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Tax Tip of the Week | New Tough Tax Rules for Business Losses March 4, 2020

Posted by bradstreetblogger in : 2019 Taxes, Business consulting, Deductions, General, tax changes, Tax Planning Tips, Tax Preparation, Tax Rules, Tax Tip, Taxes, Uncategorized , add a comment

March 4, 2020

Some businesses are very profitable, others are not – many businesses exist somewhere in the middle. Until recently, a Net Operating Loss (NOL) could be carried back two (2) years and the remainder forward for twenty (20) years (all within various limitations). Things have changed. For the vast majority of businesses, NOLs may only be carried forward without a sunset provision. BUT and there always is a BUT with the tax law – NOLs may not exceed certain amounts and percentages.  This is explained in greater detail below:
                                -Mark Bradstreet

Okay, you’re not in business to lose money but it can happen from time to time. The tax law has new rules in store for you when it comes to writing off business losses in 2018 and beyond. These rules make it more difficult to use losses to save taxes.

Net operating loss

Essentially, a net operating loss arises when the amount of a current business loss is greater than what can be used in the current year (i.e., greater than taxable income), and it becomes a net operating loss (NOL). (Technical rules apply to make an NOL more complicated than this.)

When and how the NOL is used has been changed by the Tax Cuts and Jobs Act.

•    NOLs arising prior to 2018. Generally these NOLs can be carried back for 2 years (there are some special rules for certain situations and an option to waive the carry-back) and forward for up to 20 years. The NOLs can offset up to 100% of taxable income.
•    NOLs arising in 2018 and beyond. No carry-back is allowed (other than for certain farming losses and losses of property and casualty insurance companies), but there’s an unlimited carry-forward. However, the NOL can only offset up to 80% of taxable income.

Record-keeping. If you have a carry-forward of a pre-2018 NOL, be sure to keep track of it separately from newer ones so you can use it as a 100% offset going forward. NOLs are taken into account in the order in which they are generated, so that old NOLs are used before newer ones. This rule hasn’t changed.

Non-corporate excess business losses

If you own a pass-through entity—sole proprietorship, partnership, S corporation, or limited liability company—the rules for writing off your losses have changed dramatically. Until now, if you had $1 million in revenue and $1.6 million in expenses, the $600,000 loss passed through to you would be deductible on your return (limited by your basis in the business).

Now there’s an important change in the treatment of losses. Instead of being currently deductible, excess business losses are characterized as net operating losses that must be carried forward.

What is a non-corporate excess business loss?This is the excess of business deductions for the year over the sum of (1) gross income or gain from the business, plus (2) $250,000 for singles or $500,000 for joint filers (with these dollar amounts adjusted for inflation after 2018).

So continuing the example I started earlier, under the new loss limit, instead deducting $600,000 in 2018, assuming you’re single, you’d only be able to write off $350,000 ($1.6 million – [$1 million + $250,000]). The balance of the loss–$250,000—is treated as a net operating loss that becomes deductible in 2019 to the extent permissible (explained earlier).

For owners of partnerships and S corporations, the limit is applied at the owner level, based on the owner’s distributive share of business income and expenses.

The excess business loss limit applies after applying the passive activity loss limit. The excess business loss limit is effective from 2018 through 2025.

Conclusion

To sum it up, when you’re doing well, the government is your partner by sharing in your good fortune via taxes. But when you aren’t doing well, the government doesn’t want to know you anymore. The Tax Cuts and Jobs Act rewards profitable businesses by lowering the taxes to be paid on profits. But this same law essentially penalizes unprofitable businesses by imposing limits on utilizing losses. In the past, for example, if you had an NOL, you could carry it back to generate an immediate cash refund that could be ploughed into the business. In effect, a loss could be turned into a gain. No longer.

Perhaps the lesson here is: Be profitable. Take the steps you need to ensure this—cut expenses, raise prices, etc. And work with your tax advisor to see what other measures can be used to keep you in the black.

Credit given to – Barbara Weltman

Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.  

