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Tax Reform Changed the Rules for Deducting Pass-Through Business Losses

December 11, 2018

A fair number of businesses generate tax losses, most commonly in the first few years of operation or under adverse conditions. The TCJA changes the rules for deducting these losses.

But can these losses be deducted at all? Yes, however they are limited by tax laws in certain situations. The Tax Cuts and Jobs Act (TCJA) temporarily changes the rules for deducting pass-through business losses under IRC 461(l), and these changes could negatively impact owners of startups and businesses having financial difficulties…learn more.

Some background notes

In many cases, individual taxpayers have been able to deduct losses from pass through business entities, including sole proprietorships, limited liability companies (LLCs), partnerships, and S corporations provided the owners are active in the business and have sufficient basis to take those losses.

The old rules

Before the TCJA, an individual taxpayer - subject to other limitations - could typically deduct business losses in full in the tax year when they arose:

  • If the business loss exceeded income from other sources, it creating a net operating loss (NOL).
  • The passive activity loss (PAL) rules and other provisions of tax law could limit that favorable outcome. (A passive activity loss, or PAL is any rental activity or any business in which the taxpayer does not materially participate).

What does the TCJA change?

The TCJA changes the rules for deducting an individual taxpayer’s business losses for 2018 through 2025…and the changes aren’t exactly favorable.

If your business or rental activity generates a loss, you can only deduct a portion of the business loss against other income.

  1. Business losses can still offset 100% of other business income
  2. Business losses can only offset non-business income up to $250,000 for single filers and $500,000 joint filers.

Any unused business loss is carried over to the following year and can be deducted under the rules for net operating loss (NOL) carryforwards (also subject to limitations). This requirement forces you to wait at least one year to get any tax benefit from those excess losses. Check out our blog, Tax Reform FAQs: How are Prior NOL Carryforwards Treated?

Take note that the new loss deduction rules are applied after the long existing passive activity loss (PAL) rules and basis limitations. If either the PAL rules or basis rules limit your business or rental activity loss, you won’t reach the new loss limitation rules until those other restrictions release losses, typically by a change in circumstances.

What brought on these changes?

The new loss limitation rules aim to restrict the ability of individual taxpayers to use current year business losses to offset income from other sources (like salary, dividends, and capital gains).

The practical impact of the new loss disallowance rule is that business losses for the most part are being contained within overall business activity.

Contact us if you expect your business to generate a tax loss in 2018. We can help you determine whether you will be impacted by the new loss limitation rules.

The TCJA…So Many Changes, So Many Questions…we can help you navigate this huge tax overhaul! Visit our Tax Reform Center for everything you and your business need to know, now.

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