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Jan 06, 2020

Understanding the Limits on Excess Trade and Business Losses

Following up on her thorough dissection of Section 163(j), Daria Palaschak, CPA, MST, returns to CPA Conversations to discuss more fallout from the Tax Cuts and Jobs Act of 2017. The limitation on excess trade and business losses presents many challenges to tax practitioners and taxpayers alike. Palaschak, a partner in the tax department of Sisterson in Pittsburgh, discusses how the loss limitation works, the entities affected, IRS Form 461, and more.

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By: Jim DeLuccia, Manager, Learning Content

Podcast Transcript

In today's episode, we're looking at another area affected by the 2017 Tax Cuts and Jobs Act, the limitation on excess trade and business losses. I'm happy to be joined by Daria Palaschak, CPA, MST, partner in the tax department of Sisterson in Pittsburgh. Dee, as she is better known to us, addressed section 163(j) in a previous episode of CPA Conversations, and I encourage you all to check that out. I'm glad that she's back today to go over another tax issue with me.

Dee, thanks again for being a guest on our program.

[Palaschak] No problem, Jim. I appreciate you contacting me to talk about this.

Absolutely. I've been hearing a lot about this limit on excess trade and business losses, and I guess to start off here, how does the new limitation work?

[Palaschak] Well, Jim, that's not really something that can be answered in one or even a few sentences. It's a pretty complicated calculation. What's amusing, though, is that the instructions to the Form 461 on which this calculation is done, are barely two pages long, and the IRS only has one paragraph on their website describing what excess business losses are. In addition, the new Internal Revenue Code subsection that was added, which is 461(l), is pretty short and there's no regs yet in place. In addition, the general explanation of Public Law 115-97, which is also known as the Bluebook, giving commentary on the new law, devoted only barely two and a half pages to this issue. But with all that having been said, I'll try to summarize as briefly as I can and then we can get into the nitty gritty.

Basically, a non-corporate taxpayer would need to net all of their income and losses from all their trades or businesses, and for 2019, if the net loss is more than $255,000, and it's $510,000 if it's a married filing joint taxpayer. That loss, up to $255,000, can be taken in 2019, but that is the limit, nothing above that. As I mentioned, this calculation is done on Form 461, which coincidentally is the same code section of the new law, which I thought was a little strange. This is the first time they've done that. The problem with dealing with this is determining what income and losses are considered trade or business.

This might be clear at the individual level. If you have a Schedule C, that would be trade or business, or maybe you're an S Corp shareholder or a partner in a partnership, in which you really materially participate in the business. That would all be trade or business, but when it comes to other pass-through income, sometimes it's not really clear for particularly passive investors, because the trade or business income is supposed to be determined at the entity level, so when someone gets a K-1, they need to be able to tell which of these items are trade or business.

The IRS did help in that area, because now partnerships and S Corps are required to provide this information. Partnerships need to report the information according to the instructions on Schedule K-1, Line 20, Code AS and S Corps on Schedule K-1, Line 17, Code AC and we saw that done consistently or inconsistently depending on the K-1s we got. In some cases, there was lack of reporting. On those items, we were left to our own device to figure out which items we should include. But in some cases it's pretty obvious because if you look at line one of a K-1, that line is called Trade or Business Income. So obviously that would be included, as well as, 1231 gains or losses, which are apparently from a trade or business. But when it comes to things like hedge funds, it's a lot fuzzier and they really do need to provide the specific business or non-business information to the taxpayer.

Well it sounds like, as I had said at the outset here, there's definitely a lot going on with this. I know that you mentioned, I think a little bit about entities and I wanted to see if you could explain what entities are affected, I guess specifically the non-corporate.

[Palaschak] That's correct, Jim. As I alluded to in the last question, the new law applies only to non-corporate taxpayers, which would be individuals, trusts, and estates, as well as tax exempt organizations that have to file Form 990T which is the exempt organization business income tax return. That's filed when the tax exempt organization has unrelated business income. So it's pretty widespread, it's just that it's done at the tax paying level.

As we're talking about computations here – and you mentioned about paying close attention to the instructions, which I guess aren't as thorough as we may like – but is it computed at the entity level or the individual?

