461(l): The Internal Revenue Code Section No One Knows About—But Should

The Tax Cuts and Jobs Act of 2017 (“TCJA”) added new Section 461(l) to the Internal Revenue Code (the “Code”).  This new Code section limits the ability of noncorporate taxpayers, including individuals and “pass-thru” business entities (e.g., partnerships and S corporations), to deduct business losses against nonbusiness income.  This new rule works together with the passive activity loss limitation rules of Code Section 469.

In particular, Section 461(l) denies noncorporate taxpayers a deduction for “excess business losses.”  An “excess business loss” is defined as the excess deductions of a taxpayer from all trades or businesses over any gain from the taxpayer’s trades or businesses plus $250,000 (or $500,000 if a joint return is filed).  For partnerships, S corporations, and other “pass-thru” business entities, the loss limitation is applied at the shareholder/partner level and not the entity level.

One of the main issues involving new Section 461(l) concerns whether an employee can be in the trade or business of “being an employee” and thereby allowed to apply or offset gains or losses generated by the taxpayer (or taxpayer’s spouse) from such services to gains/losses in another trade or business of taxpayer. Let’s consider an example.  Mark is an individual who is married and will file a joint tax return.  Mark is a CPA and an employee in an accounting firm.  The accounting firm pays Mark an annual salary and then bonuses at year-end.  Linda, Mark’s spouse, operates an organic kale farm at their home as a sole proprietor.  Unfortunately, Linda is not much of a farmer and the farm incurs losses.  Thus, Mark and Linda have a loss from Linda’s farming activity and income from Mark’s job as a CPA.  As adopted by Congress, 461(l) would allow Mark and Linda to offset Mark’s income from his trade or business of performing services as an employee against Linda’s loss from her farming activity.

The Joint Committee of Taxation (“JCT”) and the House Ways and Means Committee does not like the result from our above example.  On December 20, 2018, the JCT published its 2018 “Bluebook” explaining the effect of the TCJA.  In it, the JCT interpreted new Section 461(l), stating “an excess business loss . . . does not take into account gross income, or gains or deductions attributable to the trade or business of performing services as an employee.”  The JCT’s interpretation here is not supported by the language of Section 461(l), and is nowhere found in the legislative history of Section 461(l).  In footnote 209 of its 2018 Bluebook, the JCT notes that a “technical correction” to Section 461(l) may be necessary in order to exclude employee services as a trade or business.

Most recently, on January 2, 2019, then-Chairman of the Ways and Means Committee Kevin Brady issued a proposed “discussion draft” of the “Tax Technical and Clerical Corrections Act.”  Contained in this discussion draft was an amendment that would codify the JCT’s view that 461(l) should not include income or gain from the trade or business of performing services as an employee.  The amendments to 461(l) proposed in the discussion draft would be retroactive to the date the TCJA was enacted.

Taxpayers, and their tax advisors, may certainly be confused now, with language in new 461(l) implying that employees may be engaged in a trade or business of providing services, and where their related income may be allowed against losses otherwise incurred in other trade or business activities.  The JCT takes a contrary view, however, and there appears to be support for the JCT view in Congress.  Stay tuned – there will certainly be more to come now concerning this important tax issue!

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