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 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 and any adjusted basis of property contributed, along with 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. Stock basis is increased by contributions and income, and it's reduced by distributions. Debt basis is limited to loans from the shareholder to the corporation. Debt basis 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, plus
• 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 such 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 defined as 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. But 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.