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If your business loses money during the current year those losses may provide some tax relief. The losses can be used to save income taxes in future years. The losses are considered net operating losses (NOLs). NOLs occur when business deductions exceed business income. The tax law allows individuals and C corporations to carry these losses forward indefinitely to reduce taxable income. During the past few years there have been significant changes to the NOL rules.

Overview

If your business is operated as a partnership, LLC, or S corporation, your share of the business’s losses is passed through the business to your individual return and deducted from your other personal income. However, if you operate your business through a C corporation, you cannot deduct the entity’s loss on your personal return. It belongs to the corporation.

The Tax Cuts and Jobs Act of 2017 (TCJA) revised the NOL rules. It imposed an 80% limitation on NOLs and removed the ability to carry back the NOL to a prior tax year to obtain a refund. However, under the new law, NOLs can be carried forward indefinitely. Also, The TCJA placed an additional limitation on losses for individuals, known as the excess business loss limitation (EBL). Both the NOL and EBL applied to tax years beginning January 1, 2018. However, the CARES Act suspended the application of the NOL and EBL limitations until 2021.

This article will review the NOL and EBL TCJA changes that have been restored for tax years 2021 and beyond.

Net Operating Losses – Background to Recent Changes in NOL Rules

Under the TCJA, NOLs can be carried forward for an indefinite period. But the NOL utilized cannot exceed 80% of taxable income. Prior to the TCJA, an NOL could completely offset taxable income and could be carried back up to two years and forward for 20 years.

In response to the COVID-19 pandemic, the CARES Act of 2020 suspended the TCJA’s NOL rules for losses arising in tax years 2018 – 2020. The CARES Act allowed NOLs to be carried back for five years and carried forward indefinitely. In addition, the 80% limitation was deferred along with the EBL limitation rule.

Example of Current NOL Rule for 2021 and Beyond

For NOLs used in the tax year 2021 and after, the TCJA rules will apply. As a result, an NOL carried into 2021 can only offset 80% of taxable income – even though it can be carried forward indefinitely. Here’s an example of the rule. In 2021, taxpayer Y had NOL carryforwards from 2018, 2019, and 2020 totaling $1,500,000. Also, in 2021, Y has a taxable income of $1,000,000. Y can use $800,000 of the NOL to offset the 2021 taxable income ($1,000,000 x 80%). Therefore, Y’s final taxable income is $200,000 ($1,000,000 – $800,000). Taxpayer Y’s NOL carryforward is $700,000 ($1,500,000 – $800,000).

Prior to the TCJA, Y’s taxable income would have been completely offset by the NOL carryforward ($1,500,000 [NOL] – $1,000,000 [taxable income].

Who can Utilize an NOL

Generally, individuals or C corporations can carry forward NOLs indefinitely to reduce taxable income in future years. However, pass-through entities such as partnerships, limited liability companies, and S corporations cannot claim NOLs. Instead, the partners, members of limited liability companies, and shareholders of S corporations can claim NOLs proportionate to their ownership interest in the business entity on their personal tax returns.

Excess Business Loss Limitation

Prior to the TCJA, when an individual incurred a loss from a business, they could reduce their nonbusiness income (such as W-2 wages, interest, dividends, and capital gains) by the amount of that business loss without any limitations. This assumes that the individual had sufficient tax basis, met the “at-risk” requirements, and the passive activity loss (PAL) rules. The discussion of basis, “at-risk” and PAL rules are beyond the scope of this article.

The new EBL limitation is intended to restrict the ability of taxpayers to use business losses to offset other sources of income. The provision is effective for taxable years beginning after December 31, 2017, and before January 1, 2029. However, similar to the NOL provisions, the CARES Act suspended the EBL until tax years beginning after 2021.

The EBL limitation applies to noncorporate taxpayers, such as individuals, trusts, and estates, and does not allow a “business” loss to exceed $270,000 for single filers or $540,000 for married joint filers for the tax year 2022, indexed annually.

Example of EBL Limitation

Taxpayer B has a loss of $1 million in 2022 allocated from an S corporation. The S corporation loss is not subject to the basis, at-risk, or PAL limitation. Also, in 2022, B has W-2 wages of $750,000 and capital gains of $250,000 from stock sales.

At first, it appears that B’s taxable income would be $0, after deducting the $1 million S corporation loss. However, B’s taxable income is $730,000. The business loss of $1 million is not fully deductible due to the EBL limitation. For the tax year 2022, a single taxpayer may only deduct $270,000 of the $1 million S corporation loss. The $270,000 limitation will offset the taxpayer’s other income, and therefore the taxpayer will be subject to tax on $730,000 of W-2 and capital gain income. The remaining business loss that is not deductible in 2022 will be carried forward to 2023 as an NOL (and subject to the NOL limitations described above). The amount carried forward is deductible against any source of income during 2023 including wages, interest, dividends, and capital gains.

RVG and Company

The NOL and EBL limitations that restarted in 2021 are complex and potentially interconnected for taxpayers that have income from flow-through entities and other sources. Taxpayers will need to accurately determine their potential losses for each loss category to determine their taxable income and carry forward losses for future tax years.

DISCLAIMER: The information covered in this article is not intended to provide and should not be relied on for tax, accounting, or legal advice; instead, all information, content, and materials informed are for informational purposes only. Consult your tax, legal, or accounting advisor before taking action. If you require advisory services, please contact our office.

If you would like to discuss the impact of the NOL and the EBL limitations, please call RVG & Company at 954.233.1767.