Business Owners: Beware of the Limits on Deducting Losses

Even successful businesses occasionally incur losses. Start-ups and expanding businesses often have unprofitable years, and unexpected events like pandemics can knock companies that have been financially healthy for years for a temporary loop.

One potential upside is the ability to deduct such losses, thereby reducing taxes. However, business loss deductions are subject to several limitations.

Outside Basis Limits for Partnerships and S Corporations

First, a taxpayer's deduction for losses from a partnership or S corporation can't exceed the extent of the owner's adjusted tax basis in the entity. (For a detailed explanation of the tax basis, contact your CPA.) However, losses that exceed the adjusted tax basis can be carried forward indefinitely and applied as the taxpayer's basis allows.

A partner's basis is determined by his or her tax basis capital account, an adjusted basis of property contributed, and changes in the partner's share of liabilities. Additional contributions or shares of partnership liability increase basis, as do increases in the partner's share of taxable and nontaxable income.

For S corporations, a shareholder's basis equals the shareholder's stock and debt basis. The stock basis is increased by contributions and income and reduced by distributions. Debt basis is limited to loans from the shareholder to the corporation and doesn't include indebtedness guaranteed by a shareholder.

The outside basis limits must be applied before evaluating the at-risk rules to determine the extent of your deduction for a tax year.

At-Risk Rules

Under Internal Revenue Code Section 465, taxpayers can't claim a business loss deduction for more than their stake in the business. This is basically what you're "at risk" of losing at the close of the tax year when the loss happened before the current-year loss is applied. Any excess loss is carried forward until it can be applied. A taxpayer's amount "at risk" generally is:

• The amount of money and the adjusted basis of other property contributed by the taxpayer to the business
• Amounts borrowed by the company for which the taxpayer is personally liable or has pledged property as security

At-risk amounts are reduced by losses allowed in previous years, distributions received, or reclassification of debt from recourse to nonrecourse. Amounts shielded from loss through guarantees, stop-loss agreements, or other protections aren't at risk.

You can boost your at-risk amount with a contribution or loan to the business or by guaranteeing or assuming more of the company's liability. Accelerating income and deferring deductions and distributions are other options.

The at-risk rules apply only to individuals and closely held corporations. So, the limits are imposed at the shareholder or partner level for pass-through entities. If shareholders or partners in the same business have different amounts at risk, their allowable deductions likely will vary.

Other Limitations

You should also be aware of two other factors that may limit the amount you can deduct for business losses in a tax year:

1. Passive activity rules. The extent of your role in running the company also affects the amount of business losses you can deduct. Specifically, Sec. 469 prohibits individuals, closely held C corporations, and personal service corporations from deducting net passive losses generated by passive activities. Passive losses can be applied only against passive income.

A passive activity is a trade or business activity in which the taxpayer doesn't materially participate, including most rental activities. Material participation means regular, continuous, and substantial involvement in the business's operations. The IRS has seven tests for it. (See "7 Material Participation Tests" below.)

2. Excess business losses limit. Under Sec. 461(l), noncorporate taxpayers can apply their business losses to offset only business-related income or gains (not wages or capital gains), plus an inflation-adjusted threshold. For 2024, the threshold is $305,000 for single filers ($610,000 for married couples who file jointly). The limit is applied at the partner or shareholder level for pass-through entities.

If your aggregate business loss deductions exceed the sum of your aggregate business gross income or gain and the threshold amount, the excess losses are treated as a net operating loss (NOL) carryforward. Deductions for NOLs are subject to an 80% income limit in any given year. However, unused NOLs can be carried forward indefinitely.

Tread Carefully

Leveraging your business losses in the most advantageous manner is complicated. From understanding the complex at-risk rules to maintaining proper records of expenses, carryforwards, and other items, the potential for missteps is significant. Contact your tax advisor for help avoiding them.

Seven Material Participation Tests

The IRS has prescribed the following seven tests to determine whether you meet the material participation standard with respect to a particular business activity:

1. More-than-500-hours test. This is passed if the individual participates in the activity for more than 500 hours during the year.

2. Substantially-all test. This is passed if the individual's participation in the activity during the year constitutes substantially all the participation by all individuals (including those who aren't owners of interests in the activity).

3. More-than-100-hours test. This is passed if the individual participates in the activity for more than 100 hours during the year and no other individual (including nonowners) participates more during that year.

4. Significant participation activity test. A significant participation activity is one in which an individual participates for more than 100 hours during the year. The test is passed if the individual participates in the activity in question for more than 100 hours during the year and the individual's total participation in all significant participant activities during the year exceeds 500 hours.

5. Prior-year material participation test. This is passed for the year if the individual materially participated in the activity for any five of the ten immediately preceding years.

6. Personal service activity test. This is passed for the year if the activity is a personal service activity and the individual materially participated in the activity for any three preceding years.

7. Facts and circumstances test. This is passed if consideration of relevant facts and circumstances show that the individual materially participates in the activity regularly, continuously, and substantially. The individual must participate for over 100 hours to qualify for this test. In addition, an individual's hours performed in the management of an activity don't count for purposes of this test unless no other person who performs management services for the activity 1) receives compensation for such services and 2) spends more time on such services than the individual.

If you pass one or more of these seven tests for the tax year in question, you meet the material participation standard for that activity for that year. If so, you're exempt from the passive activity loss rules for that activity for that year.

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