[Palaschak] As mentioned the Form 461, it only applies to non-corporate taxpayers. They would be individuals, trusts and estates and then these people that have to file 990T, so definitely not at the entity level. In other words, if they receive a K-1 from a partnership or an S Corporation that has a loss on it, that loss will have not been limited for code section 461(l). It's the duty of the individual trust or estate to make that determination by running it through this Form 461 but they need to know. But there is a responsibility at the entity level to provide them with all the needed information to let them know which of these items on the K-1 are business or non-business. That's where sometimes I think there was a disconnect between what was being received in terms of K-1s. People weren't consistently taking that into account when they were providing K-1s to the shareholders or partners. Especially maybe firms that didn't have a good grasp on this concept.

Okay, well thanks for reinforcing that Dee and what happens to the disallowed losses?

[Palaschak] Well Jim, on the bright side, you don't lose the losses. They are carried forward to future years as net operating losses (NOLs). But unfortunately, unlike the good old days, you can't carry that net operating losses back any longer. They used to be a two year carry back. If you had some business income in the prior year and then have an NOL in the current year or excess business losses that are nondeductible in the current year, you can't carry back against that business income in a prior year. If you don't have a lot of business income in the coming years, you might have to wait a while before you can use those losses. When you do, you can now only use up to 80% of an NOL.

Because of this, I think taxpayers really need to do a lot more tax planning with respect to whether they can control the amount of business income or loss they have between years. Otherwise they might get whipsawed when they have large swings in business losses one year and business income in another year. If the business income comes before the loss year, they're going to get the benefit of the loss for a while.

That's interesting you mentioned about tax planning, those folks with those scenarios, they need to be consulting with their CPA, right?

[Palaschak] Correct. Definitely. They need to pay more attention. I think with tax planning, you can't just say we're going to do some '19 tax planning or 2020 tax planning. You have to, I think, do it amongst several years to make sure you get the best possible outcome between multiple years.

Are losses from asset sales included?

[Palaschak] Well that is a good question. On the surface, you might think the answer would be no, but actually any business losses and they have to be business losses reported on Form 4797 or Form 8949, which is the supplemental form to Schedule D. Anything on there that's a business loss or business income would be included in the calculation whether they're incurred directly by the taxpayer or whether they're coming through a K-1 from a pass-through entity. Now there isn't any guidance, as I said, on much of this and there's definitely no guidance on whether some gains or losses should be included. An example of a couple of those are, the gain or loss on the sale of S Corporation stock or sale of an interest in a passive activity. We're left to figuring that out on our own right now, so we're looking for more guidance. You can look to other code sections and make a judgment call.

For example, maybe look to Section 1411 which is the net investment income calculation and see how those are treated there because if they're investment income you would think they wouldn't be business losses. But maybe that's not true. We're just not sure.

Dee, you had mentioned at the beginning of this conversation, you talked a little bit about K-1s. What does the individual do if they haven't gotten basis on past K-1s? Who was responsible for the basis limitation reporting? Is it the entity or the individual?

[Palaschak] Well, Jim, this is a really important question because before you even get to whether you can have an excess business loss, you have to apply the tax basis and at-risk basis rules and also the passive activity loss rules to these losses. Tax basis is always a problem child. No one worries about it when they're getting income, but once large distributions or losses come into play, then basis becomes very important. The taxpayer ultimately has the responsibility of keeping track of their own tax basis. That's not fun.

If they didn't do it in the past, but at least starting in 2018, the IRS is beginning to take additional measures to make sure basis is being kept track of and that losses in excess of basis are not being deducted. For example, in the final instructions to Form 1065 for 2018, there's new requirements for partnerships that don't prepare the partnership capital accounts on a tax basis. The rule says now if the beginning or end of year tax basis capital is negative, this has to be disclosed on line 20AH of Schedule K-1. They also say in addition there are penalties of $195 per partner per month for not complying with this. So that made preparing some partnership returns a little more difficult and a lot of things to think about when you're doing these returns now at the partnership level. They have to do their best to figure out what tax basis is for their partners and that might not even be 100% accurate if a partner bought an interest from another partner. Maybe their basis is a little different but at least the partnership has a duty to try to provide that.

