There are rules that limit the amount of losses you can take from your s corporation schedule K-1. Shareholders must be aware of these 3 limitations:

1. Basis limitation
2. At risk rules
3. Passive activity loss rules

Basis limitation

What is basis? Basis is a measure of a shareholders investment in the business. Basis is not difficult to compute if done on a regular basis. Basis should be computed when, the business experiences losses; makes distributions or changes owners.

Think of basis like your checking account. Just like deposits increase your account balance and withdrawals reduce your account balance, contributions in your business increase basis and withdrawals from your business reduce basis. Basis should never be allowed to go below zero. As a result, a loss cannot be taken if it will reduce basis below zero. You cannot withdraw funds from an empty account. To explain this further, S Corporations are not taxable entities but have their income flow through to the shareholders personal return. When a loss passes through, it reduces the shareholders other income thereby reducing the tax paid. To get the tax benefit of the loss, you have to have some “basis” to cover the tax benefit you derive from the loss

For example, Gina’s schedule K-1 shows a $10, 000 loss. Gina only has a $5,000 basis in her business. Gina will only be able to deduct $5,000 this year and suspend the rest. The amount is carried forward to the next year and thereafter. Gina can deduct the loss in future years as long as she has enough basis to cover it.

At risk rules

Congress passed the at risk rule to limit a taxpayer’s ability to use nonrecourse loans to generate tax losses in excess of the taxpayer’s economic risk. Non-recourse loan is a secured debt where the lender can only recover payments up to the collateral. The borrower is not liable for the balance of the loan beyond the collateral.

Under the at risks rules, a shareholder can only claim a loss up to the amount they are at risks. Shareholders are at risks for:

1. Basis in the business
2. Loans where the shareholder is personally liable and pledged collateral for the debt

At-risk rules work a lot like stock-basis rules. Shareholders may deduct their pro rata share of the S corporation’s losses only to the extent of their at risk basis in the corporation’s stock. Shareholder activities should be analyzed to see if it is at risk. Losses that exceed at risk basis can be carried forward until it qualifies for deduction.

Passive activity loss rules

When a shareholder does not materially participate in the business or the business is in real estate rentals then the passive activity loss rules apply. The IRS defines material participation as, “A taxpayer shall be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis which is—regular, continuous, and substantial”.

A shareholder is considered to material participate of any of the following apply during the tax year:

• Participates for more than 500 hours
• The shareholder participates for less than 100 hours but no one participates more
• The shareholder materially participated within 5 of the preceding 10 years
• The shareholder participates on a regular continuous and substantial basis. Subject to facts and circumstances.

   

If the shareholder does not materially participate, the loss is classified as a passive activity loss. Passive loss cannot be deducted against active income. Passive loss can be carried forward indefinitely till it can be netted with passive income.

Can I deduct all losses from my S corporation?

Whether or not you can deduct all losses from your S corporation depends on the 3 factors discussed above. Just because you have a schedule K-1 showing a loss does not mean you get to deduct it on your taxes. You must compare the loss to see if it exceeds your basis, at risk contributions and whether or not you materially participate in the business.