On March 27, 2020, the Coronavirus Aid, Relief and Economic Security Act (CARES Act), introduced a variety of tax relief measures targeting both businesses and individuals that have suffered economic hardship as a result of the coronavirus. While the bill is intended to put cash back into taxpayers’ pockets, at least one provision, unfortunately, presents a trap for the unwary.
The CARES Act temporarily repeals tax code Section 461(l), a relatively new provision that limits the amount of business losses a non-corporation taxpayer can use to offset non-business income. This repeal is retroactive to tax years that begin after Dec. 31, 2017, and effectively provides that the loss limitation no longer applies for the 2018 through 2020 taxable years.
Section 461(l), introduced by the Tax Cuts and Jobs Act of 2017 denies non-corporate taxpayers a deduction for net business losses that exceed $250,000 for single filers or $500,000 for joint filers, with any disallowance carried forward to future years.
As such, individuals and trusts with business losses derived from sole proprietorships, partnerships, or S-corporations can only offset non-business income such as wages and investment income with business losses up to the threshold.
Benefits of the temporary repeal of Section 461(l) are potentially two-fold: (1) 2020 returns and 2019 returns not yet filed will not be subject to the limitation (potentially decreasing taxable income); and (2) 2018/2019 returns already filed are eligible for amendment (potentially generating an immediate refund). The temporary repeal may be particularly significant to owners of, and investors in, real estate as well as active traders with a trader tax status.
The repeal of Section 461(l) is not elective. As a consequence, if a taxpayer who is subject to limitation in a prior year does not amend, the IRS could adjust downward the amount of that taxpayer’s loss carryforward. If the taxpayer’s statute of limitation for the relevant year (i.e., 2018 or 2019) is closed at the time of the adjustment, then the taxpayer would lose the relevant benefit.
For example, if in 2018, a single taxpayer had a net business loss of $400,000 and non-business income of $400,000, under Section 461(l), the allowable business loss deduction would have been limited to $250,000, resulting in net taxable income of $150,000. The excess loss of $150,000 would have been carried forward as a net operating loss. Following the repeal of Section 461(l), the taxpayer could amend the 2018 return to take the full $400,000 loss, generating a refund of the tax associated with the $150,000 income previously taxed.
An issue arises if the taxpayer decides to forgo amending the 2018 return, assuming the carryforward loss may be utilized in a future year. As the loss limitation no longer exists with respect to 2018, the carryforward is improper. On examination, the IRS could disallow the $150,000 carryforward loss, which would be permanently lost if the 2018 statute of limitations is closed.
Any excess loss that, absent Section 461(l), could have been utilized in the year it was disallowed (2018 or 2019 if filed pre-CARES act) is potentially at risk of forfeiture. The importance of filing an amended return therefore cannot be understated. Filing an amended return may not only provide the taxpayer with a refund (a timing issue) but, perhaps more significantly, may prevent a loss from being disallowed (a permanent difference).
A taxpayer should also consider whether losses freed as a result of the Section 461(l) repeal are suitable for carryback under the bill’s new net operating loss provisions.
Also of note are several technical corrections that will impact Section 461(l) when it becomes effective in the 2021 tax year:
- Net business losses subject to limitation are calculated without regard to net operating losses or qualified business income deductions.
- W-2 wage income will not be considered trade or business income and therefore may only be offset by business losses to the extent of the threshold.
- Net losses from the sale of capital assets are excluded from the Section 461(l) computation.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Timothy Evans is a senior manager in international tax at Mazars USA LLP.