to account for the EBL limitation when making extension and estimated tax payments can lead to significant penalties and interest.

To illustrate the need for planning, recall the taxpayer from the example above. Without a substantial source of income, it could be years before the benefit of the $7.711 million NOL carryover is fully utilized. If the same taxpayer has $1,000,000 of compensation again in 2024 and no other taxable income, only $800,000 of the NOL can be utilized (the NOL can only offset 80% of taxable income in any given year). Therefore, the taxpayer will still have an NOL carryover of $6.911 million going into 2025.