Many business owners structure their companies as S corporations or limited liability companies...
Limitations on Pass-Through Losses from S-Corporations
An S corporation’s tax items generally pass through to shareholders on a pro rata basis and are reportable by S corporation shareholders in the shareholder’s taxable year in which the S corporation’s year ends. These items are subject to the various limitations applicable to individual taxpayers, such as those on interest expense, charitable contributions, and miscellaneous itemized deductions.
In addition, three other rules, discussed below, may limit the amount of losses and deductions that may be deducted: the stock and debt basis rules, the at-risk rules, and the passive loss rules.
The basis rules apply to all S corporation shareholders. A taxpayer cannot take S corporation losses and deductions on their return to the extent they exceed the sum of their stock and debt basis in the corporation. Losses and deductions in excess of this aggregate amount are suspended and carried forward indefinitely until the basis limitations allow them to deduct them.
If the taxpayer has sufficient basis to take the losses and deductions, they must then determine whether their ability to utilize these items is restricted by the at-risk rules. If the corporation holds real property, the at-risk rules apply to the activity of holding that real estate. While these rules are quite intricate, the general rule is that losses or deductions from the activity to which the rules apply in excess of their amount at risk are carried over until their amount at risk increases sufficiently.
The amount at risk consists of, and is increased by, the following:
• The amount of personal funds and the adjusted basis of property contributed by the shareholder to the activity;
• Amounts the shareholder borrows for use in the activity, so long as they are personally liable for repayment or pledge property as security for the loan;
• Income from the activity; and
• Certain nonrecourse financing.
The amount at risk is decreased by the following:
• Repayment of the corporation’s debt to the shareholder (but only to the extent of their adjusted basis in the debt);
• Distributions of money and property, to the extent of its adjusted basis, to them from the activity; and
• Losses and deductions passed through and allowed as a deduction under the basis rules and at-risk rules.
The passive loss rules also apply to any activity in which a taxpayer does not materially participate, as well as to most rental activities. Generally, losses from passive activities can be offset only against income from passive activities. An individual, however, annually may use up to $25,000 of passive activity losses to offset nonpassive income attributable to all rental real estate activities in which the individual actively participated during the year. This amount is phased out for taxpayers over a certain income bracket. Also, rental real estate activities in which an individual materially participates, and meets certain other eligibility requirements, are excepted from the passive loss rules altogether.
A taxpayer cannot deduct a passive activity loss which is in excess of the aggregate losses and deductions from all of the taxpayer’s passive activities for the year over the aggregate income from all passive activities for the year. A similar rule applies to passive activity credits. Passive losses and credits are carried over to the next year but may only offset passive income or tax attributable to passive activities.
When the shareholder’s interest in the passive activity is disposed of in a fully taxable transaction to an unrelated party, any suspended passive activity losses attributable to the activity are recognized and available to offset any other income.
Finally, for tax years beginning after December 31, 2017, taxpayers other than C corporations are not allowed to deduct excess business loss. An excess business loss for the tax year is the excess of aggregate deductions of the taxpayer attributable to trades or businesses of the taxpayer, over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount ($500,000 for married taxpayers filing jointly; $250,000 for all other taxpayers). In other words, the deduction for an overall net business loss is limited to $250,000 ($500,000 in the case of a joint return). The threshold amounts are indexed for inflation after 2018. Instead, the taxpayer carries forward excess business loss and treats the losses carried forward as part of its net operating loss (NOL) carryforward in succeeding taxable years.
The excess business loss limitation is applied at the S corporation shareholder level, and for purposes of applying the limitation, an S corporation shareholder will take into account its allocable share of entity income, loss, gain and deduction from trades or businesses attributable to the S corporation in its tax year within which the tax year of the S corporation ends.
These rules are fairly complex; please reach out to a member of our team if you have further questions.