Today’s author – Mark Bradstreet

– until next week.

Unraveling Conflicting Tax Rules for Active vs. Passive Income February 26, 2020

Posted by bradstreetblogger in : 2019 Taxes, Business consulting, General, Tax Rules, Tax Tip, Taxes, Taxes, Uncategorized , add a comment

February 26, 2020

Few topics in the office cause more arguments than the tax definition of active versus passive.  The answer affects your income taxes vastly more than one would ever guess.  And, not in just one area of tax but often involving a multitude of seemingly unrelated areas.  At times, both parties in our office scuffles will have written evidence to support each of their opposing views.  Taxes have many shades of gray.

                            -Mark Bradstreet

It is commonly accepted wisdom that tax rules are complicated. This belief is well supported by the conflicting tax rules that apply to business owners, depending on their participation in the business. Let me try to make some sense of these conflicting rules.

Overview

Business owners may be active in their business. This means they are hands-on and are involved in day-to-day activities. Other business owners may be mere investors, adding their capital but not their labor. The following are various rules that take into account whether owners do or do not work in their businesses.

Qualified business income deduction

The 20% deduction for qualified business income (QBI) applies to owners of pass-through entities. There is no requirement that they do or do not participate in the daily operations of the business in order to claim this personal deduction based on their share of business income. If they participate (e.g., they are an S corporation shareholder who receives a salary), this factors into the QBI determination. For example, salary to an S corporation shareholder is not an item allowed in determining QBI, but the salary does count as wages for purposes of W-2 wages used in the formula for the QBI deduction.

Net investment income deduction

The 3.8% net investment income (NII) tax depends entirely on an owner’s participation in the business. Only income from a business in which the taxpayer does not materially participate is treated as investment income and potentially subject to the NII tax. The determination of material participation is made using the passive activity loss rules (below).

Passive activity loss rules

Under the passive activity loss rules, losses from a business activity in which an owner does not materially participate, and has no passive income, are not currently deductible (sorry for the double negative but it’s the best way to explain this limitation). Suspended losses can be carried forward and used to offset passive activity income in the future.

The determination of whether an owner is passive or active is based on 7 tests. An owner is treated as materially participating (i.e., active) and is exempt from the passive activity loss rules if he or she meets any of these tests:

1.    The owner participated in the activity for more than 500 hours.
2.    The owner’s participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
3.    The owner participated in the activity for more than 100 hours during the tax year, and he or she participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
4.    The activity is a significant participation activity, and the owner participated in all significant participation activities for more than 500 hours (i.e., participation for more than 100 hours during the year and in which the owner didn’t materially participate under any of the material participation tests).
5.    The owner materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
6.    The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
7.    Based on all the facts and circumstances, the owner participated in the activity on a regular, continuous, and substantial basis during the year.

Note: When it comes to rental real estate activities and the passive activity loss rules, an owner’s participation doesn’t entitle him or her to claim losses. Owners of rental real estate activities can escape the passive activity loss rules only by demonstrating that they are real estate professionals (part of the definition of a real estate professional is based on material participation).

Self-employment tax

Sole proprietors pay self-employment tax on their net self-employment income. This is so whether they run their business or are totally in the background, relying on a full-time manager to handle the business.

General partners are subject to self-employment tax on their distributive share of self-employment income, plus any guaranteed payments. In contrast, limited partners are exempt from self-employment tax (other than for any guaranteed payments they receive for personal services rendered for the partnership).

Members in limited liability companies may or may not be subject to self-employment tax. There is no firm IRS guidance on this matter. However, tax professionals have argued that where members are mere investors (i.e., they act like limited partners), they should be treated like limited partners who are exempt from self-employment tax on their distributive shares.

Bottom line

Whether you sweat each day in your endeavors or are an investor who watches the books determines the tax rules that apply to you. Discuss your status with your CPA or other tax advisor.

Credit given to:Barbara Weltman

Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.  

Today’s author – Mark Bradstreet

–until next week.