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Senate’s Business Loss Limit Fix May Not Be What It Seems

Posted on Mar. 23, 2020

The Senate’s coronavirus bill makes changes to the treatment of business losses for individuals in order to process much-needed access to money, but some of the language could be surprising, according to practitioners.

If passed as drafted, the changes to the noncorporate business loss limitation in section 461(l) in the Coronavirus Aid, Relief, and Economic Security Act (S. 3548), introduced March 19 by Senate Majority Leader Mitch McConnell, R-Ky., would force individual taxpayers to file amended returns in certain cases, but it wouldn’t operate like the net operating loss carryback changes included in the bill.

The Senate summary provides that “the provision modifies the loss limitation applicable to pass-through businesses and sole proprietors, so they can benefit from the NOL carryback rules [in the bill] and access critical cash flow to maintain operations and payroll for their employees.”

But people who read the statutory provision would see that the 461(l) changes are significantly different from the NOL changes, said Libin Zhang of Fried, Frank, Harris, Shriver & Jacobson LLP.

“I agree that if they are intending to provide relief to individuals, like they imply in the summary, this would be a swing and a miss,” Glenn Dance of Holthouse Carlin & Van Trigt LLP said. “In fairness, though, I can’t be sure they meant what they said in the summary.” 

Dance said it would seem odd for Congress to say, “Here’s a new limitation on losses incurred after the period where we’re trying to provide relief regarding NOL carrybacks, but go ahead and carry them back anyway.”

The Tax Cuts and Jobs Act added section 461(l) to the code as a revenue raiser — according to the Joint Committee on Taxation, the provision was expected to raise more than $150 billion over 10 years.

The provision limits the use of business losses against nonbusiness income at $250,000 for single individuals and $500,000 for joint filers. If an amount is disallowed in the year it’s incurred because of the limit, it can be carried forward and treated as an NOL in future tax years. The provision is set to expire at the end of 2025.

The limit essentially acts as a one-year deferral, and right off the bat practitioners wondered what counts as business income in determining the limit. According to the IRS, wages earned by an individual count as business income, although the JCT's blue book (JCS-1-18) said a technical correction may be needed to clarify that point.

The Senate bill would treat wages as nonbusiness income and tweak section 461(l) to push its effective date to 2021. That means taxpayers would file amended returns and recalculate their losses for prior tax years as if section 461(l) hadn't been enacted in the first place, Zhang pointed out.

The TCJA barred NOLs from being carried back, but the Senate bill would scrap that change and allow NOLs to be carried back for a limited time. That would be a welcome move, Zhang said, and the same bill could have provided that NOLs generated by section 461(l) can be carried back in the same manner. Instead, the bill would repeal section 461(l) for 2018 through 2020.

Troy Lewis, a professor at the Brigham Young University Marriott School of Business, said that if a taxpayer had a 461(l) limit for the 2018 tax year and still had taxable income remaining, the bill would require a tax return amendment. 

“Such amendments will be difficult to generate as most of the tax practitioner community is focused on their own personal well-being and the health of their community first, and then compliance with 2019 next,” Lewis said. “Chances are that many that would benefit from the suspension have not yet filed 2019 [returns], and clearly nothing has been filed for 2020.”

Lewis added that the suspension of section 461(l) would be a much better benefit for 2020 because several businesses will likely continue to pay fixed costs and many are still paying displaced and shuttered workers despite a drop-off in revenue. 

“Forms will have to change if this provision is amended, [and] that will take some time,” Lewis said. “Tax software companies and the IRS itself will likely be fairly slow to update the systems (relative to normal years) for such changes. This could delay the 2018 refunds in some cases.”

Converting Capital Losses

But perhaps more interesting for the tax community is a fix that makes changes to section 461(l) that currently allows taxpayers to convert capital losses into NOLs in some cases. Under long-standing law, a taxpayer can convert $3,000 of a capital loss into an ordinary loss, and what’s not used in one year is carried forward as capital losses into future years.

The way section 461(l) interacts with the capital loss limitation rules is currently unclear.

For example, if a married taxpayer has $900,000 of business capital loss and $900,000 of nonbusiness capital gains, the taxpayer may be capped out at the $500,00 section 461(l) limit, and $400,000 of the capital loss would be disallowed.

But section 461(l) currently allows taxpayers to carry forward that $400,000 unused business capital loss as an NOL, which would be an ordinary loss, Zhang said. This result was not identified by the JCT as needing a technical correction in the blue book released in late 2018, presumably because it was already taken into account in the $150 billion revenue estimate.

Under the Senate bill, capital losses wouldn’t be included in the section 461(l) calculation, so that planning technique may be squashed. Instead, business capital losses are allowed in full, without any limitation, Zhang added.

“It is not clear how the Senate bill applies to section 1231 gains and losses, which is reminiscent of Treasury’s confusion over section 1231 in the qualified Opportunity Zone context,” Zhang said.

If enacted, the Senate bill would create issues for some states, depending on how they conform to the code. For example, California is a static conformity state that follows the code as of 2015, which means it didn’t automatically follow the TCJA’s provisions at the state level.

However, California conformed to section 461(l) starting in 2019, but it made the provision permanent and doesn’t automatically turn an excess business loss into an NOL; instead, it is carried forward more narrowly as an excess business loss.

If the Senate bill passes, taxpayers may find their California filing requirements complicated, especially if they are also subject to the alternative minimum tax at the federal and state levels, Zhang said. 

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