United States

Senate finance plan would limit deductions for 'active' tax losses

Major rewrite of loss rules for entrepreneurs and investors

TAX ALERT  | 

The pending Senate tax reform plan–announced on Nov. 9, 2017–contains an obscure provision that could have dramatic effects on entrpreneurs and investors in small or startup businesses. It could also dramatically affect real estate professionals who deduct active real estate losses against active real estate professional income.

The details are still not entirely clear because no legislative text has been revealed. However, leading experts have concluded that the proposal appears to put a new limitation on ‘active’ losses. That would include losses allowable against active income under the special rules for real estate professionals. It would also apparently include losses that are freed-up upon the complete disposition of a passive investment.

Simply put, those losses could no longer be deducted–except for a threshold amount–against salaries, fee income, pension income, investment income or passive investment income. In effect, an active loss from one business could only be deducted against active income from another business. This ‘basketing’ could be compared to the rules for capital losses, which can only be deducted against capital gains.

The threshold amounts are $500,000 for a married couple or $250,000 for single individuals. Although unused losses could be carried forward, they could never be used against more than 90 percent of taxable income. Most importantly, if past practice is any guide, there is no assurance that these threshold amounts would last; once the precedent is set Congress could easily remove them and disallow all active losses against active income other than active business income. An example may be helpful to illustrate how the provision might work:

Sam and Mary are engineers at a technology company, both making $1 million each. Mary wants to quit and start a new business where she will work full time. She will receive some pension or severance income, and has income from some investments. Sam will also work at night, spending 500 hours in the new venture. In addition to losing Mary's salary, Sam and Mary will incur real, cash losses for salaries paid to new employees. Even though they are considered ‘active’ in the business, those losses cannot be deducted against Sam's $1 million salary, Mary's pension or severance pay, or Mary's investment income–except for a very limited annual threshold amount of $500,000.  Moreover, in considering whether to take this risky career leap–there is no telling if and when Congress will eliminate even that threshold.

In addition, they try to raise funds from another couple with similar salaries, but who will be passive investors. They are okay with deferring any losses, until they are told that if they dispose of the business, they will not be able to deduct their losses against their salaries, except to the extent of the threshold amounts. In addition, there is no telling when Congress will eliminate those ‘threshold’ amounts. This is a significant ‘red flag’ to their potential investment in the business.

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