Deciphering the Tax Reform’s Impact Losses & Net Operating Losses Corporations & Individuals
New tax legislation known widely as the Tax Cuts and Jobs Act (TCJA) puts a cap on the dollar amount of net operating losses (NOLs), which can be used in any given tax period, while, at the same time, authorizing an indefinite carryforward period. Basically, this caveat is viewed by a majority of people and businesses as yet another revenue-generator to assist in offsetting revenue losses bound to occur as a direct result of the corporate tax rate reduction, corporations, beginning as early as 2018, are only allowed to utilize use a carryforward relating to NOL for up to 80 percent of a business’ determined taxable income.
Of very special note is that fact that the TCJA’s legislation surrounding NOLs affects more than just businesses. In fact, there are, and could be very significant, ramifications for taxpayers who are not corporate, as certain loss limitation legislation would apply to the noncorporate sector also. This is tremendously different from prior law as it institutes new limitations, remotely similar to rules for passive losses, on business losses of individuals that are continuous. Let’s now take a deep dive into the investigation of the TCJA’s impact on NOLs.
Net Operating Loss Changes Required by the TCJA
Updated Corporate Post-2017 NOL Limitations
Regulations pertaining to NOLs reflected in tax years following December 31, 2017 have been altered in the sense that a business’ NOL annual carryover cannot offset more than 80 percent of taxable income. The new Section 199A was introduced via the TCJA and implemented in the tax code which addresses this modification. The silver lining here is that these NOLs are now permitted to be carried forward for an indefinite period of time, rather than the prior law’s limitation of 20 years. Please note that carrybacks of NOLs are no longer an option.
Pre-2018 NOL Limitations
There have been no changes to the regulations surrounding existing NOLs and, at this point in time, prior law remains applicable such losses sustained. As mentioned, a two year carryback period is applied along with a 20 year period to carry such losses forward. In addition, there is no cap on the amount of taxable income that can be used for these purposes.
Implications of NOL Changes
With the new effective date of TCJA regulations concerning corporate NOLs being January 1, 2018, losses recognized in prior tax years will not be subject to the TCJA taxable income cap of 80 percent. As an implication, tax filers will have to differentiate between the types of losses as they are computing a possible NOL deduction. Losses incurred after 2017, need to be monitored and tracked completely separately from incurred before 2017. In addition, those taxpayers who abide by a fiscal year schedule with NOLs in tax years beginning before 2017, and also ending after 2017, are not going to be subject to the limitation of 80 percent. They would also not be candidates for a carryback option and, instead, would be carried forward indefinitely.
Specific Industry Implications of NOL Changes
Insurance companies defined in section 816(a), and not considered life insurance companies; one very pertinent example being a property and casualty insurance provider, a tax year NOL can be:
- Used and carried forward for up to 20 tax years following the loss’ tax year
- Used and carried back for up to 2 tax years prior to the loss’ tax year
Although the 80 percent of taxable income limit is not applicable to NOLs of casualty and insurance companies. Additionally, insurance companies who offer life insurance can now claim NOLs using the post-2018 treatment previously described.
A two-year carryback period for farming losses is now in place because of the TCJA. This two-year period can now be waived and it replaces the prior law’s five-year period. Also, should an NOL consists of both a farming and non-farming loss, those two losses are treated as separate losses and accounted for separately. In the case of a farm loss, it is accounted for in carryforward years following the years for a nonfarm loss. In essence, the nonfarm loss, which is now subject to the TCJA’s 80 percent cap, is initially and first applied to taxable income and, after that period, followed by application of the farm loss.
Updated Non-Corporate Post-2017 Loss Limitations
In a dramatic departure from previous tax law, TCJA implemented legislation puts significant restraints on the use of non-corporate tax filer business losses. In the past, company losses accounted for by individual people could reduce non-corporate income, some loss examples being interest, dividends and capital gains, with no limitations. Beginning in 2018, and continuing through the tax year 2025, tax filers have a constraint with regards to the allowable deduction limits and capped at a deduction of $500,000 for a married couple filing jointly. Historically, different types of business losses to offset non-business income.
Any income above these threshold amounts are deemed “excess business losses” and treated as such by being carried forward as a portion of the tax filer’s NOL carryforward in the taxable years to come. Of note is that these NOL carryforwards are now mandated by the TCJA to be subject to the new NOL limitation of 80 percent.
Excess business losses for a taxable year are defined as the dollar amount in excess of the sum of each and every deduction of the taxpayer which can be attributed to businesses or trades of the taxpayer. Excess business losses are determined without regard to provision limitations; they represent any amount over the dollar amount of aggregate gross income or gain, of the tax filer, after adding a threshold amount. Threshold amounts are indexed for inflation following December 31, 2018, rendering a taxable year threshold of $250,000 for individuals and $500,000 for joint filers. These caps and limitations are to be implemented at the partner level or S corporation shareholder level.
Working in Conjunction with Passive Activity Loss Regulations
Only after the application of legislation for passive losses can any limitation regulations be enforced. Basically, the TCJA lays out the framework for an ordering rule when it comes to passive activity limitation guidelines in that it states that passive activity losses will apply prior to the excess business loss rule. Should a loss be disallowed according to passive activity loss laws, any income or deductions from the respective passive activity would not be a factor in the determination of whether or not a taxpayer has an excess business loss. Nonetheless, when determining a tax filer’s does indeed have an excess business loss. If “aggregate deductions attributable to a trade or business” and the “aggregate gross income or gain attributable to those trades or businesses” to active trades or businesses are not restricted.
When someone is trying to figure out whether a taxpayer has an excess business loss, the limitation applies to the aggregate and deductions from all of a taxpayer’s trades or businesses. In all likelihood, if for example, a husband and wife have separate trades or businesses and the couple files a joint return, the new limit applies to the aggregate income and deductions from all of the couple’s trades or businesses.
- The ability of non-corporate taxpayers to use trade or business losses against other sources of income (such as salaries, fees, interest, dividends and capital gains) is limited. The practical result is that the business losses of a noncorporate taxpayer for a tax year can offset no more than $500,000 (for married individuals filing jointly), or $250,000 (for other individuals), of a taxpayer’s nonbusiness income for that year. Note that if married taxpayers file a joint return, the losses (up to the $500,000 limit) of one spouse can also be used to offset the other spouse’s nonbusiness income.
- The requirement that excess business losses be carried forward as part of an NOL forces taxpayers who have losses in excess of the thresholds (discussed below) to wait at least one year to get a tax refund in connection with those excess losses. For example, if a taxpayer has an excess business loss, that loss must be carried forward to the next year, even if the taxpayer has income from other sources that could have, in absence of this rule, been offset by the loss.
When it comes to tax legislation concerning losses or NOLs, business achievement and success is directly correlated to the accuracy with which tax submissions and other presentation materials are completed. With the TCJA now in effect and the seemingly tumultuous state of the economy apparent a very knowledgeable and well-versed tax team, working in tandem with an established accounting firm, is critical. Thomas Huckabee, CPA of San Diego, California understands how essential the process of completing and filing taxes in a diligently accurate and timely manner. Our firm offers all potential and existing clients priceless services, such as general and NOL loss tracking, and reporting, in addition to all standard services that a full-service operation requires.