As part of the on-going Tax Team process in the House, the S Corporation Association today submitted comments focused on the Section 461(l) Excess Loss Limitation provision created by the Tax Cuts and Jobs Act (TCJA). This provision targeted pass-through businesses solely and has been the subject of much controversy, most particularly due to the wildly inaccurate scoring that accompanied the provision’s consideration by Congress.

S-Corp has been critical of Section 461(l) from its inception, both as a response to its lack of a solid policy justification – what problem was it trying to solve? — and to its hugely inflated revenue estimates.  On the policy front, the comments note:

The excess business loss provision is a dramatic departure from general tax policy principles that active losses can be applied to active income.  In the corporate context, generally related companies may elect to file a return that consolidates all the businesses together and nets income and loss.  Section 461(l) introduces a substantial new tax burden on small and closely-held business owners—in direct contradiction to Congress’ broad goal of supporting small business.

What makes the new loss limitation even more perplexing is that it serves no useful policy purpose. Instead, Section 461(l)’s excess-business-loss limitation violates a foundational income tax precept by preventing a taxpayer from netting all of the costs of producing income against gross receipts. In so doing, the new rule causes such a taxpayer to be taxed on an amount greater than their income. Indeed, in some cases, it requires a taxpayer to pay federal income tax even though the taxpayer incurs a loss for the year.  This accelerates negative economic impacts and slows economic recovery by delaying loss deductions at least a year.

The comments also review the scoring issue tied to Section 461(l), and how errant revenue estimates resulted in two misguided but successful efforts to extend the policy beyond its original 2026 sunset:

Under IRC §461(l), as enacted in the TCJA and amended by the CARES Act, for tax years beginning after 2020 and before 2029, an “excess business loss” from a trade or business of a noncorporate taxpayer cannot be deducted in the current year. This limitation does not apply to C Corporations, which are generally allowed to net losses against income broadly.  However, any disallowed excess business loss is treated as a net operating loss (NOL) carryover. In TCJA, the provision was scored as raising $149.7B/10 years. 

The excess business loss provision was originally enacted in the TCJA, then delayed by the CARES Act until 2021.  The original expiration was extended twice, first by one year in ARPA ($31.008B/10 years JCT score), then again in the Inflation Reduction Act (IRA) for two additional years ($52.759B/10 years JCT score).  As a result, the provision no longer aligns with the expiration of most of the individual tax provisions in TCJA.  The JCT recently scored extending the provision through 2034 as raising only $21.837B/10 years – though only six years of the extension are in the window.  Note the dramatically reduced revenue estimate as compared to the original or two extensions.  Given the fact the excess losses become NOLs, that reduction seems more reasonable and the original scores appear to have far exceeded the actual revenues.

The letter closes with three recommendations for fixing this policy – proactively repeal the Section entirely, allow it to sunset as scheduled starting in 2029, or, failing those, mitigate its harm by allowing capital gains invested back into the business to be netted out against any losses.

Next year’s fiscal cliff will force Congress to make many difficult decisions both large and small.  The Excess Loss provision is one of the issues – it is poorly conceived policy largely driven by errant revenue estimates. Congress should take a hard look at this provision next year and fix it.

Click here to download a copy of the letter