In the early years of operation or during challenging economic times, many business ventures generate tax losses. Understanding when and how much of these losses can be deducted is crucial for maximizing your tax benefits. Here’s an overview of the current limitations on deducting losses from pass-through business entities, including sole proprietorships, LLCs, partnerships, and S corporations.
Understanding NOL Deduction Limits
Under current tax rules, net operating losses (NOLs) can shelter only up to 80% of your taxable income in the carryforward year. Unlike prior rules that allowed full sheltering of taxable income and carrying back NOLs to previous tax years, current regulations permit carrying forward NOLs indefinitely, but not backward.
The Evolution of Business Loss Deductions
Before the Tax Cuts and Jobs Act (TCJA) of 2018, individual taxpayers could typically fully deduct business losses in the tax year they occurred, unless restricted by passive loss rules or other tax provisions. Excessive losses would create an NOL, which could be carried back two years or forward up to 20 years.
Current Rules Post-TCJA
The TCJA introduced less favorable rules for deducting business losses. For example, passive activity loss (PAL) rules limit deductions if you don’t actively participate in the business or it’s a rental activity. PAL rules only allow you to deduct passive losses up to the amount of your passive income from other sources. Suspended passive losses can be carried forward to future years until you have sufficient passive income or sell the activity.
Additionally, the TCJA established the “excess business loss” rule, extended by later legislation. For tax years starting before January 1, 2029, you can’t deduct excess business losses in the current year. For 2023, an excess business loss is one that exceeds $289,000 for single filers or $578,000 for married joint filers. These thresholds are adjusted annually for inflation. Excess business losses are carried forward as NOLs.
Real-World Scenarios
To illustrate, consider Ed, an unmarried individual with a $350,000 allowable loss from rental properties in 2023. After applying PAL rules, Ed has an excess business loss of $61,000 ($350,000 – $289,000 threshold for single filers). Ed can deduct $289,000 of his rental loss against his other income, carrying the $61,000 excess business loss forward to 2024 as an NOL.
Another example involves Avery and Fernando, a married couple. Avery has a $300,000 rental loss, and Fernando’s startup business generates a $150,000 loss in 2023. Their combined losses of $450,000 are below the $578,000 threshold for married joint filers, so they can use their losses to offset other income without triggering the excess business loss rule.
The Practical Impact
The excess business loss rule further restricts the ability to offset income from other sources with current-year business losses. For 2023, allowable business losses can’t offset more than $289,000 of other income for single filers or $578,000 for joint filers. Excess business losses must be carried forward as NOLs, delaying the tax benefit.
Rules for S Corporations, Partnerships, and LLCs
For S corporations, partnerships, and LLCs treated as partnerships, excess business loss rules apply at the owner level. Each owner’s share of business income, gain, deduction, or loss is passed through and reported on their personal tax return.
Consider siblings Thomas and Gina, who own a clothing shop as an LLC treated as a partnership. The LLC reports a $700,000 loss in 2023, with each sibling allocated a $350,000 loss. Thomas, who is single, faces an excess business loss of $61,000, while Gina, who is married, doesn’t exceed the $578,000 threshold.
Conclusion
Navigating the rules for deducting pass-through business losses requires a thorough understanding of current tax laws and strategic planning. At Patten and Company LLC, we can help you maximize your tax benefits while complying with all relevant regulations.
Contact Patten and Company today to discuss how we can assist you with deducting your business losses and optimizing your tax strategy.
