by Steve Gorin, JD
Deductible business losses can lead to a reduction in—or refund of—income tax. This article will examine the various rules limiting the current deduction of business losses and a 2020 Internal Revenue Service (IRS) memo explaining the effect of these limits on the self-employment tax. In addition, this article discusses the impact of the coronavirus pandemic relief provided by the Coronavirus Aid Relief and Economic Security Act (CARES Act), effective March 27, 2020, which temporarily upended the 2017 tax reform.
To provide some context, our system uses the tax accounting period as its fundamental measurement. We report the income, deductions, and other taxable items and compute the resulting tax for each accounting period, which is generally the calendar year. What happens when income and deductions are spread over more than one year? The tax law dictates that each year must stand on its own and generally provides relief from unevenness only for business income and loss. Further, if a business is big enough, income tends to be accelerated and deductions tend to be deferred, making relief across the years potentially more important.
What are net operating loss deductions?
If net losses from business activities cause a taxpayer to have a negative taxable income, Internal Revenue Code Section 172 may allow a taxpayer to deduct a net operating loss (NOL). Thus, a business loss from one year may be carried to another year. Generally, the tax reform of 2017 prevents NOLs from being carried back and provides an unlimited NOL carryforward. For losses arising in taxable years beginning after December 31, 2017, the new law limits the NOL deduction to 80 percent of taxable income. However, the CARES Act authorizes any NOL arising in a tax year beginning in 2018, 2019, or 2020 to be carried back five years and to offset as much as 100 percent of taxable income from the prior years. The business loss rules set forth in the 2017 tax reform will be restarted in 2021.
Carrying back the 2018 and 2019 losses may generate tax refunds. At first glance, allowing NOLs for those years to be carried back was puzzling to me. As a practical matter, however, carrying them forward may generate little benefit relative to 2020 losses, and carrying them back does provide a practical benefit.
The CARES Act does not provide immediate relief for 2020 losses. The big tax benefits will tend to come from 2020 losses, but they will not be determined until returns are filed in the spring of 2021. Businesses that owe tax from 2019 might try to reach an installment agreement with the IRS to defer paying that tax, and then use the 2021 loss carrybacks to prior taxable years to generate a refund to apply to the installment agreement. It is possible that banks will lend in anticipation of a business receiving a refund.
Quite frankly, I very much disagree with the 2017 tax law change to NOLs. The vagaries of business cycles create ups and downs, and being able to freely use NOLs enables taxpayers to smooth their tax liability relative to the harsh reality of accounting periods, allowing a taxpayer to consider only one year’s activity at a time. I am glad that the CARES Act gives taxpayers this smoothing opportunity.
Learn more about this topic at the webinar, "Deducting Business Losses: Overview of Income Tax Limitations" on December 9, 2020, 1 PM ET.
How does a deductible business loss even occur?
A business incurs a loss when its expenses exceed its income. A business can fully deduct expenses such as supplies, rent, and labor, but deductions for depreciation or home business losses are available only to the extent that the expenses equal the business owner’s income. If the loss exceeds the owner’s income, the IRS allows businesses to carry over the remaining deduction to the following year to decrease the taxes owed for that year or carry the loss back to a previous year.
A C corporation is a silo, and any loss it incurs merely offsets other income it generates. On the other hand, the owners of a partnership or S corporation (pass-through entities) seek to use the losses on their Schedule K-1 (Form 1065) information return against other income the owners generate. This use of losses may be referred to as “sheltering” their income, and if the owners can generate these losses without having to invest much cash, the pass-through entities may be pejoratively referred to as “tax shelters.”
This concept of losses without investing cash arises in part simply from borrowing money, but also arises from depreciation deductions. Depreciation is intended to reflect the fact that tangible assets wear out over time. This is realistic with personal property, but the tax laws provide accelerated depreciation—as much as 100 percent in the first year under the 2017 tax reform—to encourage investment in capital; this generates losses or artificially reduced income in early years and phantom income in later years, when immediate expensing may not be available (because the 2017 tax law sunsets) even though cash is being invested in replacing machinery.
Real estate is even more problematic—although the building may wear out over time, real estate values often increase due to inflation or growth in the surrounding area, sometimes making land and the fully depreciated building worth more than the original purchase price. A real estate investor might use depreciation deductions to avoid tax on the net cash flow used to pay down the mortgage. Then, the investor might sell the building and pay capital gains rates, which are lower than rates on other business income or on wages and self-employment income.
