The Tax Cut and Jobs Act (TCJA) of 2017 changed the landscape for how business owners calculate and pay their income taxes. Old rules for deducting losses went away, while new ones allow for comparable deductions through an entirely new tax structure.
Understanding your tax obligation under the new guidelines confuses and confounds even the savviest entrepreneur, so this is not intended to provide tax advice. It’s to help you understand why it’s so important to have a tax reform attorney advising you.
Although the TCJA was billed to taxpayers as a reform to a policy that would streamline and simplify your tax returns, many entrepreneurs are finding the opposite to be true.
While the basic principles of the new rules are simple and straightforward, it remains a hugely complicated process that is full of “if-then, therefore” scenarios that lead straight to your tax attorney’s office.
Yes, it’s helpful that the IRS has everything online and it’s all easily searchable, but unless you are a CPA or tax attorney it’s deep in the details and difficult to interpret exactly what the rules are–it seems like there’s always a subsection to trip you up and ruin your day.
Defining Tax Reform Terms, IRS Style
Before we get too deep in the weeds, let’s make sure you’re familiar with some of the IRS terminology–understanding the vernacular goes a long way towards really grasping why you’re not getting the deductions you’re used to.
And because this is the IRS, the rules always apply, with some subsection exceptions, unless they don’t (farm exemptions are a good example). We are all waiting for the day when all the subsections and exemptions of a particular rule totally wipe out the original ruling.
Is My Business Small Impacted by Tax Reform?
If you aren’t sure, the answer is most likely yes. Per the Small Business Administration (SBA), the threshold for qualifying as a small business is 500 employees.
Pass-Through Business Structures
How your company is legally structured determines whether you can use business losses to offset personal income—can your losses “pass-through” your business to your personal tax return.
The primary consideration for whether you can offset your business losses on your personal returns is how your company is legally structured. There are four kinds of entities the IRS recognizes as pass-through entities.
- Sole proprietors and single-owner LLCs calculate their business taxes on Schedule C of the owner’s personal 1040.
- Multiple-member LLCs and partnerships calculate business taxes on a partnership return, typically a K1 form. Income passes through to individual partners. The partners in these organizations may be expected to contribute towards operating expenses for the company. These contributions are proportional and the ensuing deductions are equally proportional to the investment share.
- S Corporations calculate their taxes on Form 1120S, as income passes through to each owner.
Some trusts and estates are considered pass-through entities for tax purposes, check with your tax attorney to determine if yours falls into this category.
C Corporations are legal entities on their own and file a completely separate return with the IRS. They pay their taxes out of the corporate kitty; shareholders are not expected to chip in for expenses. One of the disadvantages of creating a C Corp is that the income is doubly taxed–the company pays taxes on corporate income, and are taxed as capital gains for the shareholders.
Most states will recognize the pass-through profits and losses from S Corps, but some do not. States with no income tax will apportion taxes due based on the amount of business you do in that state. Suppose you have an Etsy online business for SEC merchandise and 10% of your sales are in Florida and 15% are in Tennessee. Your taxes would be predicated on the comparable amount of business you do in those states. These small but important details are among the many reasons you should have an ongoing relationship with a tax attorney.
Qualified Business Income
Broadly speaking, Qualified Business Income (QBI) is the “the net amount of qualified items of income, gain, deduction and loss with respect to any trade or business”–your overall net profit. QBI deductions may also be referred to as Section 199A.
Specified Service Trades or Business
Some professions or industries, Specified Service Trade or Business ((SSTB) are subject to further limitations if taxable income exceeds the threshold amount. Deductions are reduced proportionally by excess taxable income.
Net Operating Loss
You have a Net Operating Loss (NOL) when your losses exceed your total income from all sources for the year. This situation is more common in the first year or two of running a business. An NOL can lessen your tax liabilities for not only the current year but going forward into future tax years.
Excess Loss Limitation
Caps the deductible loss for a given year.
TCJA Changes for Offsetting Losses
It’s no secret that the TCJA mostly benefitted huge, publicly-traded corporations. Under the Act, C Corporations (organizations that are recognized as legal entities under the law and pay their own taxes) saw their tax rate plummet from a graduated 35% rate to a flat 21%.
Congress felt compelled to sweeten the pot somewhat for pass-through businesses, so they came up with the QBI, or Section 199A deduction. Prior to the TCJA, business owners in the highest tax bracket were paying at a 37% rate; with QBI the effective rate has dropped to 29.6%.
These rules apply through the 2025 tax year.
The QB IDeduction Is A Double-Edged Sword
At first glance, the QBI deduction is a boon for most businesses. Prior to the TCJA, you could carry a net operating loss back to two prior years (by filing an amended return) and claim unlimited business losses, but your effective tax rate remained the same. The QBI deduction can lower your tax liability by 20%, but only if you meet certain thresholds.
If your total taxable income for 2019 was less than $160,700 (single filer) or $321,400 when married filing jointly, you may be eligible. Going into 2020, the limits are $163,300/$326,600. There will be more incremental increases until 2025.
