How will a lesser-known rule in the Tax Cuts and Jobs Act of 2017 affect wealthy flow-through business owners? The new limitation on loss deductions might be worth an Q4 discussion with a tax professional.
In the past, losses from an LLC or partnership could offset personal income. For taxable years from December 31, 2017 until January 1, 2026, noncorporate taxpayers will only be able to deduct aggregate losses from a trade or business up to $500,000 for married filing joint or $250,000 for others.
Startup entrepreneurs and real estate investors beware
This change brings in more revenue to offset marginal rate cuts granted to individuals and corporations. For owners who count on loss deductions to maintain personal solvency, it is going to be necessary to plan ahead though.
An example illustrates the potentially drastic effect of the rule change. A real estate developer may earn $8 million of income from non-real estate ventures, but lose $6 million as a residential development project languishes.
In the past, the full $6 million could be offset against the $8 million earnings, leaving a taxable income of $2 million. The new limit caps out at $500,000/$250,000 depending on filing status. In our example, the difference is tax on $7.5 million versus $2 million of income. This could cause serious liquidity issues and letters from IRS collections.
The Act still does allow for carry forward losses to future years, but they cannot exceed 80 percent of income. These losses therefore would never completely zero out federal tax liability.
Adjusting to the new rules will require planning as we near the end of 2018. Do not wait until April and a surprise tax bill that you cannot pay. Penalties and interest can quickly add up and the IRS has serious collection tools including liens, levies and passport denial.