In addition and for 2018 at the individual level, the IRS added a box to Schedule E of 1040 and this box must be checked if there is an S Corp shareholder claiming a loss or if they received a distribution or if they disposed of S Corp stock or received a loan payment from the S Corp. If any of those scenarios apply, the taxpayer is supposed to check this box on the Schedule E and then the taxpayer is also required to attach a computation of historical cost basis. This is at the individual level. In our software, if the box is checked and the basis calculation isn't completed by the preparer or by our firm, the software was treating the beginning of your basis as zero and they were disallowing the loss altogether without even respect to the Section 461. The IRS is really looking more closely at basis. I think they know there's a void in that area of people not all complying with keeping track of it. I would imagine more and more requirements to provide basis or to calculate basis and prove that you have, as these returns are all being prepared.

Dee, when you were talking about the IRS there, it leads me to my next question. Is the draft Form 461 actually finalized now?

[Palaschak] Well for 2018 there was a final version that was used but based on what's listed in the IRS website, even as of today, the 2019 form is not yet finalized. It still is listed as draft as of Oct. 1, 2019, but right now it looks virtually identical to the 2018 form and the instructions look virtually the same as well.


[Palaschak] So I mean, I guess if there's additional guidance that comes out, they may change that a little bit, but for now it's the same.

You raise a good point as we're recording today. We're recording on Oct. 30, 2019. Listeners, I suppose, we'll just have to keep a close eye out. I'm sure they're already doing it anyway, but keep a close eye out for any changes that may materialize here.

[Palaschak] Right.

Well finally, does it incorporate wages into the calculation?

[Palaschak] Well, Jim, the jury in some ways is still out on this, although the code Section 461(l) doesn't specifically list wages as being business income. The IRS website on excess business losses, the paragraph that I mentioned, does say a trade or business can include the activity of being an employee. Unlike the Bluebook, which I had mentioned before, the Bluebook indicates that wages are not to be taken into account in determining 461 limitation. They also include a footnote that says technical correction may be necessary to carry out this intent. So there's really no code or regs that say which way to go on this. Both the 2018 and the 2019 draft forms actually have a line, it's line 1 where you include wages in the starting point for the income loss entering into the 461 calculation.

However, both forms have a line, which is line 10, which asks you to make an adjustment for any income or gain reported on lines 1 through 8 that is not from a trade or business. So this has caused some tax practitioners to think that it may have been intended for the wages to be backed out. But I would say that technical guidance is definitely required here. I think right now most tax practitioners, as well as the authors of various articles and research publications that we've read, all believe that wages should be included in the 461 calculation and that's particularly because the IRS website indicates they are business income. So that's where we're at right now with this, unless more guidance comes out. But I'm guessing some practitioners may have not included wages based on that Bluebook example.

Wow. Well so much to cover here Dee, and I really appreciate you taking the time to flesh this out for our audience today.

[Palaschak] No problem, Jim. Just wanted to add something if that's okay?

Of course.

[Palaschak] As I said, most practitioners feel that more guidance, and including regs, are definitely needed in this area. In fact, in February of 2019, the AICPA wrote a letter to the IRS with a 12 page request for guidance on various issues and they laid out many of them including the wage issue and the gain issue. But as of now, there's been no response to that nor any additional guidance. It makes me feel that something's going to have to come out. Just to summarize, because of all this, and because this on top of tax reform, many of these things we were dealing with in the last four weeks of the compressed fall tax season when we were doing the trusts and the individuals because you have those two week deadlines after the 915 partnership deadline. It's layering all this on top of an already compressed tax season really made for a difficult fall season and many tax practitioners are feeling this might've been the worst one ever and I share their sentiments.

Well, I appreciate you sharing them here too and I certainly hope that things will get a little bit smoother for you and for the tax practitioners in our audience here moving forward.

[Palaschak] I agree. Thank you.

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Podcast transcripts are provided as a summary of the conversation and have been lightly edited for the written medium. The transcript is not a verbatim representation of the interview.
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