loss

Article Dean Dorton

For the third installment of our series, we will discuss excess business losses and net operating losses for individual taxpayers.

Previously, individuals offset business losses against all other income (subject to passive and basis limitations). Beginning after 2017, and applying to all taxpayers other than C corporations, there is a new concept of “excess business loss.” A taxpayer may now generate disallowed excess business losses, which will be treated as a net operating loss carryover subject to the new 80% limitation.

“Excess business loss” is defined as the excess of allowable deductions attributable to taxpayers’ trades or businesses over the sum of total taxable gross income attributable to the trades or businesses plus $500,000 for a joint return ($250,000 for all others). This is calculated after the passive activity rules limitations.

Essentially, this limits the ability to offset other income by trade or business losses; effectively, married taxpayers can only offset up to $500,000 of non-business income (e.g., investment income, wages, et cetera) with business losses.

Example for a single taxpayer:

2017 2018
Wages $100 $100
Investment income $200 $200
Eligible business losses $(500) $(500)
Taxable income/(loss) $(200) $50
Net operating loss $(200) $(250)

**Excess business loss converts to net operating loss (NOL)

This could have a significant impact on the real estate industry, particularly when considering the increased ability to expense capital assets, since the industry is depreciation-intensive.

The ability to deduct net operating losses (NOLs) will also change after December 31, 2017. For tax years beginning after that date, any NOL deduction generated will be limited to 80% of taxable income. Previously, NOLs could offset 100% of taxable income. NOLs that are being carried forward from a previous year will be allowed to offset up to 100% of taxable income, as the old law will still be applicable. Alternative minimum tax NOLs are still limited to 90% of taxable income, so there was no change in that deduction. While the deduction itself has been limited, the carryover of post-2017 NOLs is now indefinite; however, you cannot carryback NOLs after December 31, 2017. The pre-Tax Cuts and Jobs Act NOLs are limited to a 20-year carryover, and could be carried back two years.

The changes in the ability to deduct business losses and net operating losses could significantly impact planning, as it is possible that taxpayers who have been able to offset income with losses fully in the past will no longer be able to fully eliminate taxable income. Careful consideration of the cost recovery and capitalization of assets, as well as the new interest expense limitation rules, will be vital in tax planning for use of business losses and net operating losses. We will discuss the limitations on business interest expense in our next installment.

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Article Dean Dorton

As we continue our analysis of the Tax Cuts and Jobs Act (TCJA), we will address a provision that has not been widely reported, but could have an immediate impact in 2018 to certain taxpayers.

Effective for tax years beginning after December 31, 2017, an excess business loss of a non-corporate taxpayer will be disallowed in the current tax year and converted into a net operating loss to be carried over to the following tax year. An excess business loss is the excess of the taxpayer’s aggregated net active business losses over $250,000 ($500,000 MFJ). To illustrate:

H and W are married taxpayers filing a joint return. In 2018, H generates a net tax loss from his business of $600,000 and W generates a net tax loss from her business of $200,000. Both H and W actively participate in their businesses. Their aggregated net tax losses from trades or business is $800,000. Their excess business loss for 2018 is $300,000 ($800,000 – $500,000).

How does this limitation impact the taxable income of H and W?

Let’s assume that, in addition to the losses generated from their businesses, H and W have other investment income totaling $1,000,000. The following table illustrates how taxable income is calculated before and after the TCJA:

Before TCJA After TCJA
Investment income $1,000,000 $1,000,000
H’s active business loss (600,000) (600,000)
W’s active business loss (200,000) (200,000)
Excess business loss (see above) 0 300,000
Net taxable income $200,000 $500,000

While H and W cannot reduce their 2018 taxable income by the $300,000 excess business loss, this loss is converted to a net operating loss and carried over to the following year. H and W can use the net operating loss in 2019 to offset up to 80% of their taxable income. To illustrate, let’s assume that H and W have the exact same facts as above for 2019. Their 2019 taxable income would be calculated as follows:

2019
Investment income $1,000,000
H’s active business loss (600,000)
W’s active business loss (200,000)
Excess business loss (see above) 300,000
Net taxable income before net operating loss carryover $500,000
Net operating loss carryover from 2018 (lesser of NOL of $300,000 or 80% of taxable income before NOL ($400,000)) (300,000)
Net taxable income after net operating loss $200,000

This illustrates that the excess business loss limitation is merely a timing issue. Affected taxpayers, however, may be in for a surprise in this first effective tax year if not aware of this provision.

