Tom Nichols, a shareholder at Milwaukee’s Meissner Tierney Fisher & Nichols and a longtime S-Corp advisor, is out with a great piece in Tax Notes that takes aim at the poorly-crafted Section 461(l) excess business loss limitation. “A Problematic Solution to a Nonexistent Problem” breaks down the provision, its real-world consequences, and the flawed policy rationale that led to its inception.
Prior to the Tax Cuts and Jobs Act, active pass-through business losses were used by owners to offset wages, investment income, and other business income. This treatment reflected the basic principle that income taxes should be paid on an accurate accounting of a taxpayer’s net income.
Section 461(l) flipped that principle on its ear by capping the amount of active losses that can be deducted in a given year, requiring any excess to be treated as net operating losses in subsequent years. As many have learned (particularly in the wake of the pandemic), this change can cause real and lasting harm. Here’s Tom’s example:
Suppose a wealthy entrepreneur owns a manufacturing business that is temporarily struggling and throwing off accounting and tax losses of $2 million per year. Suppose that same entrepreneur also has $3 million of investment income, perhaps from past earnings of that same business, and she is willing to use that investment income to keep the business alive…
In the absence of section 461(l)… she would have $1 million of taxable income, pay tax of $370,000 (at 37 percent), and still have $630,000 left over to spend or invest for the benefit of her own family, even after using $2 million of that investment income to keep the business alive. Enter section 461(l). If the entrepreneur is married, “only” $1.5 million of that loss from the ongoing business would be disallowed, thereby increasing the couple’s federal income tax by $555,000, for a total of $925,000, leaving the family with only $75,000 of real, after-tax income.
The excess loss limitation applies to pass-throughs only – consolidated groups organized under a C corporation face no such restriction when offsetting active losses with other streams of income. Why the disparate treatment?
Is there something fundamentally wrong with wealthy entrepreneurs using their investment income to fund the jobs and operations of businesses that are losing money? I don’t think so either, but that’s the “loophole” that section 461(l) is designed to close.
…Ever since section 461(l) was enacted, I have made numerous inquiries of Treasury, the IRS, the Joint Committee on Taxation, legislative staff, and other legal, accounting, and other tax professionals regarding the policy rationale behind this provision. I have yet to hear or read of anyone trying to defend this provision on policy grounds, much less a principled defense.
Section 461(l) was a clear revenue grab, but its ability to raise revenue was wildly overstated:
[T]he revenue projection for this new provision should have been small and reflect nothing more than a one- or two-year delay in the ability of business owners to recognize their losses. But that’s not what the initial revenue estimates by the JCT predicted. The JCT predicted that new section 461(I) would increase tax receipts by $9.5 billion in the first year and by amounts ranging from $16.2 billion to $20.4 billion annually for the next eight years. That stellar tax projection, totaling $149.7 billion for the entire 10-year budget window, presented a revenue offset that was apparently too big for Congress to resist when it enacted the Tax Cuts and Jobs Act.
S-Corp has critiqued these estimates since their inception, particularly as the provision has been repeatedly trotted out to offset unrelated spending. We were proven correct last year when revised estimates reduced the projected revenue by a factor of eight or ten. But by that time, Section 461(l) had already been extended twice, all with the promise of billions in new revenue that never existed.
Section 461(l) violates the rules of good tax policy, there is no rational for its existence, and it fails to raise significant amounts of revenue. It does, however, handicap family-owned businesses when times are tough by forcing them to pay tax on nonexistent income.
As Tom concludes, “Section 461(l) is bad policy and a poor revenue raiser. Congress should repeal it.”