The Inflation Reduction Act, which was passed on Sunday, included a restriction on a tax credit for some pass-through firms made by Senate Democrats.
A business that discloses its income on the owners’ tax returns is referred to as a pass-through or flow-through business. Their individual income tax rates are applied to such income. S-corporations, some limited liability companies, partnerships, and sole proprietorships are all examples of pass-through entities.
According to tax experts, the Democrats’ proposal — a bundle of historic climate-related, tax, and health-care reforms — restricts the ability of pass-throughs to use large paper losses to write off expenses like salaries and interest.
This cap, referred to as the Limitation on Excess Business Losses, is already in effect. The ban would be continued for an additional two years under the revised bill, instead of ending in 2027 as originally planned. The Senate Democrats’ first draft of the bill did not include such extension, but it was included during the subsequent negotiation and amendment process.
Along party lines, the Inflation Reduction Act was approved and will now go to the House.
Rich real estate owners probably suffered the most
The pass-through restriction was first introduced by Republicans in the 2017 tax law known as the Tax Cuts and Jobs Act.
The statute specifically prohibits pass-through owners from deducting non-business income from business losses that exceed $250,000. The statute set a ceiling of $500,000 for a married couple filing a joint tax return; that amount threshold only applies to single taxpayers.
Due to an inflation adjustment, those limitations will be higher in 2022: $270,000 and $540,000, respectively.
“The business losses can only offset other business income, not salaries and interest and investment gains,” a senior fellow at the Urban-Brookings Tax Policy Center, Steve Rosenthal, said of the proposal.
According to Rosenthal, the limitations impacted “rich guys” who, for instance, used business losses as tax deductions against bonuses, salaries, and investment income.
The restrictions may theoretically be applied to any pass-through company that consistently posts a sizable operating deficit. However, according to Jeffrey Levine, a certified financial planner and certified public accountant located in St. Louis, the real estate industry is probably one of the most negatively impacted. This is because real estate enterprises are able to continually accrue significant losses on paper by abusing the regulations surrounding depreciation.
“It’s a really big deal for uber-wealthy people with a ton of real estate, and then the occasional business that loses a ton of money every year,” Levine, who serves as the company’s chief planning officer, said.
The pass-through restriction and the other features of the Republican tax plan that applied to individual taxpayers were initially set to expire after 2025.
Democrats did, however, add a year to the cap in the American Rescue Plan, which President Biden approved as law in 2021. According to the Joint Committee on Taxation, the one-year extension would generate nearly $31 billion in revenue.
According to Rosenthal, the subsequent extension of the Inflation Reduction Act would probably generate an equivalent amount of revenue every year.
The business losses don’t necessarily go away, though. If Congress doesn’t further extend the cap, owners could be able to defer the tax benefits to subsequent years.
“The losses almost always get claimed later,” Rosenthal said.