California business owners expecting substantial tax losses in 2026 face an important difference between federal and state tax law. The California Franchise Tax Board has confirmed that the state's excess business loss threshold is $320,000 for individual filers and $640,000 for married taxpayers filing jointly. The corresponding federal limits are only $256,000 and $512,000.
That difference can affect how much of a business loss is deductible in 2026, particularly for individuals who receive significant W-2 wages, investment income, or other income alongside losses from a partnership, S corporation, or sole proprietorship.
The difference does not end with the dollar thresholds. Federal and California law also treat disallowed business losses differently in subsequent years, creating separate carryforward calculations.
Understanding those differences is an important part of proactive tax planning for California business owners, especially before committing to transactions intended to accelerate deductions.
Key takeaway:
For married taxpayers filing jointly in 2026, the federal excess business loss threshold is $512,000, while California allows $640,000. However, these thresholds apply only after other relevant loss limitations are considered. A larger California threshold does not necessarily mean the taxpayer will have a larger California deduction.
What Is an Excess Business Loss?
Internal Revenue Code Section 461(l) limits the amount of net business losses that certain taxpayers other than corporations can deduct in a single taxable year.
An excess business loss generally arises when a taxpayer's aggregate trade or business deductions exceed aggregate trade or business income and gains by more than the applicable annual threshold.
The limitation is calculated at the taxpayer level rather than separately for each individual partnership, S corporation, or business activity.
For example, an individual may receive substantial wages from employment while reporting a significant loss from an active business. The business loss may be otherwise deductible, but Section 461(l) can restrict how much of that loss reduces current year taxable income.
W-2 wages earned as an employee are not treated as trade or business income for purposes of increasing the Section 461(l) threshold.
The rule also applies independently of several other limitations. A loss must first survive any applicable basis, at risk, and passive activity restrictions before being considered in the excess business loss calculation.
Federal and California Excess Business Loss Limits for 2026
The IRS established the federal 2026 thresholds in Revenue Procedure 2025-32, Section 4.31. California confirmed its separate 2026 amounts in the November 2026 edition of FTB Tax News.
| Filing status | Federal 2026 threshold | California 2026 threshold | California difference |
|---|---|---|---|
| Single | $256,000 | $320,000 | $64,000 higher |
| Married filing separately | $256,000 | $320,000 | $64,000 higher |
| Married filing jointly | $512,000 | $640,000 | $128,000 higher |
The California joint threshold also applies to qualifying married or registered domestic partner taxpayers filing jointly under the state's rules.
These amounts determine the maximum net business loss that may escape the excess business loss limitation. They do not override other limitations or create an automatic deduction.
Why Did the Federal Threshold Decrease in 2026?
For 2025, the federal threshold was $313,000 for individual filers and $626,000 for married taxpayers filing jointly.
Those figures decreased to $256,000 and $512,000 for 2026 because Congress changed the statutory inflation adjustment rules in the One Big Beautiful Bill Act, Public Law 119-21.
The legislation reset the inflation calculation using 2024 as the base year. The change to the inflation calculation applies to taxable years beginning after December 31, 2025.
The same legislation also made the federal excess business loss limitation permanent, with that extension applying beginning with taxable years after December 31, 2026.
California did not adopt these federal changes and continues to calculate its thresholds under its own conformity provisions.
Example: A California Business Owner With a $900,000 Loss
Assume a married California couple filing jointly has substantial W-2 income and an otherwise deductible $900,000 net loss from an actively operated business during 2026.
For simplicity, assume the loss is identical for federal and California purposes, there are no other trade or business income items, and all applicable basis, at risk, and passive activity limitations have already been satisfied. Also assume there are no prior year loss carryovers.
| Calculation | Federal | California |
|---|---|---|
| Net business loss before Section 461(l) | $900,000 | $900,000 |
| 2026 threshold | $512,000 | $640,000 |
| Loss permitted under this limitation | $512,000 | $640,000 |
| Disallowed current year excess business loss | $388,000 | $260,000 |
In this simplified example, California permits $128,000 more of the business loss to escape the excess business loss limitation in 2026.
That does not automatically translate into a particular tax savings amount. The actual benefit depends on the taxpayer's other taxable income, applicable deductions, state adjustments, and future use of the disallowed losses.
The two disallowed amounts also become different types of carryforwards for federal and California purposes.
Federal and California Loss Carryforwards Work Differently
The distinction between current year loss limitations is only part of the analysis.
Federal Excess Business Losses Become NOL Carryforwards
Under IRC Section 461(l)(2), a federal excess business loss disallowed for the current taxable year is treated as a net operating loss carryover to the following taxable year.
The carryover is then subject to the applicable provisions of IRC Section 172.
For net operating losses arising in taxable years beginning after December 31, 2017, the federal NOL deduction generally cannot exceed 80% of taxable income computed under the applicable rules, although special statutory exceptions may apply.
Therefore, the $388,000 federal disallowed loss in the example does not automatically become a $388,000 deduction in 2027.
Its use depends on future taxable income and the applicable NOL limitations.
California Retains a Separate Excess Business Loss Carryover
California Revenue and Taxation Code Section 17560.5 modifies federal Section 461(l).
Instead of converting a disallowed excess business loss into an NOL under Section 172, California generally treats the disallowed amount as an excess business loss carryover.
The carryover enters the California excess business loss calculation in the following taxable year under the state's modified rules.
As a result, the timing of future deductions can differ substantially between the two systems.
