The internal revenue code has various provisions that restrict partners and S-Corp shareholders from recognizing certain losses in the tax year that the loss was incurred. These restrictions come in various forms: at-risk losses, passive activity losses, and excessive business losses to name a few. Individuals with ownership interests in these types of pass-through entities should be aware of these loss-limitation-rules, while also understanding how ‘tax basis’ in these pass-through investments affects an owners ability to deduct losses.
In general, a taxpayer’s distributive share of pass-through loss (including capital loss) is allowed only to the extent of the adjusted basis of such individual’s interest in the pass-through entity at the end of the pass-through entity’s year. If, in a given taxable year, an individual’s share of pass-through losses exceeds its outside basis, any excess amount is carried over for use in the next taxable year in which the individual has outside basis available.
Individuals owning real estate or other passive investments should also be aware of the ‘passive activity loss’ limitations. Under these rules, losses and expenses attributable to passive activities, of certain taxpayers, may only be deducted from income attributable to those passive activities. Any excess amounts are carried over to years in which there is passive activity income (or upon entire disposition of the activity, if sooner).
As a result of the recent Tax Cuts and Jobs Act, beginning in 2018, business losses are limited to $500,000 (Married Filing Jointly and $250,000 for all other filers) with any excess loss carried forward to future years. An excess-business-loss occurs when the net aggregate deductions for a year exceed net aggregate gross income by more than the aforementioned $500,000/$250,000 limitation. For example, assume two taxpayers file a joint tax return. They have $900,000 of investment income. Separately, the taxpayer incurs a $750,000 business loss while the spouse recognizes $150,000 of business income. Under prior tax law the three amounts were netted leaving the taxpayers with net aggregated income of $300,000. For tax years starting in 2018, the net-business-loss would be limited to $500,000, leaving the taxpayers with net aggregated income of $400,000 with a disallowed business loss carryover of $100,000 which is applied to forward to future years. This outcome is unfavorable, as in this scenario, the taxpayers would be currently liability for taxes on the additional $100,000 of income.
Partners and S-Corp shareholders should be aware that there are some business loss tax planning opportunities available to them before the end of the year and should make sure their CPA is walking them through the planning process. The rules determining loss deductibility are rather complex, and depending on an individual’s specific fact pattern, more than one of the loss limitation rules might apply contemporaneously. If you would like S&G to help you navigate through these loss limitation rules, please email or call us to discuss your specific situation.