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.

If this taxpayer could have deferred the sale of stock (generating the $10 million gain) until 2024, they would have recognized $711,000 of taxable income in 2023 ($1,000,000 of compensation less $289,000 allowable business loss deduction) and an NOL carryover of $7.711 million to 2024. Recognizing the $10 million gain from the sale of stock in 2024, in addition to the $1,000,000 in annual compensation, would enable the taxpayer to fully utilize the EBL generated NOL carryforward in 2024. The taxpayer would have $3.289 million of income ($10 million stock sale gain plus $1 million in compensation less $7.711 NOL carryover) and no remaining NOL going into 2025.

This example highlights the critical need of planning for EBL limitations. The taxpayer has the same $4 million amount of economic income between 2023 and 2024 but a slight timing difference yields vastly different tax results. In the first iteration, the taxpayer recognizes $10.911 million of taxable income over the two-year period ($10.711 million in 2023 and $200,000 in 2024). After adjusting the timing of the stock sale in the second iteration, the taxpayer only recognizes $4 million of taxable income over the same period ($711,000 in 2023 and $3.289 million in 2024).

Outstanding questions

Even though the EBL was enacted in 2017, there are still several questions about the application of the EBL limitation that remain outstanding, such as:

• Is gain or loss on the disposal of a pass-through entity interest that conducts an active trade or business considered trade or business income EBL purposes?
• Are guaranteed payments considered trade or business income in the EBL computation?
• How do EBLs interact with self-employment and net investment income tax calculations?

To date, the IRS has not provided any direct guidance on the EBL limitation other than tax form instructions. Applying the EBL limitation is often a complicated exercise, and it is important to explore how it may apply to your situation before making extension and estimated payments and filing your return. Some situations will require research and thoughtful planning, or possibly disclosure.

The future of the excess business loss limitation

The EBL limitation has been used as a revenue-raising provision in three different major legislative packages (regardless of which political party was in the majority). With continuing uncertainty as to whether any tax legislation could pass before the end of 2023, the extension of the EBL limitation remains possible. This provision is viewed as a revenue raiser without actually raising rates; making it politically appealing to both parties. Further, it is possible that additional modifications will be made over the course of the EBL life cycle, however long it may be. We encourage you to reach out to your Baker Tilly advisor regarding how the EBL limitation may impact your tax situation.

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.