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It’s Round 3 of the Excess Business Loss Saga in HEROES Act

Posted on May 19, 2020

Business loss limits for individuals are back on the table under the latest House coronavirus relief bill, but reinstating the limits retroactively with changes from its initial version raises both practical and constitutional issues, according to practitioners.

The excess business loss limitation for noncorporate taxpayers under section 461(l) is suspended until 2021 to provide access to cash for taxpayers, but that limit would be retroactively effective for the 2018 tax year under the Health and Economic Recovery Omnibus Emergency Solutions (HEROES) Act (H.R. 6800).

Taxpayers who filed their 2018 and 2019 tax returns with the initial limit in place may have recently amended them to receive refunds as a result of the limit being lifted until 2021 under the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136). The HEROES Act would reverse that and reimpose the business loss limit for the prior years, but it wouldn’t be the same limitation as before — changes made under the CARES Act would also apply retroactively.

According to Christopher W. Hesse of CliftonLarsonAllen, that means taxpayers who had wage income along with businesses losses in 2018 and 2019 might find themselves with a retroactive tax increase.

While some practitioners are sounding the alarm on the limit returning for prior years under the House bill, others are less sympathetic because they say removing the excess business loss limit in the CARES Act mostly helped the rich.

“Cry me a river—this is ridiculous,” Steve Rosenthal of the Urban-Brookings Tax Policy Center said in response to claims that adding the excess loss limit back for prior years would be unfair. Rosenthal said the section 461(l) limits were added by the Tax Cuts and Jobs Act (TCJA) in late 2017, and it wasn’t until late March that the limit was suspended until 2021, so taxpayers can’t claim with a straight face that reinstating the limits now would be unfair.

“There is, in my view, no detrimental reliance. C’mon,” Rosenthal said. “Most taxpayers would not even have done anything with their tax returns.” Rosenthal acknowledged that some taxpayers may have filed a “quickie refund,” which is procedurally a more beneficial way to get cash from the IRS because the amended return process usually takes longer.

The so-called quickie refund generally allows taxpayers to file refunds after a tax year has ended but before the tax return is filed for the year, Rosenthal said.

Round 1

The TCJA added section 461(l) 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 a net operating loss in future tax years. The provision is set to expire at the end of 2025.

For partners to take losses, they must have sufficient basis under section 704(d), they must satisfy the at-risk rules under section 465, and the losses can’t be limited by the passive rules under section 469 before the section 461(l) limits kick in.

The limit essentially acts as a one-year deferral, and 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.

Round 2

The CARES Act settled the debate on treatment of wages by amending section 461(l) to clarify that wages are treated as nonbusiness income in applying the limits. The changes were even stricter — capital losses are no longer considered when applying the limits.

Some practitioners have pointed out that by leaving capital losses out of the calculation, the law shut down a potential planning opportunity that would allow taxpayers under the original section 461(l) language to convert a capital loss to an ordinary loss in future years when the excess amounts are treated as NOLs.

Under the CARES Act, the new excess business loss limitation applies beginning in 2021, which allows taxpayers to go back and claim refunds for taxes paid on amounts as a result of the limit.

Round 3

Under the HEROES Act, however, the limit would again apply beginning in 2018 and would be permanent.

Practitioners say it wouldn’t simply be a do-over by lawmakers if section 461(l) was reapplied in 2018; it would be a tax increase because wages aren’t business income.

Hesse used an example of how a real-world scenario would play out if the HEROES Act language were enacted retroactively.

Say a married couple filed a joint income tax return for 2018 in which the wife earned $300,000 in wage income and the husband had $700,000 in business losses from an S corporation. In 2018, under the section 461(l) limits in place under the TCJA, there was no excess loss because the net amount was less than $500,000.

But under the HEROES Act, the excess business loss would be $200,000, which would be carried forward to 2019 as an NOL. In that scenario, Hesse said the taxpayers would have to file an amended return for 2018 to increase their income and pay tax.

“There seems to be no concern for the taxpayer who filed a complete and accurate tax return based upon the law that was in effect during the year income was earned,” Hesse said.

Libin Zhang of Fried, Frank, Harris, Shriver & Jacobson LLP said the retroactive treatment of wage income back to 2018 isn’t surprising, given that it was already noted as a technical correction in the JCT blue book from 2018. 

“There is some precedent that technical corrections can be applied retroactively,” Zhang said. The Supreme Court in United States v. Carlton512 U.S. 26 (1994), upheld the one-year retroactive application of a legislative fix to an estate tax law.  

“The retroactive change with somewhat more constitutional concerns is to the interaction of section 461(l) and the capital loss rules, which was never mentioned by the JCT or Congress as a technical correction even though it has been widely discussed in the tax community,” Zhang said.

Another issue that would need to be addressed if the HEROES Act excess loss limits became law is how it would interact with NOL changes. The TCJA eliminated the carryback of NOLs and only allowed them to offset 80 percent of taxable income, with carryforward allowed indefinitely.

The CARES Act changed that by allowing losses incurred in 2018 through 2020 to be carried back for five years and removing the 80 percent taxable income limit for 2020 and earlier. The HEROES Act would only allow NOLs incurred in 2019 and 2020 to be carried back, but not before tax years beginning before 2018. Other limits would apply.  NOLs incurred in 2018 and later are subject to the 80 percent taxable income limit if used in 2021 and later.

Because excess business losses are treated as NOLs in “subsequent years,” it’s uncertain whether the NOLs from excess business losses could be carried back or only used in future years, Zhang said.

“But the impact may not be significant either way, because the business losses limited by [section] 461(l) can either generate an immediate refund or can be used shortly in the next year against 80 percent or 100 percent of next year’s business and nonbusiness income,” Zhang said.

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