We want to give you a better experience, where you feel connected to your financial journey and confident that you’re making the best decisions for your business. As part of this, we’ll feature blog posts on frequently asked questions. No question is a dumb question, so if you want to learn more about something, just ASK.
Today we address the topic of basis as it relates to flow-through loss limitations (it’s a tax issue). True to form, this complicated mechanism is different depending on your taxable entity type (read, the type of organization you decide to form when you start a business). Whether you’re an S-corporation or partnership, basis can impact the amount of flow-through losses you will be able to recognize in the current year or carryover to future tax years.
So why is this so important?
Understanding basis is one of the keys to tax planning. So in case you hadn’t guessed, it’s an important one to get right. Getting it right, however, is more than just a simple calculation.
It’s a three part test.
There are three hurdles a taxpayer must pass to deduct a flow-through loss. Pay particular attention, because the order matters:
- There must be basis (value) in the activity. We call this outside basis.
- There must be an amount at-risk. We call this at-risk basis.
- You must have passive income to deduct passive losses. (We have no clever name for this one)
Calculating basis is different based on the type of taxable entity.
Part I: Outside Basis
Below are the basic components of outside basis:
+ Capital Contributions
+/- Income/losses of the entity
+/- Change in debt basis
+Tax exempt income
– Capital Distributions
– Non-deductible expenses
Unlike partnerships, S-corporation shareholders do not receive basis for debts owed by the company to third parties. The only way for an S-corporation shareholder to have debt basis is to make a direct loan to the business. With a partnership, the partner has basis in his/her share of the partnership’s debt.
With us so far? Let’s keep going. In addition, there are slight differences in the ordering rules. For partnerships, basis is first adjusted by all positive basis adjustments and items of income, and is then decreased (but not below zero – you can’t have negative basis) for distributions, and lastly by items of loss. For an S-corporation, first increase basis for capital contributions and items of S-corporation income. Then decrease by distributions (again, basis can’t be negative, so not below zero), followed by non-deductible expenses, and lastly by S-corporation losses/deductions. A permanent election can be made to reduce shareholder basis by items of S-corporation losses/deductions before the reduction for non-deductible expenses.
In case you hadn’t noticed, here it is again: basis cannot be negative. Distributions in excess of basis result in taxable income (capital gain) for both partnership and S-corporation owners. Of course there are different rules/issues to consider if distributions are non-cash items or liquidating distributions. Losses/deductions in excess of basis carry forward and may be deducted when sufficient basis exists.
Part 2: At-Risk Basis
As a taxpayer, you are only able to deduct flow-through losses against basis for which you are at-risk (you’re personally on the hook). At-risk basis is similar to outside basis except in the handling of debt. In an S-Corporation, at-risk basis is generally the same as outside basis. However, there are exceptions (when isn’t there an exception in the tax world). If the source of the funds contributed or loaned by the shareholder to the S-corporation is from a nonrecourse obligation (no risk of loss if the loan defaults) or from an investor that has an interest in the S-corporation, those funds are not included in at-risk basis. As mentioned above, an S-corporation shareholder does not have basis in any debts of the S-corp that are from a third party (such as a bank).
Partners have at-risk basis for their share of the partnership’s qualified nonrecourse debt and recourse debt (a.k.a. the portion you are personally on the hook for).
Isn’t debt, debt?
Not quite. Here’s why:
- Qualified nonrecourse debt is debt borrowed in the connection of real property such as real estate. In addition, there are several other requirements to include qualified nonrecourse debt in at-risk basis.
- Recourse debt is debt for which you are personally, ultimately liable (read, you have personally guaranteed partnership debt, pledged personal assets to secure partnership debt, or personally loaned funds to the partnership).
- Nonrecourse debt is debt that does not meet the requirements of either recourse or nonqualified nonrecourse
Part 3: Passive Loss Rules
If the business is considered a passive activity according to the IRS rules (don’t even get us started. We’ll save this topic for another time), you are only able to deduct passive losses against passive income.
I seriously have no idea what you just said.
Okay, here’s the short version. Basis matters. If you do not have enough basis there are two tax implications. If you take distributions (a company’s payment of cash or other assets) without sufficient basis, the distributions would be considered capital gains and taxed at the applicable rates. In addition, you may need to suspend flow-through losses until you have the basis to deduct them.
Basis is important to get right. It also can be incredibly complicated. This post gives you the highlights, but does not encompass every situation/issue. So it’s really best to work through this with your tax professional.