Editor: Kevin D. Anderson, CPA, J.D.
Many questions have been raised by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, which was signed into law on Dec. 22, 2017, by President Donald Trump. The new limitation on excess business losses provision is effective for noncorporate taxpayers for tax years beginning after Dec. 31, 2017, and it is scheduled to sunset after Dec. 31, 2025. Much attention has been given to the Sec. 199A deduction for qualified business income, the new qualified opportunity zone provisions, and the Sec. 163(j) limitation on business interest expense. But there is another major change that affects individuals and trusts for which little regulatory guidance has been issued: the excess business loss limitation of noncorporate taxpayers under Sec. 461(l).
The TCJA amended Sec. 461 to include a subsection (l), which disallows excess business losses of noncorporate taxpayers if the amount of the loss is in excess of $250,000 ($500,000 in the case of a joint return). These threshold amounts for disallowance will be adjusted for inflation in future years (Sec. 461(l)(3)(B)). The disallowed amount is carried forward as a net operating loss (NOL) to the following tax year under Sec. 461(l)(2), thus eliminating the need for a separate carryback provision.
A number of other loss deferral provisions are applied before the excess business loss limitation under Sec. 461(l): the basis rules under Sec. 1366 for S corporations and Sec. 704(b) for partnerships; the at-risk rules under Sec. 465; and the passive loss limitations under Sec. 469. A newly created Form 461, Limitation on Business Losses, which has been issued in draft form, outlines these ordering rules and must now be used for individuals to reflect how these restrictions affect the availability of losses for 2018 and forward. While final regulations have been issued under Sec. 199A (T.D. 9847), there does not appear to be a date on the horizon even for proposed regulations under Sec. 461(l), although taxpayers can at least review the draft Form 461 and its accompanying filing instructions. Absent new regulations, taxpayers are left with the statute and the Joint Explanatory Statement of the Committee of Conference, as well as some guidance in the Joint Committee on Taxation "Blue Book" general explanation, the latter of which creates some confusion around the question of wage inclusion in the calculation.
Below is a brief discussion of questions about how the loss limitation provision operates.
Should wages be included in the calculation of Form 461?
There is some discrepancy about the intent to include wage income in the excess business loss calculation. The Blue Book general explanation, released on December 20, 2018, provides that:
An excess business loss (the deduction for which is limited by section 461(l)) does not take into account gross income or gains or deductions attributable to the trade or business of performance of services as an employee. For example, assume married taxpayers filing jointly for the taxable year have a loss from a trade or business conducted by one spouse as a sole proprietorship as well as wage income of the other spouse from employment. The wage income is not taken into account in determining the amount of the deduction limited under section 461(l). [Joint Committee on Taxation, General Explanation of Public Law No. 115-97 (JCS-1-18), December 2018]
On Dec. 19, 2018, the IRS issued an alert, however, in which it stated that:
A "trade or business" can include, but is not limited to, Schedule F[, Profit or Loss From Farming,] and Schedule C[, Profit or Loss From Business,] activities, the activity of being an employee, an activity reported on Form 4835[, Farm Rental Income and Expenses], and other business activities reported on Schedule E[, Supplemental Income and Loss]. Business gains and losses reported on Form 4797[, Sales of Business Property] and Form 8949[, Sales and Other Dispositions of Capital Assets] can be included in the excess business loss calculation. They also include pass-thru income and losses attributable to a trade or business. [IRS, "Excess Business Losses," available at tinyurl.com/y6mchk22]
If one looks to the draft Form 461 itself, it provides for the inclusion of wage income in Part 1, line 1. Further down on the form, however, in Part II, line 10, it provides a catch-all line where this income may be excluded. Given the information available, it appears to be the IRS's intent to allow for wage income to be included in the calculation of "gross income or gain" for this section.
What is the application to hedge fund investments?