This is where the SSTB comes into play. Higher-earning professions–doctors, attorneys, consultants, entrepreneurs–fall into this “special service” category and exceed the income limits. If you’re single and your adjusted gross income (AGI)–your taxable income–is greater than $210,700, or $421,400 for joint filers, the QBI deduction may disappear, unless you meet other IRS criteria.
Excess Loss Limits
If you’re just getting your business off the ground or you had a bad year, chances are good that you’re showing a loss for 2019. Given the current uncertainty in the economy, developing strategies to manage a down year in 2020 is a good idea, even if you showed a profit this year.
The IRS ruling on claiming losses is the following:
The amount by which the total deductions from all trades or businesses exceed a taxpayer’s total gross income and gains from those trades or businesses, plus $250,000, or $500,000 for a joint return
In layman’s terms, you can’t claim any loss greater than $250,000/$500,000 for the year (IRS Form 461). Excess loss is now considered NOL and is determined by calculating your net business loss (NOL) from normal business operations using IRS rules. NOL may be carried forward and can offset up to 80% of taxable income in future years. Prior to figuring your NOL, there are two additional rules to consider:
- At-risk rules
- Passive activity rules
The IRS has dozens of publications online to help you get a grasp of the rules that apply to you. IRS Publication 925 details the NOL rules, and IRS Publication 536 has more details about carryovers.
Real-Life Examples of Deducting Losses
Here are some examples of how you can deduct losses. One thing that might be of interest is that multi-million dollar businesses aren’t necessarily C corporations, so if your business is heading into that revenue range you don’t have to change your organization.
Graham is a gourmet grocery retailer. His business is set up as a single-owner LLC, so he files his business returns on Schedule C of the joint personal 1040 he files with his wife.
His aggregate income for the year was $800,000. He invested in a second location this year, and his expenses were $1million. His total loss was $200,000. Since the loss was less than $500,000, he can take the entire $200,000 deduction.
Let’s assume that for the next tax year, 2020, Graham invests in a third location, and his NOL is $625,000 which exceeds the $500,000 threshold by $125,000. In the simplest terms, Graham takes the half-million deductions in 2020 and carries over the additional $125,000 for 2021.
Frieda and three of her friends have an organic vegetable farm. They have structured the company as an S Corporation, and income passes through to the individual owners.
Frieda And Friends Fine Organic Carrots had an income of $60,000 this year, and a NOL of $70,000. Frieda’s share of the income is $15,000 and her portion of the loss is $17,500, for a personal NOL of $2500.
Her husband’s W2 income for the year is $120,000 and they file a joint return. Since their aggregate income for the year is less than $321,400, they can claim the full loss of $2500 on their return.
Eliza is a stylist–a consultant–and is a Sole Proprietor, so she files a Schedule C. She is single. Her income for the year was $95,000, and her losses were $110,000. Her deductible loss is $15,000. Note that she is a consultant, and falls into the SSTB category. But since her income is below the $160,700 maximum, she can write off the entire loss this year.
Develop Strategies to Manage Loss Limits
Economic downturns are a basic part of life. The US economy has been expanding for over a decade and small businesses have really been a driving part of this engine. Sure, there have been blips and occasional market swings that set off alarm bells, but we haven’t seen anything like the present situation since the Great Depression.
As an entrepreneur, you need to be on top of all the aspects of your company and have a plan in place for all the foreseeable possibilities.
This includes meeting with your tax advisors and financial planner to develop these strategies, especially if it looks like you may be subject to lose limits. Watch expenditures closely, monitor trends, and be ready for any curveball the economy throws your way. Knowing that you’re in for a bumpy ride lets you take advantage of some tax strategies now, rather than getting an unpleasant surprise in a year.
Here’s a for-instance scenario. You have two options for “expensing” equipment and other capital investments. You can use the Section 179 deduction or the 100% “bonus” depreciation to write off the costs incurred with an investment if you’re not at risk for exceeding your loss limit.
On the other hand, if you’re skating close to the edge of excess, you can use regular depreciation to spread out the deductions over several years and minimize your current loss. IRS Publication 946 explains these methods in greater detail.
IRS Filing Deadline Extensions for 2019 Tax Reform
On March 17, 2020, the US Treasury Department extended the 2020 filing deadlines to accommodate the repercussions of Covid-19. Since most business owners file extensions until October anyway this may not have any real bearing on your deadlines. If you owe money for 2019 you have a 90-day extension for the deadline to pay your taxes, up to $1 million in tax liability.
Get the Professional Help You Need
In the current economic environment, you need an experienced tax attorney more than ever before. The changes in the tax rules brought about by the TCJA, combined with business uncertainty in all sectors of the economy, demand expertise not only with IRS rules and regulations but with the underlying legal implications, too.
Call Silver Tax Group for a review of your tax obligations and advice in future tax strategies anytime.