Tax Law Insights

While the Coronavirus has delayed tax season by a few months, Congress’s response may have created the first ever refund season in the recently passed and much discussed relief package known as the Coronavirus Aid, Relief, and Economic Security Act, or “CARES Act” for short.  While the Act employs various relief techniques, Congress’s most effective and tried-and-true relief method – amending the Internal Revenue Code (the “Code”) – may ultimately play the most significant role.

On that note, the CARES Act amends many tax-related provisions, including liberalizing Sections 172 (NOLs), 461(l) (excess business losses), 53(e) (alternative minimum tax), 163(j) (business interest expense), and 168 (depreciation rules).  This note focuses on amendments to Section 461(l)’s excess business loss rules and the potential refunds generated.

Section 461(l) in General, Pre-CARES Act

In December 2017, the Tax Cuts and Jobs Act (“TCJA”) added Section 461(l) to the Code.  This section often operated under the radar of tax practitioners.  Many soon discovered that this inconspicuous Code section significantly impacted certain “pass-thru” entity (e.g., partnerships, LLCs, sole proprietors, and “S corporations”) owners.

Section 461(l)’s impact took the form of a loss limitation.  The limit applied to a taxpayer’s “excess business losses” – calculated as net losses from all trades or businesses that exceeded $500,000 per married couple joint return ($250,000 for singles) and adjusted for inflation, per tax year.  For partnerships, S corporations, and other pass-thru business entities, the loss limitation applied at the partner/shareholder level, not the entity level.

Before the TCJA, such losses were often unlimited as long as the taxpayer materially participated in its pass-thru businesses.  Post-TCJA, Section 461(l) limited even participating owners’ ability to use net business losses to offset “non-business” income. Think of that income as passive or investment income (capital gains, trust distributions, dividends, interest, and some rental income) and possibly, as discussed below, W-2/employee income.

Business owners with non-business income exceeding $500,000 (or $250,000 for single filers) took the brunt of Section 461(l)’s loss limitations.  And while the universe of taxpayers impacted may be small, the impact on each affected taxpayer was significant.

CARES Act Amendments to Section 461(l)

The CARES Act retroactively removes that impact by providing those taxpayers with refunds for 2018 and 2019, and removes excess business loss limits in 2020.  The Act specifically accomplishes this by:

1. 1. Eliminating “excess business loss” limitations for taxable years 2018, 2019, and 2020;
   2. Clarifying that deductions under Sections 172 and 199A are not taken into account in determining the amount of a taxpayer’s deductions used to calculate its “excess business loss”;
   3. Providing that neither deductions, gross income, nor gains from employee services are included in the excess business loss calculation; and
   4. Adding provisions relating to the application of capital gains and losses in determining a taxpayer’s excess business loss.

Suspension of Excess Business Loss Limitation for Certain Taxable Years

When Section 461(l) was first enacted, it was intended to limit pass-thru “excess business losses” for taxable years 2018 through 2025.  That limit, with no corporate analogue, disproportionately stressed small business owners operating as partnerships and S corporations, and, of course, most limited liability companies (which usually elect partnership or S corporation treatment).

Perhaps acknowledging Section 461(l)’s disproportionate impact on small businesses owners, the CARES Act removes the excess business loss limitation for 2018, 2019, and 2020.  Beginning in 2021, however, the limit springs back into effect and, once again, limits pass-thru loss deductions.

Trade or Business of Being an Employee

As noted in a prior Tax Blog post, one puzzling and unresolved question that stirred debate in tax circles was whether Section 461(l) allowed employees to classify their employment income as “business” income and thereby use pass-thru losses to offset W-2 income without Section 461(l) limits.  The CARES Act ends that debate.

Now, excess business loss calculations “shall be determined without regard to any deductions, gross income, or gains attributable to any trade or business of performing services as an employee.”  In other words, W-2 income is not business income under 461(l), and because the CARES Act is also retroactive (more on that below), perhaps it never was.

Effect of Capital Gains and Losses in Determining Excess Business Losses

There has been equal confusion since Section 461(l)’s enactment regarding whether capital gains and losses earned by a pass-thru business (and passed through to the owner) were taken into account in calculating a taxpayer’s excess business loss.   The CARES Act clears that up too, also retroactively.  Pass-thru capital losses will not be included in a taxpayer’s aggregate deductions for 461(l) calculation purposes.  A business’s capital gains, however, will be included in aggregate business income, but only to the extent of the lesser of (i) the net capital gain income attributable to the taxpayer’s trade or business, or (ii) the taxpayer’s capital gain net income.

Retroactive or Prospective?

Almost every time Congress amends/corrects tax laws, the retroactivity issue arises.  The question becomes:  “will the changes apply as if they were in existence during an earlier tax year, or merely from the date of change forward?”  With the CARES Act’s amendments to Section 461(l), the answer is a definitive “Yes.”

Retroactively, the CARES Act removes all limits on excess business losses for tax years 2018 and 2019.  Prospectively, it does the same for 2020 filings.  Likewise, the amendments regarding W-2/employee income and capital gains and losses apply as if they were originally part of the TCJA, making those changes both retroactive and prospective.

In any event and most importantly, the Act’s retroactive effect provides an avenue for impacted taxpayers to seek refunds for 2018 and 2019.   Additionally, by solving the W-2 income and capital gains controversies-that-never-were, the CARES Act may alter a taxpayer’s prior limitation calculation, which also affects any refund amount.  Finally, when the 2021 tax season comes around, and all of this virus mania is behind us, we might even consider Section 461(l) to be fairly straightforward.