NOL Carry Limitations
When it comes to net operating losses (NOLs), business losses are still subject to the limitations prescribed by the Internal Revenue Service. Individuals who are partners in a partnership or shareholders of an S Corp. must be aware of the tax basis limitation before applying the at-risk and passive loss limitations to business losses.
When dealing with business losses, some of the biggest limitations taxpayers may face include the At-risk and Passive Activity Loss Limitations. For individuals, the limitations also include the excess business loss limitation. While for corporate businesses, the limitations include the § 382 limitation on business ownership change.
Additionally, other tests and limitations can include but are not limited to:
- constructive receipts doctrine
- substance over form doctrine
- claim of right doctrine
- all events test
- corn products doctrine
- ordinary and necessary test
Types of Limitations
For many taxpayers, the first limitation that must be applied to a business loss is a tax basis limitation. Taxpayers that need to pay close attention to this limitation are typically partners in partnership and shareholders in an S. Corp.
The tax basis is ordinarily the taxpayer’s cost for the property subject to any adjustments. In terms of a partnership, it will likely be the partner’s cost in forming the partnership in addition to any adjustments to basis taken by the partner. For an S Corp., it will likely be the taxpayer’s cost of the shares subject to any adjustments.
A taxpayer’s losses are limited to the taxpayer’s basis. This means a partner’s share of the partnership loss is limited to the partner’s adjusted basis in the loss year. A shareholder’s losses from an S. Corp. are limited to the adjusted basis of the stock and the S. Corp.’s indebtedness to the shareholder. After applying the tax basis limitation to the losses, the taxpayer must then apply the other loss limitations prescribed by the Code.
Following the application of the tax basis limitation, a taxpayer would then apply the at-risk limitation to the loss. Under § 465 business losses are limited to the amounts at-risk and apply to both individuals and C Corps. who have met the stock ownership requirement.
This code section seeks to limit the taxpayer’s business loss for the taxable year to the amount at-risk. According to the Internal Revenue Code, that amount can be a combination of these things, “the amount of money and the adjusted basis of other property contributed by the taxpayer to the activity and amounts borrowed with respect to such activity.”
Borrowed amounts require that the taxpayer be personally liable for debt through a recourse loan. A nonrecourse loan can become at-risk when it has been guaranteed with a different property as a security for the debt. Essentially what the Code indicates is that for a debt or loan to be considered at-risk for the taxpaying individual, it almost always needs to be a recourse loan.
The at-risk limitation only applies to certain types of activities. Although the Code lists these certain activities, the limitation also extends to any trade or business activities for the production of income that was not listed in the Code for which the taxpayer is at-risk. This Code section was designed to prevent tax avoidance by persons being able to take on large losses and deduct them against their income when in reality the taxpayer was never really on the hook for the large amounts. The taxpayer is limited to the risk he is responsible for, in terms of the loan and for the amount of money he has put into the property or project.
Passive Activity Limitations
The passive activity loss limitation applies after the at-risk limitation has been applied to losses. Passive activities are certain types of business or investment activities in which a taxpayer did not materially participate in during the tax year. There are two types of passive activities subject to the limitation on the deduction of the losses under § 469:
- When a taxpayer did not actively contribute to the trade or business
- Certain rental activities for which the generation of income is attributable to the property and not the labor or other efforts of the taxpayer
This limitation applies to the following taxpayers:
- Estates or trusts
- Closely held C Corps.
- Personal service corporations
The Code defines passive activity loss as the amount by which the aggregate losses from all passive activities for the taxable year exceeds the aggregate income from all passive activities for such year. A passive activity is any activity which involves a trade or business in which the taxpayer does not materially participate. To break it down further we must look at what activities are subject to passive activity rules, what constitutes a trade or business, and what is material participation. For guidance on what activities qualify as passive, it is necessary to turn to the treasury regulations.
The treasury regulations define activity as an appropriate economic unit which requires grouping into applicable economic units based on a facts and circumstances test. Some factors under this test include:
- Similarities and differences in types of trades or businesses
- The extent of control
- The extent of common ownership
- Geographical location
Material participation by a taxpayer is defined as regular, continuous, and substantial. It is an objective test that can be satisfied in various ways by the taxpayer if the taxpayer satisfies one of the seven tests. Some exceptions exist for activities that would typically constitute passive activity. These exceptions apply to portfolio income and rental activities with material participation by the taxpayer with losses of up to $25,000.
