We regularly receive questions from individuals asking why a loss reported on a Schedule K-1 received was not deducted on their tax return. Typically, this occurs because there are four separate loss limitations that must be met before a loss can be deducted on the return: 1) tax basis, 2) at-risk basis, 3) passive activity loss rules, and 4) excess business loss rules. Individuals that invest in flow-through entities and receive a Schedule K-1 from a partnership, LLC, or S-corporation should speak with their CPAs so they are aware of these rules and their impact on their taxes.

Tax Basis Limitations

Losses that exceed the investor’s tax basis in the flow-through entity are disallowed and carried forward indefinitely for as long as the investor remains an owner in the flow-through entity. Tax basis is the amount of money or property that a taxpayer has invested in the entity, increased by the investor’s distributive share of income, and decreased by the distributive share of losses, non-deductible expenses, and distributions. Tax basis also includes an investor’s allocable share of liabilities reported on the Schedule K-1 for investments in partnerships or LLCs.

For example, an investor contributes $100,000 to an LLC for an ownership interest. During the year, the investor is allocated a tax loss of $120,000, primarily due to depreciation deductions. Without any allocation of liabilities, under the tax basis test, the investor can only deduct $100,000 of the loss in the current year. The remaining $20,000 will be carried forward to future years to offset income or gains from that property.

If there is an allocation of liabilities of $200,000 the investor’s tax basis after the loss would be as follows:

Initial contribution               $100,000
Liability allocation               $200,000
Loss allocation                   ($120,000)
Tax basis                               $180,000

Thus, the liability allocation allows the investor to fully deduct the losses under the first test, tax basis.

At-Risk Basis Limitations

The at-risk basis is the amount of money that a taxpayer has at risk in a business venture. In a partnership, this includes money that has been invested in the business, as well as any liabilities allocated to the investor that are qualified non-recourse or recourse. Generally speaking, qualified non-recourse liabilities are available to entities that finance real property from a third-party bank and recourse liabilities are those that the taxpayer is personally liable for.

For example, an investor contributes $50,000 into an LLC that does not hold real property. The LLC borrows an additional $50,000, which is not personally guaranteed, to finance the venture. If the LLC incurs losses of $100,000 in the first year, the investor can deduct $50,000 of the losses under the at-risk basis limitation test. If the LLC holds real property and the $50,000 loan was deemed qualified non-recourse debt, the investor would be allowed to deduct the full $100,000 in the first year under the at-risk basis limitation test. Likewise, if the investor personally guaranteed the loan, the debt would be considered recourse and the full $100,000 could be deducted under the at-risk basis limitation test.

The rules are a bit different for S-corporations. In an S-corporation, at-risk basis includes money that has been invested in the business, as well as loans made to the S-corporation directly by the shareholder.

The at-risk basis limitation is designed to prevent taxpayers from deducting losses that exceed the amount of money they have at risk in a business.

Passive Activity Loss Limitations

A passive activity is a business or rental activity in which the taxpayer does not materially participate. Passive activity losses can only be used to offset passive activity income. If the taxpayer has no passive activity income, the losses can be carried forward to future years and used to offset future passive activity income or gains.
The passive activity loss limitation is designed to prevent taxpayers from using losses from passive activities to offset income from active business ventures or investments.

For example, an investor owns a rental property that generates a loss of $10,000 during the year. The investor also operates a business where they actively participate that generates $100,000 in income. The rental loss, which is treated as a passive activity loss, cannot offset the income of the business that the investor actively participates in. If the investor has other passive activity income during the year, that income could be used to offset the passive activity loss income form the rental.

Excess Business Loss Limitations

The excess business loss limitation applies to non-corporate taxpayers (such as individuals, S-corporations, partnerships, and LLCs) who have losses from business activities that exceed a certain threshold. The excess business loss limitations are applied at the partner level. For tax years beginning in 2023, the threshold is $289,000 for single taxpayers and $578,000 for married taxpayers filing jointly. If the taxpayer’s losses exceed the threshold, the excess losses are not currently deductible and must be carried forward as a net-operating loss in future years. The excess business loss limitation is designed to prevent high-income taxpayers from using losses from non-business activities to offset income from profitable businesses.

Loss Limitations Test Examples

Let’s walk through an example analysis of the four tests.

Jamie, a single individual, invests $500,000 in a property management business in which she actively participates. In addition, the business takes out a $100,000 loan, which is personally guaranteed by Jamie. The business also has accounts payable of $25,000 at year end. During the first year of business, there was a loss of $300,000.

Initial contribution                $500,000
Nonrecourse liability            $25,000
Recourse liability                  $100,000
Loss allocation                    ($300,000)
Basis                                      $325,000

Under the tax basis limitation test, the full $300,000 is deductible because the ending tax basis is positive at $325,000.

The at-risk basis does not include the nonrecourse liability of $25,000 since Jamie has not personally guaranteed the accounts payable liability. Thus, the at-risk basis is:

Initial contribution               $500,000
Recourse liability                 $100,000
Loss allocation                    ($300,000)
At-Risk Basis                        $300,000

Under the at-risk basis limitation test, the full $300,000 is deductible because the ending at-risk basis is positive.

Jamie actively participates in the property management business and thus the loss is considered non-passive and fully deductible under passive activity loss limitations.

In addition to the activity from the property management business, Jamie also has capital gain from the sale of stock of $300,000. Before considering the excess business loss limitations test, Jamie’s adjusted taxable income is $0 ($300,000 capital gain less the $300,000 loss from business). However, under the excess business loss limitation test, Jamie is allowed to deduct $289,000 of the loss in 2023. The remaining $11,000 is treated as a net-operating loss in 2024. Thus, Jamie’s adjusted taxable income in 2023 is $11,000 ($300,000 capital gain less the $289,000 business loss).

Conclusion

Loss limitations can be complex, and taxpayers may need the assistance of a tax professional to ensure they are calculating and deducting their losses correctly. By understanding the different types of loss limitations, taxpayers can minimize their tax liability and maximize their deductions. If you have questions regarding loss limitations, send us an email and we’d be happy to consult with you.

© Clark Nuber PS, 2023. All Rights Reserved

This article contains general information only and should not be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.