The Tax Cuts and Jobs Act of 2017 (TCJA) amended Section 461 of the Internal Revenue Code. The tax provision limits the amount of trade or business losses noncorporate taxpayers can utilize to offset their nonbusiness income. Ever since the limitation took effect in the 2021 tax year, it has adversely impacted the tax liability of many business owners putting a strain on cash flows.

This change to the law was originally scheduled to expire at the end of 2025; however, it has been extended through 2028. It is important for owners of pass-through entities including sole proprietors and their tax advisors to understand and incorporate the EBL limitation into annual tax planning for 2024 and beyond.

How It Works

EBLs are calculated by determining the amount by which the total deductions attributable to all of a taxpayer’s trades or businesses exceed the total gross income and gains attributable to those trades or businesses plus a threshold amount indexed for inflation.

For 2024, the threshold amount is $305,000 ($610,000 for married couples who file jointly). Net business losses in excess of the threshold amount are disallowed and carried forward to the next tax period as a net operating loss (NOL). In the subsequent year, the NOL deduction is subject to an 80% taxable income limitation. As a result, it could take years for the NOLs to be fully utilized.

For partnerships and S Corporations, the Sec. 461 limitation is applied at the partner or shareholder level. However, it is not applied until after application of the outside basis, at-risk and passive activity loss limitations.

NOLs and IRC Sec.199A qualified business income deductions are excluded from aggregate deductions when computing excess business losses, as are deductions for losses from sales or exchanges of capital assets. Aggregate gross income or gain doesn’t include wages earned by working as an employee of the business. Moreover, the amount of gains from the sale or exchange of business assets included in aggregate gross income or gain is limited to the lesser of 1) capital gain net income, or 2) capital gain net income attributable to a business.

Impact on Tax Planning

Generally, the excess business loss limitation greatly increases the importance of properly timing your business and nonbusiness income and losses. For example, it might not be tax-efficient to claim bonus depreciation on a capital purchase in the year the asset is placed in service if it would create a substantial loss that you cannot immediately use for tax purposes in its entirety. You could be better off simply amortizing the expense.

If you know you will have an unavoidable large amount of excess business losses in the current year, you may want to defer taxable income into the next year so you can apply the resulting NOLs sooner. If you don’t have significant income in the following years, you may not be able to reap the value of the NOLs for years. On the other hand, if you expect your tax rate to go up in future years, the NOLs might be worth more.

The Sec. 461 limitation should also be taken into account when calculating estimated tax payments. Underpayment of quarterly taxes due to the application of the limitation can lead to costly penalties and interest.

We Can Help

Application of the Sec. 461 excess business loss limitation is complicated, and the IRS has provided limited guidance to date. Contact us to help you avoid potential pitfalls that could result in an unpleasant surprise in your tax bill.