By George Paulsen, CPA, Tax and Advisory Partner of Hood & Strong LLP
The Tax Cuts and Jobs Act was enacted in the last administration’s second year and created two revenue raisers that impact people with business losses. When COVID-19 closed businesses, Congress deferred these revenue producers until 2021 and provided tax benefits for money-losing businesses to carry the losses back five years as tax refunds. In 2021 those benefits expire, and the laws enacted in 2017 may surprise taxpayers who have Excess Business Losses or previous Net Operating Losses (NOL) that are being carried forward.
Code Section 461 Limits the amount of business losses that can be offset against non-business income, and Code Section 172 allows loss carryovers into subsequent years.
The good news is that NOLs that are carried forward do not expire. Also, NOLs from 2017 and earlier are 100% deductible, reducing the tax due in the current year to zero.
The bad news going forward is that reducing tax to zero on an individual tax return will be very hard to do.
These IRS laws, deferred due to COVID-19, become effective this year and work together to leave some income taxable for people with large losses and/or NOL carryforwards. Starting in 2021 there will be no NOL carrybacks, only carryovers.
Code Section 172 contains the rules for NOL deductions and will allow an aggregate deduction of all NOLs coming forward before January 1, 2018. For the year 2018 and forward, the taxpayer is allowed the lesser of NOLs after 2017, or 80% of the taxpayer’s taxable income computed without the NOL.
As a result, NOLs before 2018 are very valuable.
172 Example 1: An individual taxpayer has an NOL carryforward from after 2017 of $50,000 and taxable income before the NOL of $100,000. $50,000 of post-2018 NOL is less than $80,000 (80% of taxable income) so the NOL coming forward is fully deductible. An NOL from 2018 or later must remove the Qualified Business Income deduction in the calculations and then the limitation mentioned above applies.
172 Example 2: A taxpayer has an NOL carryforward from 2017 of $175,000 and taxable income of $100,000 without the NOL carryforward. The 80% rule does not apply, so $100,000 will be the allowed NOL in 2021 and result in taxable income of zero. $75,000 of the 2017 NOL will carryforward to 2022.
The NOL rules now do not let you take your taxable income to zero except if you have pre-2018 NOLs.
Before you can claim the NOL you must test to see if you have Excess Business Losses under Code Section 461. Also beginning this year through 2025, business losses are limited to $250,000 for individuals and $500,000 for married couples. Any disallowed loss is treated as an NOL and carried forward under 172. Passive loss rules may also limit the losses allowed before the use of NOLs.
461 Example 1: A married taxpayer has business income of $1,000,000 with other income of $800,000 and business losses of $2,900,000. The business loss deduction allowed is $1,500,000, resulting in taxable income of $300,000. ($1,800,000-($1,000,000+$500,000 allowance)). The unused $1,400,000 is converted into an NOL under Code 172 to carry over to 2022.
461 Example 2: A married taxpayer has business income of $1,000,000 with other income of $800,000 and business losses of $600,000, as well as an NOL carryover from 2017 of $2,000,000. First, 461 is applied resulting in a pre-NOL taxable income of $1,200,000. Next, the NOL is applied allowing $1,200,000, resulting in taxable income of zero and an NOL carryforward to 2022 of $800,000.
461 Example 3: Had the NOL in example 2 carried into 2021 income from post-2017 NOLs, the 80% limit would have applied, allowing $960,000 of NOL to be applied and leaving taxable income at $240,000 and increasing the NOL carryover to $1,040,000.
461 Example 4: A married taxpayer has business income of $800,000 with other income of $1,200,000; business losses are $1,600,000 along with a post-2017 NOL carry over of $1,400,000. Application of the 461 test results in pre-NOL taxable income of $700,000, with a $300,000 loss conversion to an NOL carryforward to subsequent years. After application of the 461 test, the NOL carryforward from 2018 or later can be applied to 80% of the pre-NOL 2021 taxable income of $700,000. This results in $560,000 of the $1,400,000 NOL being applied to 2021 and reducing the taxable income to $140,000. The balance of the post-2017 NOL — $840,000 — also rolls forward with the $300,000 converted Excess Business Loss to 2022, with $1,140,000 available for 2022 and beyond.
Like Code Section 172, Code Section 461 forces the taxpayer to have some taxable income by disallowing, in the current year, excess business deductions over $500,000 and the application of NOLs to 80% of taxable income. In the future, an NOL carryforward on your tax return will have taxable implications once you use up your pre-2018 NOLs. If you can plan to keep your non-business income under $250,000 for single taxpayers or $500,000 for married taxpayers and generate more business losses than business income in the same year, you can reduce your taxable income for the year to zero. All of this takes some work, but it can be well worth it in this evolving tax environment.
Contact AEIS Today
As one of the leading employee benefits firms in the Bay Area, AEIS, Inc. has a wide network of experts and partners to help you with your business and high-net-worth individual needs, from taxes to HR to payroll. If you need tax help, reach out to us at AEIS, Inc. at Alyssa@AEISAdvisors.com if you would like to be connected with George Paulsen and his team of tax advisors and CPAs at Hood & Strong, LLP.
This post was originally published in Hood & Strong’s Newsletter.
Disclaimer: Any information related to compliance or other subject matters in this blog is intended to be informational and does not constitute legal advice regarding any specific situation. The content of this blog is based on the most up-to-date information that was available on the date it was published and could be subject to change. Should you require further assistance or legal advice, please consult a licensed attorney.