January 2nd, 2025

Congress, Repeal Section 461(l).

The new Trump Administration, flanked by a thin majority of members in both the House and in the Senate, has promised that Congress will extend the favorable tax provisions that were otherwise scheduled to expire at the end of 2025 under the Tax Cuts and Jobs Act of 2017 (“TCJA 2017”), P.L. 115-97 (12/23/2017). Presumably, this extension of parts of the TCJA 2017 will be part of a budget reconciliation bill which requires only a 51-member majority vote of the Senate (and majority vote of the House). Presumably the TCJA 2017 extenders will be further extended for another eight-to-ten year period, or, alternatively, perhaps a few provisions will be made permanent. Deficit reduction is most likely first on the Republican leadership’s radar.

With tax legislation clearly on the immediate horizon, Congress should re-examine a draconian, revenue-raising provision that found its way into the TCJA 2017 without receiving a loud chorus of "boos" from the professional community let alone various leaders in affected business sectors, such as owners of small businesses, particularly those operated in partnership form. The provision in question is Section 461(l). Section 461(l) limits a non-corporate taxpayer's ability to deduct losses, including economic losses not generated by cost recovery allowances. The Section 461(l) "penalty" provision expires on December 31, 2026. The Biden Administration wanted it to be made permanent. See August, "The "No-Look, Just Pass It" Legislation to Prevent Abuse of Partnerships by Wealthy Investors and Mega-Corporations to Avoid Paying Tax", Corporate Taxation (WG&L) (Sept/Oct 2021).

Loss Limitation Rules: An Overview

There are several if not more loss limitation rules in the Code that apply to individuals conducting business in a pass-through entity, such as a partnership or S corporation, or as a sole proprietor. There is the passive activity loss limitation provision contained in Section 469. There also is the at-risk provision in Section 465. Yet another limitation applies to the deductibility of interest, such as investment income expense limitation and the excess business interest rule. In order to get to these rules of limitation, a shareholder in an S corporation or a partner in a partnership must first climb over the outside basis hurdle under Section 1366(d) (S corporation shareholders) or Section 704(d) (partners in a partnership). There are more limitations to consider including the idea that you can’t expense that which must be capitalized and further assuming as capitalized such expenditure is not amortizable or can be immediately expensed as a cost recovery allowance.

What's Unfair About The Section 461(l) Loss Limitation Rule?

The Tax Cuts and Jobs Act of 2017 went well beyond these limitations when Congress enacted Section 461(1). It provides those taxable years beginning after 2017, and before 2026, an “excess business loss” of a taxpayer other than a corporation is not allowed for the taxable year. The disallowed excess business loss is treated as a net operating loss (“NOL’’) for the taxable year for purposes of determining any NOL carryover to subsequent taxable years. A business loss for this purpose is: (i) the sum of otherwise allowable deductions for the tax year attributable to trades or businesses of the taxpayer; less (ii) all gross income or gain for the year attributable to such trades or businesses. Deductions for NOL carryovers or carrybacks and the deduction allowed under Section 199A are not taken into account. The provision applies after application of the passive loss limitation rules and all other rules of limitation or capitalization mentioned in the preceding paragraph. Moreover, tax items attributable to a trade or business of performing services as an employee are disregarded. A business loss, as computed, is an “excess business loss” and is non-deductible where it exceeds $250,000 ($500,000 for joint returns) as adjusted for inflation.

This provision received strong criticism right out of the box. This revenue raiser provision surgically inserted into the TCJA 2017 was “scored” to raise almost $150 billion over 10 years. The Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136 extended effective date of Section 461(l), in general, from 2021 through taxable years beginning before 2029. Note again that Section 461(l) applies after application of the “basis triathlon” of the outside basis rules for partners in partnerships under Section 704(d), shareholders owning stock (and debt) under Section 1366(d), the at-risk rules under Section 465 and the passive activity loss rules in Section 469. Don’t forget the 80% NOL carryover limitation that applies once the Section 461(l) “excess” is converted into business loss in each succeeding year.

Section 461(l) is just bad tax policy. While deductions granted are a matter of legislative grace by act of Congress, in reality Section 461(l) can, as a matter of economic reality, impose income tax on “gross receipts” for a taxpayer actively engaged in business which generate an operating loss in excess of the threshold amount for which the taxpayer is otherwise not subject to any other limitation that Congress did not previously prescribe. The idea of disallowing business losses to non-corporate taxpayers of a substantial amount whereas corporate taxpayers are not subject to such limitation is Congress’ “hidden ball trick” that seeks to obtain approval from entrepreneurs and investors, but fails to be convincing. It needs to be repealed whether or not Section 199A is extended.