Our tax laws provide these somewhat artificial incentives to encourage investment with the hope that this investment will provide jobs. Along come owners of pass-through entities who borrow the capital, however, so that they get deductions without putting out most of the cash needed for the business. When these deductions are gone, they sell the business at capital gains rates. This is how our system produces tax shelters and facilitates the wealthiest individuals paying taxes at lower rates than the rest of us.
Responding to concerns about this system that seems rigged in favor of the wealthy, Congress provided limits on what it perceived to be tax shelters, while still providing very nice incentives for entrepreneurs who are risking their financial security and dedicating themselves to building thriving businesses. I will now briefly describe these limits, and you can decide for yourself whether these limits fairly balance these conflicting tax objectives.
Losses not allowed in prior years due to the basis rules
First, a taxpayer must have basis against which to deduct losses. Owners generally may deduct losses to the extent of their basis in their S corporation stock or partnership interest; for a partnership (including an LLC tax as a partnership), this basis includes certain debt basis.
These basis limitations provide more optionality for S corporations than for partnerships. When an S corporation borrows from a third party, its owners do not get basis for the loan, even if they provide very strong guarantees to the lenders. An owner gets basis from a loan only if the owner is the lender. However, if an owner borrows from a lender and loans that money to the S corporation, then the owner gets basis. In such a back-to-back loan, the owner may take a security interest in the company’s assets and then assign that security interest to the lender, so that the lender has a security interest in the company’s assets. By choosing between a back-to-back loan and a direct loan from a lender to the company, the owner can determine how much basis is available to absorb losses.
When a partnership borrows from a third party, the liabilities are allocated to its owners, who get basis for the loan. Guarantees may change how the liabilities are allocated among the owners, but they do not change whether the liabilities are allocated to the owners as a whole.
Losses not allowed in prior years due to at-risk rules
The at-risk rules (see Code Section 465), which limit losses to the amount at risk in a business activity, limit the extent to which partners can use debt basis to support losses. An example of their application is a partner who is allocated a liability but has not guaranteed or otherwise become subjected to paying that liability out of pocket; the at-risk rules may prevent that partner from deducting losses against the basis created by that liability. Sometimes partners guarantee liabilities to support losses (which guarantees the IRS will respect only if real), but guarantees are most commonly required by lenders.
Suppose a nongrantor trust owns an interest in an S corporation or a partnership that incurs losses suspended by the basis limitation. When the trust terminates, the suspended losses are lost forever, with no tax benefit. This reinforces my inclination to draft trusts that last the beneficiary’s lifetime, with the beneficiary becoming trustee when appropriate, rather than terminating and artificially forcing the issue of losing suspended losses.
Whatever losses are not suspended by the above rules may then be suspended by the passive loss rules (Code Section 469). The general idea is that anyone who does not spend sufficient time working in a business should not use losses from that business to offset other income. If the owner becomes sufficiently active or sells his or her entire interest in the business to an unrelated party, then the owner may use the losses.
The idea is that suspending a loss and using it against income in a high-earning year may be better than using the loss right away against modest income or income that the standard deduction or itemized deductions already protect from tax.
Losses not allowed due to passive loss rules
Although owners of partnerships and S corporations generally can deduct losses, subject to various basis and at-risk limitations, a passive loss from a trade or business is deductible only against other passive income or when the activity that generated the loss is sold in full. Passive income does not include gross income from interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business.
How do these rules fit in with self-employment tax?
FICA is paid one-half by the employee and one-half by the employer. If an individual is self-employed, then the individual pays both halves, which combined are called self-employment (SE) tax. Generally, all partnership or sole proprietorship income from business operations is subject to income tax and SE tax. IRS Chief Counsel Advice (CCA) Memorandum 202009024, Whether the Basis Loss Limitation and the At-Risk Loss Limitation Apply in Determining a General Partner's Self-Employment Tax, mentions that, generally, an individual’s net earnings from self-employment (NESE) is gross income from any trade or business carried on by that individual, less the deductions allowed for income tax purposes that are attributable to such trade or business, plus the individual's distributive share of income or loss from any trade or business carried on by a partnership of which the individual is a member. The CCA explains that the basis, at-risk, and passive loss rules described above for income tax purposes also apply for self-employment tax purposes. When those suspended losses are triggered, they are reported directly on the schedules of an individual income tax return that determine NESE. Contrast that with an NOL, which is not deductible against NESE. Therefore, to the extent that reducing NESE helps, one would rather have suspended losses under the basis, at-risk, or passive loss rules than have that loss converted to an NOL.
Learn more and receive substantial technical resources by attending our business planning webinar, Deducting Business Losses: Overview of Income Tax Limitations, on December 9, 2020 presented by Steve Gorin, JD.