In the fund universe, there is a distinction between "trader" and "investor" funds. If the fund is deemed to be engaged in a trade or business, then a partner in such a fund may be able to treat this income as trade or business income or loss when calculating any individual excess business loss under Sec. 461(l). "Trade or business" in the tax law necessitates continuity, constant repetition, and regularity of activities; however, investment activities alone, regardless of quantity or frequency, do not constitute a trade or business (Higgins,312 U.S. 212 (1941); Whipple, 373 U.S. 193 (1963)). As items derived from trading activities are considered trade or business income, the fact that those items are separately stated on a partner's Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., should not affect the ultimate reporting on Form 461 as trade or business income. Furthermore, Schedule K-1 presentation to advise ultimate owners of flowthrough entities of their allocable share of "trade or business" income will also become increasingly important, especially in the instance of a fund of funds. Finally, it is important to distinguish between trade or business income and material participation, such as in the case of a real estate fund investment. Material participation is not needed to establish the presence of a Sec. 162 "trade or business" that would qualify for inclusion in the excess business loss calculation.
Is an S corporation shareholder's capital gain available to offset excess business losses?
If a business is being sold in an applicable asset acquisition, ordinary income and Sec. 1231 gains should be attributable to a trade or business even if Sec. 1231 gain ultimately ends up as a net capital gain and is reported on Form 8949. Sec. 461(l)(4) states that any Schedule K-1 items from a partnership or S corporation are taken into account at the partner or shareholder level, and the limitation is applied at the partner or shareholder level. Furthermore, the Dec. 19, 2018, IRS alert references business gain and losses reported on Form 4797, and Form 8949 as being eligible for inclusion in the excess business loss calculation.
If a shareholder sells his or her S corporation stock, the application of the rules is not as straightforward as with an asset sale. Unfortunately, no guidance currently exists in the statute that defines "gross income or gain of [the] taxpayer for the tax year which is attributable to such trades or businesses" (Sec. 461(l)(3)(A)(ii)(I)). While uncertainty exists as to whether a shareholder may consider a gain from the sale of his or her S corporation stock as part of the computation of excess business loss, other provisions call upon taxpayers to characterize gains or losses from the sale of S corporation stock. For example, the Sec. 1411 regulations employ a lookthrough approach to determine whether the gain or loss is part of an individual's net investment income, primarily as a result of Sec. 1411(c)(4), which provides certain exceptions to the application of the net investment income tax to active individuals on the sale of their interests in an underlying partnership or S corporation.
Moreover, the more recent Sec. 163(j) regulations provide that a taxpayer's adjusted taxable income includes gain from the sale of S corporation stock to the extent it is attributable to the S corporation's assets used in a "non-excepted" trade or business under Prop. Regs. Sec. 1.163(j)-6(l)(4)(ii). Thus, a similar lookthrough rule is used in Sec. 163(j) even where it is not specifically provided for in the statute. The proposed regulations for Sec. 163(j) refer to Sec. 461(l) in the context of Sec. 163(j) applying before the application of Secs. 461(l), 465 (at-risk rules), and 469 (passive activity rules) (Prop. Regs. Sec. 1.163(j)-3(a)(4)). The IRS could provide more clarity in the future specifically as to the disposition of S corporation stock under Sec. 461(l), but for now, this parallel guidance is all the authority that exists.
While the majority of regulatory developments as a result of tax reform focused on more broad statutory developments such as those of Sec. 199A and Sec. 163(j), more guidance is needed when it comes to the excess business loss limitation under Sec. 461(l), as it will impact the income taxation of many noncorporate taxpayers, including trusts, for this filing season. Planning for the new loss limitations of Sec. 461(l) should include a review of all trade or business involvement of taxpayers potentially facing a limitation, including those of trusts.
Editor's note: On Feb. 28, 2019, the AICPA submitted comments to Treasury and the IRS, requesting guidance on various issues related to Sec. 461(l).
Kevin D. Anderson, CPA, J.D., is a partner, National Tax Office, with BDO USA LLP in Washington, D.C.
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