Business owners who actively participate in their business have historically been allowed a full deduction for any net business losses incurred during the year. However, the 2017 Tax Cuts and Jobs Act (TCJA) introduced new limitations that could catch some business owners by surprise come tax time. These limitations relate to the treatment of “excess business losses” in the year of the loss, as well as net operating losses (“NOLs”) in subsequent tax years.

Excess Business Losses (Initial Year)

Taxpayers other than C corporations are now limited in the amount of business losses they can deduct against their non-business income. For married couples filing jointly, that limit is $500,000; for all others, it is $250,000. In other words, taxpayers with non-business income in excess of these dollar thresholds will not be able to shelter that income with business losses. Unfortunately, the Tax Code is not entirely clear on what constitutes “non-business income.” The term presumably includes investment-type income such as dividends, interest, annuities, and capital gains, but it may include compensation and rental income as well. The IRS has yet to provide guidance on this point. 

Deductions that are limited under this new rule do not completely vanish, but are instead preserved in the form of a Net Operating Loss (NOL) that can be used in other tax years. However, as discussed below, there are now additional limitations that apply to NOLs as well.

Example: John and Jane are married taxpayers who own a business and also have an investment portfolio. In 2018, their business suffers a loss of $2 million while their portfolio generates $750k of investment income (consisting of dividends, interest, and capital gains). Because the investment income constitutes “non-business income,” John and Jane cannot deduct more than $500k of their business loss against it. So despite having an overall loss for the year, John and Jane will still be taxed on $250k of income ($750k - $500k). The unused portion of their business loss—$1.5 million—creates an NOL that will be carried to other tax years.

NOLS (Subsequent Years)

The TCJA made two important changes to the usage of NOLs. First, NOLs can no longer be carried back to earlier tax years; they can only be carried forward to subsequent years. Second, it is no longer possible for NOLs to offset 100% of a taxpayer’s income in those subsequent years; instead, NOLs can now offset a maximum of 80% of taxable income. Any unused NOL continues to carry forward to future years. Note that these changes do not affect NOLs that arose in 2017 or earlier. 

Example: John and Jane’s NOL from 2018 cannot be carried back to earlier tax years; it can only be carried forward. In 2019, John and Jane’s business generates a $100k profit, while their investments produce $900k of interest and dividends, for a total income of $1 million. Despite having an NOL of $1.5 million from the previous year, they are only allowed to deduct $800k in 2019 (80% of $1 million). Thus, John and Jane will still be taxed on $200k of income ($1 million - $800k). The remaining unused portion of their NOL—$700k—continues to carry forward into 2020.

The Doty Group is a full-service CPA firm offering Tax, Audit, Valuation, and Advisory Services to Business and Individuals in Tacoma, WA. If you have more questions regarding this or other Tax Reform matters, please give us a call at (253) 830-5450 or e-mail info@dotygroupcpas.com.