Authored by Paul Dillon and Michelle Hobbs
The legislation informally known as the Tax Cuts and Jobs Act (TCJA) limits the amount of net operating losses (NOLs) that can be utilized in a given tax year while allowing for an indefinite carryforward. Seen as another revenue-raiser to help pay for the corporate tax rate reduction, businesses, starting in 2018, can only use an NOL carryforward for up to 80 percent of computed taxable income. Not only does the TCJA change the NOL rules, it also imposes loss limitation rules on noncorporate taxpayers. This is a significant change from existing law and places new limitations, somewhat similar to the passive loss rules, on active business losses of individuals. The following continues our series updating you on the changes brought about by the TCJA.
Net operating losses
NOL limitations for post-2017 losses. The rules for NOLs arising in tax years beginning after Dec. 31, 2017, are modified such that a corporation’s NOL carryover can only offset 80 percent of taxable income without regard to the new section 199A deduction. However, these NOLs can now be carried forward indefinitely instead of limited to 20 years. Carrybacks of these losses are no longer permitted.
NOL limitations for pre-2018 losses. Rules for existing NOLs remain the same. These losses can be carried back two years and forward 20 years. There is no taxable income limit to usage of pre-2018 losses.
Observation. This effective date means losses that arose in tax years that began before Jan. 1, 2018, will not be subject to the 80 percent of taxable income limit. As a result, taxpayers will have to distinguish between the two types of losses when computing the NOL deduction. Pre-2018 losses should be tracked separately from post-2017 losses. Also, fiscal year taxpayers with NOLs arising in tax years beginning before Dec. 31, 2017, and ending after Dec. 31, 2017, would not be subject to the 80 percent limitation but would also not be eligible for a carryback; instead, these could be carried forward indefinitely.
Example. ABC Corporation has a $2 million cumulative NOL from 2017 and prior tax years. ABC generated a $15 million NOL in 2018. 2019 taxable income is forecast to be $15 million. ABC can use its entire $2 million pre-2018 NOL and $12 million of the 2018 NOL (80 percent multiplied by pre-NOL income of $15 million). As a result, 2019 taxable income would be $1 million with a $3 million NOL carryforward.
Effect of NOL changes. Carryforwards may offset only 80 percent of taxable income, resulting in an effective tax of 4.2 percent in a profitable carryforward year.
Impact on insurance companies. For an insurance company as defined in section 816(a), other than a life insurance company, i.e., a property and casualty insurance company, the NOL for any tax year can be:
- carried back to each of the two tax years preceding the tax year of the loss, and
- carried forward to each of the 20 tax years following the tax year of the loss.
The 80 percent of taxable income limit doesn’t apply to NOLs of property and casualty insurance companies. Life insurance companies will now claim NOLs using the post-2018 treatment described above.
Farming losses. There is now a two-year carryback for farming losses instead of five and can be waived. Additionally, if an NOL consists of both a farming loss and a nonfarming loss, then the two losses are treated separately. The farm loss is accounted for in carryforward years after the nonfarm loss. In other words, the nonfarm loss, subject to the 80 percent limitation, is first applied to taxable income followed by application of the farm loss.
Application of sections 381 and 382. The rules of section 381 still apply to NOLs acquired in certain corporate acquisitions and section 382 still applies to changes in corporate ownership of a loss corporation.
Limitations for noncorporate taxpayers
Limitation on losses for noncorporate taxpayers. In a significant departure from prior law, the TCJA restricts use of business losses of noncorporate taxpayers. Previously, business losses recognized by individuals could reduce nonbusiness income (such as interest, dividends and capital gains) without limitation. Beginning in 2018, through the 2025 tax year, taxpayers can only deduct up to $500,000 (for married filing joint taxpayers) of these losses against nonbusiness income. Amounts above the threshold are considered “excess business losses” and carried forward and treated as part of the taxpayer’s NOL carryforward in subsequent taxable years. These NOL carryforwards are also subject to the new 80 percent NOL limitation.
An excess business loss for the taxable year is the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer (determined without regard to the limitation of the provision), over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount. The threshold amount, indexed for inflation after Dec. 31, 2018, for a taxable year is $250,000 ($500,000 in the case of a joint return).
The limitation will be applied at the partner or S corporation shareholder level. The limitation is applied after the application of the passive loss rules.
- Example: In 2018, T, a single taxpayer, has deductions of $500,000 from a business. T’s gross income from this business is $200,000, for a net business loss of $300,000. T also has $300,000 of nonbusiness income from interest and capital gains. Under the new restriction, T’s business loss of $300,000 is not allowed in full. Rather, it is limited to the $250,000 threshold under the TCJA. The remaining $50,000 of loss is considered an excess business loss. Note: The $250,000 limit is increased to $500,000 for taxpayers filing joint returns.
- T’s $250,000 business loss is available to reduce T’s nonbusiness income of $300,000 so T has a 2018 adjusted gross income (AGI) of $50,000.
- Assuming the same facts as above, if this were 2017, T’s loss would have been fully deductible in the current year and T’s AGI would have been zero.
- The unused excess business loss of $50,000 is considered an NOL and carries forward to 2019. It would then be subject to the 80 percent NOL limitation rules going forward.
- In determining whether a taxpayer has an excess business loss, the limitation applies to the aggregate income and deductions from all of a taxpayer’s trades or businesses. Presumably, if a husband and wife have separate trades or businesses and the couple files a joint return, the new limit applies to the aggregate income and deductions from all of the couple’s trades or businesses.
- The ability of noncorporate taxpayers to use trade or business losses against other sources of income (such as salaries, fees, interest, dividends and capital gains) is limited. The practical result is that the business losses of a noncorporate taxpayer for a tax year can offset no more than $500,000 (for married individuals filing jointly), or $250,000 (for other individuals), of a taxpayer's nonbusiness income for that year. Note that if married taxpayers file a joint return, the losses (up to the $500,000 limit) of one spouse can also be used to offset the other spouse's nonbusiness income.
- The requirement that excess business loss be carried forward as part of an NOL forces taxpayers who have losses in excess of the thresholds (discussed below) to wait at least one year to get a tax refund in connection with those excess losses. For example, if a taxpayer has an excess business loss, that loss must be carried forward to the next year, even if the taxpayer has income from other sources that could have, in absence of this rule, been offset by the loss.
Coordination with passive activity loss rules. This limitation applies after the application of the passive loss rules.
The TCJA provides an ordering rule in this area so that the passive loss limitation rules apply before the excess business loss rule. Presumably, if a loss is disallowed under the passive activity loss rules, any deductions or income from that passive activity would not be considered in the determination of whether a taxpayer has an excess business loss. However, in the determination of whether a taxpayer has an excess business loss, “aggregate deductions attributable to a trade or business” and the “aggregate gross income or gain attributable to those trades or businesses” to active trades or businesses are not limited.
These revisions are effective for tax years beginning after Dec. 31, 2017. We expect the Treasury to release guidance on any necessary reporting requirements as well as definitions and sample calculations. We will continue to update you on this provision as well as the multitude of other changes brought on by the TCJA. In the meantime, we encourage you to contact your Baker Tilly tax advisor to help you maximize your net operating loss deductions.
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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.