The ability to take losses in a closely held business that you are invested in is dependent on three things:
- Your basis in the entity,
- The amount that you have at-risk, and
- Whether you fall under passive activity loss limitations.
These calculations also may differ depending on the type of entity that you are invested in.
To calculate your tax basis in an S corporation:
+ Initial Capital Contribution or Amount Invested
+ Additional Paid in Capital
+ Separately Stated Income Items from K-1
+ Tax Exempt Income from K-1
– Nondeductible expenses and losses
+ Debt you are personally liable for
- If any of the expense or loss items cause your basis to go below zero, those losses must be suspended and carried forward to the next tax year.
Tax basis in a partnership is calculated similarly to basis in an S corporation. The adjusted basis of property that you contributed to the partnership plus any additional contributions, increased share of partnership liabilities and income less any distributions, decreased share of partnership liabilities and losses will equal your basis in the partnership.
- Like an S corporation, partnership basis can’t go below zero, and any losses that cause the partnership to go below zero should be suspended and carried forward to the next tax year.
- Unlike an S corporation, partnerships can add both recourse and qualified non-recourse liabilities to their basis.
- A recourse liability is one in which the partner has the economic risk of loss for the liability. A qualified non-recourse liability is a liability that is obtained by the partnership that has real property as collateral for the loan.
If you have basis in a business that you are invested in, you must determine if you are at-risk for that investment before determining if you are eligible to deduct losses. For an S corporation, the amount that you are at-risk is equal to your total basis in the S corporation. With a partnership on the other hand, you can have a different amount at-risk than your basis. This depends on the specific type of partnership that the business operates under.
Finally, if you determine that you have basis and are at-risk for your investment in a closely held business, you must determine if the passive activity loss limitation rules apply to you.
Basis, at-risk, and passive activity loss limitations are all very complex issues, so please contact us directly for further information or clarification.