Many business ventures generate tax losses, especially in the first few years of operation or under adverse conditions. When can losses be deducted — and how much can you deduct in any given year? This article explains current limitations on the ability of individual taxpayers to deduct losses from pass-through business entities, including sole proprietorships, limited liability companies (LLCs) treated as sole proprietorships for tax purposes, partnerships, LLCs treated as partnerships for tax purposes and S corporations.
Before the Tax Cuts and Jobs Act (TCJA) took effect in 2018, an individual taxpayer's business losses could usually be fully deducted in the tax year when they arose. That was the result unless:
Before the TCJA, you could carry back an NOL to the two preceding tax years or carry it forward for up to 20 tax years.
The TCJA and later legislation changed the rules for deducting an individual taxpayer's business losses. Unfortunately, the changes aren't favorable.
If your business or rental activity generates a tax loss, things get complicated. First, the passive activity loss (PAL) rules may apply if it's a rental operation or you don't actively participate in the activity. In general, the PAL rules only allow you to deduct passive losses to the extent you have passive income from other sources, such as positive income from other business or rental activities or gains from selling them.
Passive losses that can't be currently deducted are suspended. That is, they're carried forward to future years until you either have sufficient passive income or sell the activity that produced the losses.
To make matters worse, after you've successfully cleared the hurdles imposed by the PAL rules, the TCJA established another hurdle that was then extended by later legislation. Specifically, for tax years beginning in before January 1, 2029, you can't deduct an "excess business loss" in the current year.
For tax years beginning in 2023, an excess business loss is one that exceeds $289,000 or $578,000 if you're a married joint filer. These amounts will be adjusted for inflation in later years.
The excess business loss is carried over to the following tax year and can be deducted under the rules for net operating loss (NOL) carryforwards. (See "Limits on Deducting NOLs," below.)
Important: This excess business loss rule applies after applying the PAL rules. So, if the PAL rules disallow your business or rental activity loss, you don't get to the excess business loss rule.
To illustrate how these rules work, consider Ed, an unmarried individual who owns rental real estate. For 2023, he has a $350,000 allowable loss from his rental properties (after considering the PAL rules). So, his excess business loss for the year is $61,000 ($350,000 – the $289,000 excess business loss threshold for an unmarried taxpayer).
Ed has no other business or rental activities, but he has $400,000 of income from other sources. Ed can deduct the first $289,000 of his rental loss against his income from other sources.
The $61,000 excess business loss from 2023 is carried forward to Ed's 2024 tax year and treated as an NOL carryforward to that year. Under the current rules, Ed can use that NOL carryforward to shelter up to 80% of his taxable income in the carryforward year.
If Ed's rental property loss for 2023 is $289,000 or less, he won't have an excess business loss, because the loss is below the $289,000 excess business loss threshold for an unmarried taxpayer. So, he wouldn't be affected by the excess business loss rule.
Alternatively, consider Avery and Fernando, a married joint-filing couple. In 2023, Avery has a $300,000 allowable loss from rental real estate properties (after considering the PAL rules).
Fernando runs a small startup business. He operates the business as a single-member limited liability company (LLC) that's treated as a sole proprietorship for tax purposes. For 2023, his business has a $150,000 loss.
Avery and Fernando have no other business or rental activities, but they have $550,000 of income from other sources. This couple doesn't have an excess business loss for the year because their combined losses are $450,000, which is below the $578,000 excess business loss threshold for a married joint-filing couple. So, they're unaffected by the excess business loss rule. Therefore, they can use their $450,000 of business losses to shelter income from other sources.
The rationale underlying the excess business loss rule is to further restrict the ability of individual taxpayers to use current-year business losses (including losses from rental activities) to offset income from other sources, such as salary, self-employment income, interest, dividends and capital gains.
The practical impact is that your allowable current-year business losses for 2023 can't offset more than $289,000 of income from such other sources or more than $578,000 for a married joint-filing couple.
The requirement that an excess business loss must be treated as an NOL that can only be carried forward to a future tax year forces you to wait at least one year to get any tax benefit from the excess loss.
For business losses passed through to individuals from S corporations, partnerships and LLCs that are treated as partnerships for tax purposes, the excess business loss rules apply at the owner level. In other words, each owner's allocable share of business income, gain, deduction or loss is passed through to the owner and reported on the owner's personal federal income tax return for the owner's tax year that includes the end of the entity's tax year.
To illustrate, consider Thomas and Gina, siblings who quit their jobs at the end of 2022 to start a clothing shop. They operate the new business as an LLC that's treated as a 50/50 partnership for tax purposes. Thomas is single and Gina is a married joint-filer. They each invest $500,000 in the new enterprise.
The 2023 LLC tax return for the business reports a net loss of $700,000. Each owner is allocated a $350,000 loss. Neither owner has any income or losses from other business activities. But Thomas has $300,000 of income from a trust, and Gina's husband has $200,000 of salary income.
The excess business loss rule is applied at the owner level. So, Thomas has an excess business loss of $61,000 from the LLC ($350,000 – the $289,000 excess business loss threshold for an unmarried taxpayer). For 2023, he can deduct $289,000 of the LLC loss (the amount up to the threshold) against his trust income. The $61,000 excess business loss is carried forward to his 2024 tax year as an NOL carryforward.
Gina, on the other hand, has no excess business loss from the LLC because her $350,000 loss is less than the $578,000 excess business loss threshold for a married joint-filing taxpayer. For 2023, the first $200,000 of the LLC loss can be deducted against her husband's salary income. The remaining $150,000 loss from the LLC generates a 2023 NOL that can be carried forward to her 2024 tax year. Note that the 2023 NOL won't be exactly $150,000 because various adjustments must be made to calculate the correct NOL amount.
Are you expecting your business to generate a tax loss this year? If so, consult with your tax advisor to determine whether you'll be affected by the excess business loss rule.
Under the current rules, net operating losses (NOLs) generally can't shelter more than 80% of your taxable income in the NOL carryforward year. (Under prior law, you could generally shelter up to 100% in the carryforward year.)
In addition, under the current rules, NOLs can't be carried back to an earlier tax year. Instead, they can be carried forward indefinitely. (Before the TCJA, NOLs could be carried back for two years or forward for up to 20 years.)
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