May 31, 2018

2018 Tax Reform – The Excess Loss Limitation Likely to Squeeze Owners of Cyclical Businesses

As businesses consider the impact of the Tax Cuts and Jobs Act (TCJA) introduced late last year, the corporate tax rate is receiving substantial attention.  However, according to a 2014 report by the Brookings Institution, only about 5% of the 26 million businesses in the United States were C Corporations.  This means nearly 25 million businesses are considered pass-through entities.  Pass-through entities are not taxed at the entity level.  Instead, their income is passed to their owners who pay taxes at their own respective individual tax rate.  While some pass-through entities are quite large (private equity firms, for example), most are small businesses with less than $10 million in gross receipts.  The pass-through treatment has offered an appealing structure for anyone not wishing to pay an entity-level tax.  Pass-through structures also allow taxpayers to escape the double taxation that occurs when distributing funds out of a C Corporation structure.

The TCJA added a new pass-through provision that would limit the loss an individual taxpayer could recognize from a pass-through entity to $250,000 ($500,000 in the case of a joint return) in any given year.  The new excess loss limitation will go into effect for tax years beginning after December 31, 2017.  The new limitation is applied after the at-risk limitations and passive activity loss rules are applied.  Any loss disallowed by this new limitation will be carried forward by the individual taxpayer as a net operating loss available for the next year.  Complicating matters further, the modification of the net operating loss (NOL) rules (limiting them to 80% of taxable income with an indefinite carryforward period) could impact the tax strategy of many pass-through entities.  Since prior losses would not fully offset current income, this NOL deduction limitation would likely increase the cash outlay for cyclical businesses.

One of the better strategies to alleviate this issue would have been taking advantage of deductions in 2017, while losses could still be recognized.  The timing of the legislation made this tactic difficult, but not impossible, to execute.  Going forward, it is a good idea to look at accounting methods and decide whether accounting method changes should be considered to mitigate the limitation of losses.

Many questions arise when considering these changes.  When considering the loss limitation rules, the primary issue relates to how the IRS will ultimately define business income.  One parallel concept exists when looking at how to determine the income of a pass-through entity / qualified business income as defined under the passthrough deduction rules.  Qualified business income is ordinary income but does not include capital gains and losses, dividends and interest, annuity payments, foreign currency gains and losses, reasonable compensation paid to the business owner, or guaranteed payments made to a partner for services rendered.  While it is not clear whether the pass-through loss limitation will involve a similar calculation of income, this expanded definition could alleviate some of the limitation for a partnership’s generating losses due to  partner compensation.

This is merely one example of the murky details of this provision.  As is the case with many of the new provisions, we will need to wait for regulations before we know exactly how to calculate this limitation.  Once the regulations are published, the time to do any planning around this, or other, issues will likely have passed.  To discuss possible excess loss or pass-through alternatives, or to request a speaker on this topic for your organization or event, contact one of our PYA executives below at (800) 270-9629.

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