The main takeaway from passive activity loss limitation is that in a particular year, if a taxpayer has passive losses that exceed passive gains, then the taxpayer will have a passive loss that cannot be deducted against nonpassive income. That passive loss, with some exceptions, is not deductible in the current year. A passive loss can be carried forward and deducted against future passive income.
The types of taxpayers that need to be cognizant of this limitation are likely limited partners and those non-real estate professionals who are investing in real estate. These limited partners or real estate investors would not be able to deduct business losses that arise because they would likely fall victim to the passive loss limitation.
This limitation intends to prevent taxpayers from utilizing passive losses against their nonpassive income. This prevents manipulation from taxpayers who would attempt to create negative tax liabilities or significantly reduce their tax liability on nonpassive income.
Concerning NOL, passive activity loss is not included in the NOL calculation. Since a passive loss cannot be carried back, it will not help a taxpayer looking to take advantage of the CARES Act NOL Carryback resurrection.
Excess Business Loss Limitations
The death of the NOL carryback in the 2017 Act made way for the new advent of a new limitation. The excess business loss deduction applies after the at-risk and passive activity loss limitations. This limitation, as author Steven Hodasyz said, “violates the most basic notions of what an income tax is.”
The limitation penalizes businesses such as startups and others that have a large amount of business losses by unfairly, “creating a tax base that includes more than net income.” So, it is only fitting that the temporary revival of the NOL carryback saw the postponement of the excess business loss deduction as part of the CARES Act.
The excess business loss limitation applies to noncorporate taxpayers which means individuals, trusts, and estates. The Code defines excess business loss as the excess of the taxpayer’s total trade or business deductions, minus the sum of the total trade or business income or gain, plus $250,000 for a single taxpayer or $500,000 for joint filers. The excess amount is treated as an NOL carryover that the taxpayer may use in the future.
The CARES Act repealed the excess business limitation until 2021. The law now allows taxpayers that would have been limited by the excess business loss to go back and amend 2018 and 2019 returns and fully utilize the deduction. This will allow taxpayers who had to pay income tax because of the limitation, to obtain refunds in 2018 or 2019.
This will also help taxpayers who had an NOL in 2018 or 2019, but that was limited by the excess business loss limitation and only allowed to carry forward both NOLs. Now, taxpayers will be able to go back and use the full amount of their loss as carryback instead of a carryforward.
For taxpayers, this is a welcome reversal from the 2017 Act, even if albeit temporary. Taxpayers will now be able to collect refunds on taxes paid if they were subject to the excess business loss in 2018 or 2019. The other option would be larger NOLs to carryback to previous years.
The temporary repeal of the excess business loss limitation is a win for taxpayers who need access to liquidity now.
§ 382 Carryforwards Following Ownership Change Limitations
Corporate businesses may be facing changes to ownership as a result of COVID-19. Some corporate businesses may have shareholders looking to leave the corporation as a result of the economic downturn from COVID-19, while other shareholders may see this downturn as an opportunity to increase their ownership shares.
When dealing with a corporation’s potential NOL, an analysis must begin to determine whether there was a change in ownership that could trigger § 382. The Internal Revenue Code section comes into play when within a three-year period there is an aggregate change of ownership that is equal to an excess of 50 percent.
This section once triggered a limitation on the use of the corporation’s NOL for a carryforward. This limitation equals the value of the old loss corporation times the long-term tax-exempt rate.
Any company that has undergone or contemplating an ownership change should be cognizant of potential § 382 limitations as they relate to NOL carryforwards. Shareholders interested in increasing their ownership share should also be considering the § 382 limitation, especially if there are NOLs in play.
Corporations subject to an ownership change should note that as § 382 indicates, this limitation applies only to carryforwards, which means carrybacks are not subject to § 382 limitations as defined under the Code. A corporation that faces a § 382 limitation on its ability to utilize the NOL carryforward should welcome the opportunity to carryback the NOL to avoid this limitation.
Plan Your 2020 Tax Strategy
Taxpayers have the remaining months left in 2020 to engage in tax planning that will optimize their losses in a manner that could result in a refund of prior years’ taxes paid. Likewise, this may be an opportunity for taxpayers that still owe unpaid income taxes from prior years to reduce or eliminate that liability.
If you have questions about how the CARES Act could affect your net operating losses, please reach out to the May Firm today.