There are a number of mysteries embedded in the House reconciliation bill, but number one among those is why the House is taking tax advice from former Speaker Nancy Pelosi.
Buried in the House bill is a provision championed by the former Speaker to treat the active losses of a pass-through worse than any other type of loss. The provision targets family businesses and would effectively preclude many of them from ever realizing these losses. Here’s why the Senate should reject this ill-advised provision.
Background: Prior to the Tax Cuts and Jobs Act (TCJA), taxpayers with active business losses could use them to offset wages, investment income, and other active business income, consistent with the principle that our income tax should tax the net annual income of taxpayers.
Section 461(l) of the TCJA abandoned this concept, requiring active business losses exceeding a certain threshold to be carried forward as a net operating loss. Subject to certain limits, the taxpayer would then recognize those losses in the following year or two. Not a big deal for those with temporary losses, but for owners of start-ups or for businesses experiencing longer downturns (like a pandemic, for example), that delay could turn into permanent harm. As we wrote last fall:
[S}ection 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 Nancy Pelosi Provision: Now the House wants to make this ill-advised policy even more restrictive. The House-passed provision doesn’t just extend current policy — it further restricts excess losses under Section 461(l). Then-Speaker Pelosi first proposed this expansion as part of the Build Back Better Act back in 2021. As we noted at the time:
As damaging as making permanent the onerous EBL limitation rule would be, H.R. 5376 also includes modifications that, if enacted, would double down on that damage. By further restricting the use of all active business losses for passthrough entities within a new category of active business losses, these modifications carry the potential effect of permanently disallowing losses that result from ordinary and necessary trade or business expenses. In so doing, the proposed modifications undermine the fundamental tax accounting principle of matching expenses and revenue. To cap it off, active business losses would be treated more adversely than passive activity losses.
Fortunately for family businesses, the BBB failed and the Nancy Pelosi tax hike died with it. Now the Senate has an opportunity to stand up for family businesses and kill this provision, again.
Examples of Harm: During the Tax Teams process, S-Corp submitted comments in opposition to Section 461(l), including examples of how the existing law harms family businesses. Here are two examples:
Start-Up: Most start-ups do not attract outside money – they are financed directly by the entrepreneur. For start-up owners who sold investment assets to finance their startup, Section 461(l) can preclude them from netting out the start-up’s losses against any ordinary gains they realized from the sales. This imbalance can – and does – result in the business owner owing taxes in years where they lost money!
Pandemic Sales and Losses: A second obvious case is where a family sold investment assets to keep an existing business afloat during tough times. Under the current proposal, if family investment assets are utilized to ensure the business remains operational, the loss recognized by the business will be capped while any gains might be subject to additional tax. This family is now responsible for paying taxes on income it doesn’t have.
No Dispensation Provision: The Nancy Pelosi Tax Hike does not include the ability to recognize excess losses upon a sale. Business losses generated on the sale of a business would not be able to be recognized but instead be capped each year. Therefore, even though a true financial loss has occurred, taxpayers would still be subject to taxation. This provision would treat active business losses worse than passive losses as, even under the Passive Activity Rules, when the passive activity is completely disposed of all losses are released.
More Scoring Issues: Those familiar with Section 461(l) will recall the JCT has a record of getting the revenue estimates of this provision spectacularly wrong. Those inflated estimates helped drive the policy initially and explain how section 461(l) became the only tax hike in the 2021 American Rescue Plan. We covered that history here.
The new provision continues the JCT’s tradition of failure. The Nancy Pelosi Tax Hike was originally scored to raise $9 billion over ten years. It was later revised, with no explanation, so the same proposal now raised three times as much — $27 billion.
Bottom Line: The goal of the reconciliation bill is to help families and Main Street businesses, not raise their taxes. The Excess Loss Limitation should be repealed, not expanded. It was a poorly thought-out policy in 2017, and it is even worse now.