California Enacts its Version of Limitation on Business Losses for Non-Corporate Taxpayers
As many in California already know, the State does not conform automatically to new Federal tax legislation, including the Tax Cuts and Jobs Act enacted on December 22, 2017 (“TCJA”). Instead, any conforming changes must be enacted by the California legislature. On July 1, 2019, California Governor Gavin Newsom (D) signed Assembly Bill 91 “Loophole Closure and Small Business and Working Families Tax Relief Act of 2019” (“AB 91”). That legislation selectively conforms to some of the provisions of the TCJA.
One of those provisions, which California has modified significantly, limits deductions by individual taxpayers for excess business losses.[1]
On the Federal level, IRC §461(l), enacted as part of the TCJA, provides that from 2018 and until 2026, individual taxpayers’ business losses can offset up to only a certain amount of non-business income. Those limits initially were set at $500,000 for married taxpayers filing jointly and $250,000 for single filers and adjusted for inflation annually. Any business losses that are disallowed in a given year are recharacterized as net operating losses (“NOLs”) which can be carried forward to future tax years and offset at that time up to 80% of any type of income, business or non-business. For instance, if a taxpayer has enough business or non-business income in the immediately following tax year, the main effect of IRC 461(l) will be to shift the deduction for business losses in excess of the applicable amounts ($500,000/$250,000, as adjusted for inflation) to the next tax year but capped at 80% of the taxpayer’s income in that year.
Example: In 2019, a married taxpayer has $2,000,000 of business losses from a business activity in which the taxpayer materially participates and $2,000,000 of non-business income. Prior to the TCJA, the business losses generally would have fully offset the non-business income, leaving the taxpayer with zero income and no tax liability for the year. However, under IRC §461(l), the taxpayer can use up to only $500,000 (as adjusted for inflation) of his business losses to offset the non-business income. The disallowed portion of the business losses (ignoring the inflation adjustment for 2019, that portion would be: $2,000,000 – $500,000 = $1,500,000) will be carried forward to the next tax year as NOLs, and could offset up to 80% of the taxpayer’s business and non-business income in 2020 and in future tax years. For instance, if the taxpayer has $1,500,000 of income (business or non-business) in 2020, $1,200,00 (80% x $1,500,000) of that income could be offset by these NOLs, and the taxpayer’s Federal taxable income for 2020 would be reduced to $300,000.
California’s version of the deduction limitation on excess business losses operates in a more unforgiving way than IRC §461(l).[2] First, unlike the Federal provisions that will expire in 2026, California’s amendments are permanent. Second, unlike the Federal tax treatment, in California, the disallowed portion of the business losses will not become NOLs which could offset business and non-business income in future tax years. Instead, that disallowed portion will retain its character as an excess business loss and again will be treated as such in those future tax years. In other words, if in future tax years the taxpayer does not have enough business income, the disallowed portion will again be subject to the limits ($500,000/$250,000, as adjusted for inflation) when offsetting the taxpayer’s non-business income. Thus, in the example above, if in 2020 all of the taxpayer’s $1,500,000 is non-business income, the taxpayer would only be able to offset $500,000 (as adjusted for inflation in 2020) against that non-business income, leaving the taxpayer with $1,500,000 – $500,00 = $1,000,000 (again, ignoring the inflation adjustments) of income which will be taxed in California, whereas the taxpayer’s Federal taxable income for the same year would be only $300,000. Therefore, the main effect of California’s modifications is a longer deferral period for the utilization of large business losses for taxpayers with non-business income, as compared to the Federal approach.
Two additional points merit attention. Currently, it is not clear whether wages are business or non-business income under IRC §461(l). If they constitute business income, they can be freely offset by business losses, and if not, they would fall under the applicable limitations for non-business income, as described above. Without any further guidance, a more cautious view consistent with the declared intent of this statute would be that wages are non-business income under IRC §461(l). It is also unclear under that section whether gains on the sale of interests in pass-through entities (e.g., S corporation stock) that are engaged in an active trade or business and in which the seller has actively participated constitute business or non-business income. A better view is that such gains should constitute business income under IRC §461(l). However, given California’s narrower, not taxpayer-friendly approach to modifying this Federal law, it would not be surprising if California at some point in time concludes that wages and gains from the sale of interests in pass-through entities are all non-business income under California’s new version of the business loss limitation rules.
Individuals and other non-corporate taxpayers, who in the same tax year have both business losses and income that could be characterized as non-businesses, may not be able to fully offset their losses against that income, especially for California tax purposes. That could result in higher taxes. In that case, proactive tax planning would be advisable prior to a taxpayer’s recognizing non-business income or a business loss. Our Tax Group can always help with practical and creative tax planning that takes into account our clients’ specific circumstances. For further information, contact Coblentz Tax attorney Jeff Bernstein (jbernstein@coblentzlaw.com).
[1] This limitation applies not just to individual taxpayers but also to other non-corporate taxpayers (e.g., non-grantor trusts, estates, and tax-exempt organizations).
[2] See Section 17560.5(b) of the CA Revenue and Taxation Code, as amended by Section 13 of AB 91.