A new rule imposed by the 2017 tax law could prove troublesome for businesses and their owners — as well as the broader economy — in the next recession.
The tax law changed provisions around "net operating loss," a part of the tax code that allows businesses to offset the taxes they pay on their profits with losses they incur during another tax year.
The concept, similar to tax-loss harvesting, offers businesses a tax refund in a year they incur losses. It therefore helps even out profitable and unprofitable years from a tax standpoint.
However, new net-operating-loss rules will likely adversely affect businesses — both pass-through entities and C corporations — and exacerbate the next recession, tax experts said.
"You can call it a recession bomb," said Leon LaBrecque, a financial adviser at Sequoia Financial Group.
Some companies have built up enormous net operating losses. Amazon, for example, had federal and state net-operating-loss carry-forwards of $627 million and $919 million, respectively, at yearend 2018 that it could use to offset future U.S. income tax, according to a securities filing.
New rules under the tax law signed by President Donald J. Trump in December 2017 offer a double whammy: The law eliminated the ability to carry losses back to previous tax years, and it only allows a carry-forward deduction to offset 80% of taxable income.
For example, a business can't use a $100 loss incurred this year to offset profits from 2018. And if the business has a $100 profit in 2020, it can only offset 80% of those profits — meaning it would still pay tax on $20 of profit.
There are two silver linings, however. The company's remaining 20% loss could be carried forward into future years — in this example, to offset profits in 2021 and beyond — and any losses can be carried forward indefinitely, rather than just for 20 years.
"It's a very dramatic difference," Mr. LaBrecque said of the new rules. "It's almost like an extra tax."
The Joint Committee on Taxation estimates the changes to the NOL deduction will raise $201.1 billion for the federal government through 2027.
By allowing businesses to deduct their current losses against past profits, the old rules provided economic help for struggling businesses via an immediate cash infusion, said Steven Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center.
"That softens the blow to the direness of that [situation]," he said.
However, in a future recessionary environment when companies are suffering from widespread losses, they must wait for a year of profits to get a cash infusion, Mr. Rosenthal said, and that infusion will be smaller.
'It's money you don't have in your pocket that you can't put back into your business," said Robert Keebler, founder of accounting and tax advisory firm Keebler & Associates.
This dynamic could prove troublesome in the near term. Economic forecasters polled in June by the National Association for Business Economics said they saw a 60% chance of a recession hitting by the end of 2020.
"We'll go into a recession one of these days, probably sooner rather than later," said Mr. LaBrecque, adding that financial advisers and taxpayers are overlooking the likely repercussions from NOL rules.
The tax law also amended rules related to "active loss limits," which could exacerbate the problem during a recession, tax experts said.
The old rules allowed owners of pass-through businesses to deduct "active" business losses against income from "passive" sources, such as salary or investment income. ("Active" means, for example, that the owner materially participates in the business.) This reduces the tax from passive income sources. For example, a pass-through owner could previously use $750,000 in losses one year to offset $2 million of portfolio income — thereby only paying tax on $1.25 million.
The tax law amended the rules so that only active losses up to $500,000 (for married couples filing jointly) can be deducted against passive income.