Avoid the Net Operating Loss Penalty
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Editor’s note - This article discusses net operating losses in the context of a cattle ranching operation. The new rules do provide more flexibility to agricultural businesses, but all industries now face changes in how net operating losses are allowed.
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Greater emphasis needs to be placed on ranchers’ understanding of the impact of incurring tax losses after the changes to the Net Operating Loss (“NOL”) rules contained in the Tax Cuts and Jobs Act (“TCJA”). Managing the timing of your income and deductions is more important than ever in order to minimize your long-term tax liabilities. This article examines the way to handle a farm NOL and also discusses the changes to the rules for NOLs. A rancher can no longer rely on the NOL carryforward provisions to result in no federal tax liability in a future year. Remember, there has always been a penalty for having a NOL. Therefore, it is important for ranchers to understand the impact of these changes as well as the more burdensome accounting and recordkeeping that accompany the new rules.
The Impact on Ranch NOLs by TCJA
Quick overview under the old tax law, a net operating loss (NOL) was allowed to be carried back five years to offset income reported in that year or any subsequent years if the loss was that large. The rancher could also elect to carry the loss back only two years or elect to carry the loss forward for up to 20 years. A net operating loss carryback could also impact the rancher’s income averaging for subsequent years in a positive way. In addition, a rancher who had received a subsidy from the USDA and/or a loan from the CCC was only able to deduct a loss equal to the greater of $300,000 or the total net income earned from ranching over the last five years. This provision essentially prevented a rancher from carrying back more than a $300,000 loss in many cases.
Under the new law, most taxpayers no longer have the option to carryback a net operating loss (NOL). An exception applies to certain farming losses which still allows a two-year carryback for ranchers. For losses arising in taxable years beginning after Dec. 31, 2017, the net operating loss deduction is limited to 80% of taxable income before the NOL deduction. Therefore, NOLs that are carried back can only offset 80 percent of taxable income. Remember, the carryback exception is only for farm losses. A rancher may have net income from ranching but a large business loss on Schedule C. The rancher may believe they can carry back the overall loss since they are ranching. The answer is no. You can only carry back an actual ranching loss. However, if a rancher had a NOL carry forward from 2017 to 2018, the law continues to allow the rancher to offset 100% of taxable income until the NOL expires or is used up. This is on a first-in first-out basis.
The TCJA made other changes to how ranchers can treat NOLs. For tax years beginning after 2017 and before 2026), the maximum aggregate loss that can be deducted in any one year is now $500,000. The law eliminated the old excess farm loss rule as aforementioned and replaced it with the new provision that a taxpayer adds all of its business income, losses and gains together. If this net number is a loss, then it is limited to $500,000 and the excess is carried forward as part of an NOL.
Remember an excess business loss for a taxable year is the excess of aggregate deductions of the taxpayer attributable to each trades or businesses of the taxpayer (determined without regard to the limitation of the provision), over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount. The NOL carried over from other years may not be used in calculating the NOL for the year in question. In addition, capital losses may not exceed capital gains. Non-business capital losses may not exceed non-business capital gains, even though there may be an excess of business capital gains over business capital losses. These rules are complicated, and your tax adviser should be of help
Example:
Bill operates a ranch and incurs a Schedule F farm loss of $750,000 during 2019. His wife has wage income of $50,000 and no other income. They have capital gains of $20,000 and a capital loss of $30,000. The net business loss for the year is $700,000. (Wages are considered business income at least under the old NOL rules and the $10,000 capital loss is restricted to capital gains.) This net $700,000 loss is greater than $500,000 therefore, Bill can only carry back $500,000 to 2017 and carry forward $200,000 or he can elect to carry forward all $700,000 to 2020. If he elects to carry it back to 2017 where he reported $500,000 of net taxable income. He can only use $400,000 of the loss to offset taxable income. The remaining $100,000 is carried forward to 2018 where he had $250,000 of income and he can reduce his income by the remaining $100,000. The remaining $200,000 of the $700,000 is carried forward to 2020. In some cases, the ability to only offset 80% of taxable income is a good thing since it keeps the lower tax bracket income in place. For 2017, the $100,000 of income not allowed to be offset by the NOL is taxed at 10% or 15% with about $25,000 at 25%.
Remember a NOL has a penalty element. The penalty includes the loss of itemized deduction, at a minimum the standard deduction bracket, and the ability to qualify for some child and earned income credits. In addition, deductions may be lost for, IRA contribution and health insurance costs and it can substantially reduce the benefit of any Section 199A deduction earned the future year of deduction.
Rules to Consider on Carry Forward Losses
In the case of a partnership or S corporation, the TCJA applies the NOL rules at the partner or shareholder level. Each partner’s distributive share and each S corporation shareholder’s pro rata share of items of income, gain, deduction, or loss of the partnership or S corporation are taken into account in applying the limitation under the provision for the taxable year of the partner or S corporation shareholder. This adds complexity to accounting requirements.
A change in one’s marital status adds more complexity. There are additional rules that apply if a taxpayer’s marital status is not the same for all years involved with a NOL carryback/carryforward. Only the spouse who had the loss can claim the NOL deduction. On a joint return, the NOL carryback deduction is limited to the income of the spouse with the loss. The refund for a divorced person claiming a NOL carryback against a joint return with a former spouse cannot be more than the taxpayer’s contribution to taxes paid on the joint return. The tax code sets forth a step-by-step procedure to be used in calculating the portion of joint liability allocated to the taxpayer with the NOL carryback.
Changes in filing status are treated similarly for those who use a mix of married filing joint and married filing single on returns in the carryback or carryforward years.
Note a NOL that has been carried forward is deductible on a decedent’s final income tax return. It cannot be carried over to a decedent’s estate. Also, an NOL of a decedent cannot be carried over to subsequent years by a surviving spouse
Planning Options
Ranchers should have attempted to estimate their taxable income before the end and take actions to create a small income. However, if one overestimated their income post year options are available to reduce the NOL:
Elect out of 100% bonus depreciation on some or all asset classes. Example: take bonus on 15-year property but not on 5- or 7-year property
Use Section 179 to reduce taxable income to appropriate levels to soak up the 10 and 12% tax brackets and standard deduction, etc.
Do not make the de minimis election to expense all assets under $2,500
Elect to capitalize all repairs
Elect to capitalize appropriate costs like fertilizer
Elect to bring some deferred payment contracts into income in the current year if they had the foresight to enter into such contracts
The new tax law continues to add complexity to our tax planning. Ranchers will need to spend even more time before year-end to determine the appropriate amount of taxable income or in certain cases, net operating losses. It won’t be easy to get to the right number.
Just because the farming business loses money doesn't mean that there isn't a tax benefit that can be realized to soften the blow. That's where understanding the NOL rules come into play.
Summary
It is important for ranchers to understand the impact of the changes to the NOL rules. Consideration should be given to the more burdensome accounting and recordkeeping that accompany the new NOL requirements. Remember a NOL has a penalty element and a rancher can no longer rely on the NOL carryforward provisions to result in no federal tax liability in future years. An overall multiyear tax savings can be realized by limiting NOL’s and by proper allocating tax deductions to the years that provide the maximum tax benefits. Be aware that NOL’s may easily be lost by a change in filing status and or death. Your tax adviser may be of help in your quest to minimize your over tax liability over a number of years. Do not leave tax dollars on the table because of lack of planning and making the best long term tax elections.