Originally published on Forbes.com.
It’s a pretty slick move to work a special interest tax break into a revenue raiser, but it looks like that is what the Senate managed with the new limitation on excess business losses. At first I thought the new rule (Act Section 11012 on page 46) was meant to put an end to sketchy tax shelters, but on closer examination it seems that it continues the Tax Cuts and Jobs Act (TCJA) preference for the rich or middling business owners as opposed to their salaried brothers and sisters. And there is a break for subsidy farmers. That was pretty slick because the whole section shows up as gaining $149.7 billion.
The tax increase part of Section 11012 of TCJA adds Code Section 461(l) to the Internal Revenue Code (IRC), which on its face is taking another stab at tax sheltering.
About The Tax Shelter Forever War
If you are an individual, there are two ways to dramatically cut your taxes. One way is to keep accretions of wealth from ever showing up on Page 1 of 1040. That’s the Warren Buffett way. The other is to post a large negative number somewhere in the computations feeding into Line 22 on Page 1 of Form 1040. Much of tax history is about people finding clever ways to post those negative numbers, sometimes called tax shelters, and legislation and regulation and audits and case law thwarting them – or not. Tax shelters are like zombies. It only looks like they have been killed.
Instead of killing those zombies, there is a series of hoops they have to jump through to splat that big negative number on your return. There were five hoops, which I describe in some detail here. You have to be able to say with a straight face that you were trying to make money and have the IRS or the court believe you. The loss has to actually be your loss not that of the non-resident Irish leprechaun that you partnered with. You have to have basis (I explain that here. Don’t get me started.) You have to be “at-risk”. And then there is Code Section 469, the oxymoronic passive activity loss rules. (When those rules came out in TRA 1986, Lu Gauthier of the Boston Tax Institute started handing out applications to tractor trailor driving school to CPAs who came to his seminars.)
The Latest Zombie Killer
And now there is 461(l) which is not going to stop too many zombies. If there is a whole horde of them that made it through the first five hoops, it should carve some off. Excess business losses are deferred and treated as net operating loss carryovers (which now will only be able to wipe out 90% of a subsequent years income). The Conference report explains excess business losses this way:
An excess business loss for the taxable year is the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer (determined without regard to the limitation of the provision), over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount. The threshold amount for a taxable year is $250,000 (or twice the otherwise applicable threshold amount in the case of a joint return). The threshold amount is indexed for inflation.
Never mind how big your losses are. In order for this rule to affect you, you need to have at least $500,000 in income other than trade or business income. The fellow I am going to make up to illustrate this rule is named Calhoun Cornucopia. He owns five automobile dealerships that his daughters run. He takes a token $100,000 salary from each of them and has flow through income of $2,000,000 from the dealerships, which are S corporations. His true love is farming. And he and Esmeralda (his wife) live on a 5,000 acre operation that is mostly corn. Despite significant subsidy payments Calhoun manages to lose about a million a year on the farm.
Calhoun has won enough hobby loss audits that the IRS has given up on that. The farm is his farm so there is no allocation issue and the losses are funded by his dealership profits so there is no concern about basis or at risk. He keeps good logs of his time and there is no question that he spends more than 500 hours running the farm. So his million-dollar farm loss will jump through all five hoops. And in 2018 the sixth hoop will give him no trouble at all. Because Calhoun does not have any excess business loss at all. For excess business loss purposes, all his trade or business income is lumped together. His trade or business income is net positive thanks to his daughters astutely running the dealerships.
Harder On the Big Salaries
Change the facts just a little. Instead of automobile dealerships, Calhoun was a big-time executive and is getting a $2.5 million a year in deferred compensation. Now he does have an excess business loss of $500,000, the amount by which the loss is over the threshold. That loss is treated as a NOL and if it is a loss year in and year out, he will not get to use it until the law changes. (The change is scheduled but who knows what is going to happen?)
There you see the preference for owners over employees, including even very prosperous employees.
Easier On Subsidy Farmers
But where is the break for subsidy farmers? In adding 461(l), the Act suspends 461(j). Section 469(j) was a hoop that is between at-risk and passive activities, that I ignored in my original analysis. I could say that I ignored it, because it is not generally applicable, but that would be lying. I ignored it because it was not something I knew about. Not a lot of amber waves of grain in Central Massachusetts. Anyway if you are getting any of a variety of agricultural subsidies that our hardy self-reliant farmers might get and like old Calhoun there still manage to lose money farming, 461(j) limits your loss and kicks it into the next year in a manner similar to 469.
The threshold is the greater of $300,000 or the aggregate net farming profits in the last five years. Under 461(j), Calhoun in both of the scenarios above would have $700,000 of his farm loss suspended. So being subject to 461(l) is a somewhat better deal for the salaried Calhoun and a home run for the one with the dealerships.
When I ran this by Lu Gauthier, he wrote back to me that the $500,000 threshold was good enough for him and his clients. So I guess he is not worried about it. I also got a comment from an anonymous source that knows more about farm country than I do. He hadn’t thought about it as a benefit to subsidy farmers. Thinking about 461(l) (the new restriction), he had thought that it would apply to a lot of gentleman farmers and that 461(j) was thereby made redundant. On reflection, he agreed that it could be a benefit in some situations and would not rule out that there had been some clever lobbying going on.
Why The Code Keeps Getting Longer
In another way, this might be more illustrative of the way the forever war against tax shelters is waged. The at-risk rules initially only applied to a limited number of activities such as video and then had their application expanded to pretty much everything other than real estate. So you could view substituting 461(l) for 461(j) in a similar manner. It expands a limitation while easing it on the people it already applies to.
But I’m a cynical bastard and always hope to be the one who uncovers a conspiracy, so I’ll assume they did it on purpose.