Article Dean Dorton

For anyone who takes a spin at roulette, cries out “Bingo!” or engages in other wagering activities, it’s important to be familiar with the applicable tax rules. Otherwise, you could be putting yourself at risk for interest or penalties — or missing out on tax-saving opportunities.

Wins

You must report 100% of your wagering winnings as taxable income. The value of complimentary goodies (“comps”) provided by gambling establishments must also be included in taxable income because comps are considered gambling winnings. Winnings are subject to your regular federal income tax rate, which may be as high as 39.6%.

Amounts you win may be reported to you on IRS Form W-2G (“Certain Gambling Winnings”). In some cases, federal income tax may be withheld, too. Anytime a Form W-2G is issued, the IRS gets a copy. So if you’ve received such a form, keep in mind that the IRS will expect to see the winnings on your tax return.

Losses

You can write off wagering losses as an itemized deduction. However, allowable wagering losses are limited to your winnings for the year, and any excess losses cannot be carried over to future years. Also, out-of-pocket expenses for transportation, meals, lodging and so forth don’t count as gambling losses and, therefore, can’t be deducted.

Documentation

To claim a deduction for wagering losses, you must adequately document them, including:

  1. The date and type of specific wager or wagering activity.
  2. The name and address or location of the gambling establishment.
  3. The names of other persons (if any) present with you at the gambling establishment. (Obviously, this is not possible when the gambling occurs at a public venue such as a casino, race track, or bingo parlor.)
  4. The amount won or lost.

The IRS allows you to document income and losses from wagering on table games by recording the number of the table that you played and keeping statements showing casino credit that was issued to you. For lotteries, your wins and losses can be documented by winning statements and unredeemed tickets.

Please contact us if you have questions or want more information. If you qualify as a “professional” gambler, some of the rules are a little different.

Article Dean Dorton

You can only deduct losses from an S corporation, partnership or LLC if you “materially participate” in the business. If you don’t, your losses are generally “passive” and can only be used to offset income from other passive activities. Any excess passive loss is suspended and must be carried forward to future years.

Material participation is determined based on the time you spend in a business activity. For most business owners, the issue rarely arises — you probably spend more than 40 hours working on your enterprise. However, there are situations when the IRS questions participation.

Several tests

To materially participate, you must spend time on an activity on a regular, continuous and substantial basis.

You must also generally meet one of the tests for material participation. For example, a taxpayer must:

  1. Work 500 hours or more during the year in the activity,
  2. Participate in the activity for more than 100 hours during the year, with no one else working more than the taxpayer, or
  3. Materially participate in the activity for any five taxable years during the 10 tax years immediately preceding the taxable year. This can apply to a business owner in the early years of retirement.

There are other situations in which you can qualify for material participation. For example, you can qualify if the business is a personal service activity (such as medicine or law). There are also situations, such as rental businesses, where it is more difficult to claim material participation. In those trades or businesses, you must work more hours and meet additional tests.

Proving your involvement

In some cases, a taxpayer does materially participate, but can’t prove it to the IRS. That’s where good recordkeeping comes in. A good, contemporaneous diary or log can forestall an IRS challenge. Log visits to customers or vendors and trips to sites and banks, as well as time spent doing Internet research. Indicate the time spent. If you’re audited, it will generally occur several years from now. Without good records, you’ll have trouble remembering everything you did.

Passive activity losses are a complicated area of the tax code. Consult with your tax adviser for more information on your situation.