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08.26.2019   |   Blog Articles, Federal Tax, Income Tax, Tax Law Insights

The Interaction of Section 461(l) and the Passive Activity Loss Rules

Section 461(l) of the Internal Revenue Code (“IRC” or “Code”) provides that a taxpayer other than a C corporation is not allowed to deduct “excess business loss[es]” that arise from the taxpayer’s active trades or businesses.  Any amount disallowed in a taxable year under IRC § 461(l) will be carried forward to subsequent taxable years as a net operating loss under Code § 172.  An “excess business loss” is defined as the excess (if any) of the taxpayer’s aggregate deductions for the taxable year that are attributable to the taxpayer’s trades or business (without regard to the limitation on excess business loss) over the sum of (1) the taxpayer’s aggregate gross income or gain attribute to such trades or businesses, plus (2) $250,00 ($500,000 in the case of a joint return).  Thus, section 461(l) of the Code essentially defines a taxpayer’s excess business loss as the aggregate net loss for the year attributable to the trades or businesses of a taxpayer over $250,000 (of $500,000 if filing jointly).  This would likely include the trade or business of being an employee.

Section 461(l)(6) specifically states that the excess business loss calculations are to occur “after the application of section 469.”  This may appear to be relatively straightforward ordering rule—taxpayers first apply the rules under section 469 and then make the necessary calculations under 461(l).  While there are definitely straightforward cases where the language of the statute and common practice arrive at the same result, there are also situations where the outcome, dictated by the ordering rule of applying 469 then 461(l), becomes less certain.  For example, assume that Gerald is an unmarried CPA who owns and operates his own CPA firm through a single-member LLC.  Gerald’s gross income from his CPA business is $200,000 and associated expenses are $400,000 (further assuming Gerald has the requisite amount at risk and he materially participates in his business).  Gerald decided he needed to start earning some extra money, so he decided to invest in a limited partnership that farms cinnamon basil.  Unfortunately, business is bad because no one knows what to do with cinnamon basil and Gerald is subsequently allocated $200,000 of the partnership’s ordinary business losses.  Finally, in a last ditch effort to make some extra money, Gerald heavily invested in the stock market and received $500,000 of investment income in that year.

The ultimate question is whether the $200,000 loss from the partnership is included in the calculation of Gerald’s excess business loss for that taxable year.  If it is not included, then no part of the loss from his CPA business would be excluded as an excess business loss for that taxable year.  If, however, his allocable share of partnership losses from the cinnamon basil farm is included in the excess business loss calculation, in addition to his net loss from his CPA business, Gerald would have exceeded the amount of losses permitted under 461(l).

From a practical standpoint, if a loss is disallowed under section 469, any deduction or income from that passive activity should not be considered in calculating whether a taxpayer has an excess business loss.  Thus, if section 461(l) is to be applied after the application of the passive activity loss rules, those same passive activity losses should be excluded from the calculation of whether the taxpayer has an excess business loss.  Stated another way, taxpayers should not have to “double count” a loss—first under section 469 and again under 461(l).  Simple, right?  Not so fast.  As practical as that reading may be, the formula used for calculating the amount, if any, of an excess business loss does not expressly limit the “aggregate deductions to a trade or business” and the “aggregate gross income or gain attributable to those trades or businesses” to actives trades or businesses.  Because Congress did not provide such an express limitation in the statute, a literal reading of the 461(l) could require the inclusion of gross income and deductions form a taxpayer’s passive activities in this calculation.  While this position could be supported by 461(l)’s statutory language, it would obviate the general purpose that section 461(l) apply to active business losses.

Another potential issue arises with the interaction of 461(l) and other loss limitation rules—specifically the at-risk rules under section 465.  Notably, Congress did not provide a reference to the at-risk rules under section 465 when it enacted 461(l).  One might conclude that Congress omitted any reference to section 465 because section 465 is to be applied prior to the application of section 469—thereby making any reference to section 465 superfluous.  Looking past Congress’s action (or inaction) to reference section 465, such omission poses an interesting interplay between the two Code sections.  Specifically, when calculating the amount of excess business losses in the current year, does a loss that was disallowed under section 465 get included in the excess business loss calculation?  A cogent argument could be made in support of a position that a loss disallowed by 465 both should and should not be included in the excess business loss calculation.

Since its enactment, 461(l) has proven itself to be a thorny issue for taxpayers.  There appear to be more questions than answers and even less guidance from Congress and Treasury.

This issue and many others under section 461(l) are discussed more in-depth by Professor Steven Hodaszy in the forthcoming issue of the Tax Lawyer titled The Curious Case of Section 461(l): Why This Unclear and Unwise New Rule Should Be Construed as Narrowly as Possible.

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