Tuesday, July 28, 2015

Basis Limitations and the Deductibility of Losses for a Business under the Internal Revenue Code

Basis Limitations and the Deductibility of Losses for a Business under the Internal Revenue Code

When you decide to start a business venture, there are a myriad of things to consider.  We regularly assist small business owners, especially start-up businesses, walking them through the steps that need to be taken in order to make the business official and legal.  There are many ways a business can be organized and there are both non-tax and tax factors as well as state and local statutory requirements that need to be taken into consideration when embarking on this exciting journey of starting a business.

I previously wrote an article regarding the non-tax factors that should be considered when starting a business.  This article is one of a series of articles that focuses on the tax implications of certain business activities and things you should consider when choosing your business entity.  The most prominent federal tax considerations in choosing a business entity include:

This article considers the limitations on the deductibility of losses in a business.

Taxpayers who wish to use losses from a business or investment activity to offset their income from other sources must structure the venture to be taxable as a partnership, LLC, or S corporation.  A partner may generally deduct his share of losses up to the basis of his partnership interest and an S corporation shareholder may deduct losses up to the basis for his stock.  Losses of a C corporation do not pass through to shareholders; they must be carried back or carried over to offset future corporate income.

For ventures that use significant amounts of borrowed funds, a partnership or LLC structure is the preferred organization form because the basis of a partner's interest increases by his share of the partnership's liabilities.  Each partner is treated as if he personally borrowed his share of the partnership's obligations and contributed that amount of cash to the partnership, even if the partnership debt is nonrecourse (i.e., no partner is personally liable for repayment of the debt).  The resulting basis increase enables partners to deduct losses attributable to funds the partnership borrows.

A shareholder's basis for stock in an S corporation does not include corporate liabilities, other than loans the shareholder makes directly to the corporation; therefore, corporate obligations to third parties do not increase a shareholder's basis.  A shareholder can increase the basis of his stock by borrowing funds personally and lending or contributing the proceeds to the corporation.  When the loan must be directly secured by corporate assets, however, this transaction is not possible in practice.

Highly leveraged ventures usually are organized as limited partnerships or LLCs because partners can deduct significant greater losses than S corporation shareholders who make the same out of pocket investment.

Passive Loss Limitations

Losses attributable to nonrecourse liabilities may be restricted under §465 of the Internal Revenue Code (IRC).  Section 465 limits a taxpayer's deductions for losses to the amount he has at risk in the activity at the end of the tax year (i.e., his capital contribution plus liabilities for which he bears personal liability).  This limitation does not apply to qualified nonrecourse financing used in real estate activities.  These rules apply to certain closely held C corporations.

Under §469 of the IRC, certain taxpayers may not deduct losses incurred in passive activities that exceed their income from other passive activities.  This section applies to individuals, estates, trusts, closely held C corporations, and personal service corporations.  An activity is passive if it is a trade or business in which the taxpayer does not materially participate.

These passive loss rules are also applied to partners, LLC members, and S corporation shareholders in a similar fashion.  Each partner or shareholder separately determines whether his income or loss from the activity is passive based on his participation in the activity.  With some important exceptions, a limited partner's share of all partnership income or loss is passive.

The passive loss rules are modified to apply to closely held C corporations in which it may not use passive losses and credits to offset portfolio income but may use them to offset income from an active business.  A closely held C corporation when there are five or less owners that directly or indirectly own more than 50% of the value of the stock for at least the last half of the tax year.

The passive loss limitations apply fully to personal service corporations (a corporation in which its principal activity is performing personal services that employee-owners substantially perform and all of the employee-owners collectively own more than 10% of the value of the corporation's stock).

For a complete analysis of the tax implications of C Corporations, Partnerships, and S Corporations click here for the Joint Committee on Taxation's publication entitled "Choice of Business Entity: Present Law and Data Relating to C Corporations, Partnerships, and S Corporations."

Attorney Angel Oliver / McGrath and Spielberger, PLLC assists clients with all sorts of tax matters, both federal and state (including but not limited to North Carolina and South Carolina). Click here to contact Ms. Oliver about your tax matter.