The 2017 Tax Cuts and Jobs Act (“TCJA”) is well-known for its sweeping tax changes impacting businesses of all sizes. Thriving pass-through companies and their owners benefited from lower tax rates, qualified business income deductions, and expanded immediate expensing of fixed assets.
In contrast, however, struggling businesses and their owners suffered from new or expanded limitations making use of their losses, including new limits on interest expense, a new excess business loss regime, the elimination of net operating loss carrybacks, and percentage limits on using net operating loss carryovers. And while pandemic-inspired laws such as the CARES Act provided a short reprieve, the onerous “kick them when they are down” provisions are back in effect and should be considered in your tax planning.
The Excess Business Loss (EBL) limitation rules are especially challenging for people with high incomes and high losses from pass-through businesses. Pass-through business losses are already subject to many limits before losses can offset other income – 1) adequate tax basis, 2) being at risk for the amount lost in their business to claim losses, and 3) material participation in the business. Even if overcoming those hurdles is possible, the loss may still not fully offset income. The good news is that high-income taxpayers may be able to avoid or minimize the excess business loss limitation trap with thoughtful, strategic tax planning.
The EBL rules limit how much net “business losses” can offset non-business income (i.e., salaries, portfolio interest, dividends and capital gains, and some passive income). “Excess business loss” is the amount of business losses and deductions greater than business income or gains from business income after all the other limitations have been applied over a certain threshold. The threshold amount is indexed annually for inflation, and for 2022, the threshold amount is $270,000 ($540,000 if Married and Filing Jointly).
EBL & NOL Implementation
Today, the EBL rules are fully in effect, and any EBL is converted into a net operating loss for future tax years.
Net Operating Loss (NOL) rules have also contracted in recent years. The 2017 law required that net operating losses must only carry forward indefinitely, not back. Again, Congress provided a short reprieve due to the pandemic, but that hiatus is over. Net operating losses are further limited in that their use in any tax year may not exceed 80% of pre-NOL taxable income. Understanding how the excess business loss and net operating loss limitation rules interact and impact tax planning is unique to each taxpayer’s portfolio. Your tax advisor will provide options and recommendations to best fit your situation.
Mitigating Tax Liability
The TCJA fundamentally changed tax policy and planning. While these new limitation rules can be burdensome, we are helping taxpayers mitigate their tax liability by proactively managing their business operations and financial strategies. For example, managing the timing and amounts of certain income and expenses can prevent or mitigate exposure to the excess business loss limitation. A few possibilities include the following:
- Slowing depreciation of company assets,
- Fast-tracking business investment income
- Reducing salaries and other benefits in a year of loss
- Timing the sale of assets
With the possibility of a looming recession, managing losses is more important than ever for taxpayers with pass-through entities whose businesses may face difficult times. The inability to offset most income with business losses, deduct certain interest expenses or carryback losses to previous years is challenging for any business and owner that may have a few tough years. Now is the time to discuss year-end planning and strategically approach the end of 2022 and the start of 2023 to avoid getting caught in the excess business loss trap.
Teri Kaye is a Florida licensed CPA who serves as Tax Services Leader for Daszkal Bolton, one of South Florida’s largest independent accounting and advisory firms. She has 30-plus years of experience in public accounting specializing in holistic tax planning and compliance for high-net-worth families and their entities.