For the example above, the taxpayer would begin with a $388,000 federal NOL carryover attributable to the excess business loss and a separate $260,000 California excess business loss carryover, before considering other items and adjustments.
Those balances must be maintained independently because the federal NOL rules and California excess business loss carryover rules are not interchangeable.
Business Losses Must Pass Other Limitations First
Section 461(l) is not the first limitation applied when determining whether a business loss is currently deductible.
For a shareholder of an S corporation, the relevant analysis generally begins with stock and debt basis under IRC Section 1366(d), followed by applicable at risk and passive activity limitations.
For a partner, the outside basis rules under IRC Section 704(d), the at risk rules, and the passive activity rules must also be considered.
Only losses that remain allowable after those limitations are generally considered in the Section 461(l) computation.
A taxpayer should therefore avoid assuming that a large Schedule K-1 loss automatically qualifies as a currently deductible business loss up to the annual threshold.
Rental Property Losses Require Special Attention
Rental real estate losses are generally passive under Section 469 unless an applicable exception applies.
A large depreciation deduction generated through cost segregation may therefore produce a suspended passive loss rather than an immediately deductible loss.
The excess business loss limitation does not override those restrictions.
For a more detailed explanation, see how suspended passive rental losses become deductible.
California Depreciation Differences Can Change the Entire Calculation
The larger California excess business loss threshold does not mean that California will necessarily allow a larger current year business deduction.
California does not conform to the federal 100% bonus depreciation provisions under IRC Section 168(k).
A business that purchases qualifying equipment may receive a substantial federal depreciation deduction while being required to depreciate the same property over a longer period for California purposes.
Consequently, the starting amount of the business loss may be different before the federal and California Section 461(l) thresholds are applied.
For example, a business could generate a significant federal tax loss through bonus depreciation but report substantially less depreciation and therefore less of a loss for California purposes.
For more information, see my discussion of IRS Notice 2026-11 and the restoration of 100% federal bonus depreciation.
The broader California conformity differences are discussed in California Tax Conformity After SB 711 and SB 1435.
A proper year end projection should calculate the federal and California business income or loss separately before applying the respective excess business loss limitations.
What Does SB 1435 Change for California Business Losses?
California Senate Bill 1435, enacted September 14, 2026, clarified the state's treatment of certain federal Section 461(l) amendments.
In particular, California Revenue and Taxation Code Section 17560.5 addresses the treatment of deductions and income attributable to services performed as an employee.
The distinction matters because W-2 compensation is not treated as business income for the purpose of determining the excess business loss limitation.
A taxpayer with substantial employee wages and losses from an unrelated business cannot increase the permitted business loss threshold merely by adding those wages to trade or business income.
SB 1435 also preserves California's separate approach to excess business loss carryovers.
The legislation's applicable amendments generally reach taxable years beginning on or after January 1, 2025.
Therefore, affected taxpayers should consider the enacted California conformity provisions when reviewing both 2025 returns and 2026 projections.
Reporting the Excess Business Loss on Federal and California Returns
The federal excess business loss calculation is generally performed using IRS Form 461, Limitation on Business Losses.
California uses Form FTB 3461, California Limitation on Business Losses, to determine the state adjustment and track excess business loss amounts.
For California individual returns, the resulting adjustments generally flow through Schedule CA (540) or Schedule CA (540NR), as applicable.
Because the federal and state limitations differ, preparers should not simply transfer the federal Form 461 adjustment to the California return without performing the separate California computation.
The same principle applies to prior year carryovers. A federal NOL schedule does not replace the California excess business loss carryover records.
The FTB has confirmed its 2026 limits in Tax News and indicated that the amounts will be included in future indexing memorandum publications. The final 2026 form instructions should be checked when the returns are prepared.
If your business expects a significant 2026 loss, Schedule a Consultation to review the federal and California treatment before final year end planning decisions are made.
Planning Considerations Before December 31, 2026
Business owners anticipating substantial deductions should evaluate both the current year and future year consequences.
- Project business income and losses separately: Determine the amounts attributable to each activity and distinguish business items from wages and portfolio income.
- Apply limitations in the correct order: Review partner or shareholder basis, at risk exposure, and passive activity rules before Section 461(l).
- Model federal and California depreciation: Accelerated federal deductions may not produce comparable California losses.
- Review loss carryovers: Identify existing federal NOLs and California excess business loss carryovers.
- Evaluate the timing of transactions: Equipment acquisitions, business sales, and other income or deduction events can affect the business loss computation.
- Coordinate estimated taxes: Federal and California current year deductions may differ, producing materially different tax liabilities.
- Maintain separate supporting schedules: Federal Form 461 and California Form FTB 3461 calculations should reconcile to their respective returns and carryforward records.
For business owners expecting losses near the applicable thresholds, a relatively small change in income or deductions may affect the amount carried into future years.
Planning should focus on the overall tax benefit rather than simply maximizing current year deductions on one return.
Final Takeaway
The California Franchise Tax Board's confirmation of the 2026 excess business loss thresholds reinforces an important distinction between federal and California tax law.
For married taxpayers filing jointly, the federal threshold is $512,000, while California's threshold is $640,000.
However, the calculation is more complex than comparing two dollar amounts. California may recognize different business income and deductions, applies separate conformity provisions, and retains excess business losses as carryovers under its own modified Section 461(l) framework.
Taxpayers with substantial partnership, S corporation, sole proprietorship, or other qualifying business losses should evaluate both systems before relying on an anticipated deduction to offset other income.
See current federal rates on the Economic Dashboard.
