There are three main reasons why your S corporation or partnership loss might be non-deductible:
1. You can’t deduct losses in excess of your basis.
2. Even if you have basis to deduct losses, the basis has to be “at-risk,” and
3. Even if the basis is “at-risk,” losses that are “passive” might be limited.
So how do you know your basis?
COMPONENTS OF BASIS
- Your basis starts with your initial investment in your ownership interest.
-It is increased by tax-exempt income (like municipal bond income) and reduced by permanently non-deductible expenses (like the 50% non-deductible portion of meals and entertainment expenses); these are reported on line 16 of the 1120S K-1 and line 18 of the 1065 K-1. If you have a business that generates depletion deductions, your “excess depletion” from 1120S K-1 line 15c, or line 20 of your partnership K-1, also reduces your basis.
- It is increased by capital contributions, which appear nowhere on the 1120S K-1 and on Part I, line L of the 1065 K-1.
- It is reduced by distributions, which are on line 16 of the 1120-S K-1 and Line 19 of the 1065 K-1.
If your losses exceed your basis, your losses are limited to your basis. If you have multiple deduction items, you have to prorate them to fit your basis.
Lets say you have an S corporation interest that starts 2010 with $3,000 in basis. You have a K-1 line 1 loss of 9,000, line 4 interest income of $2,000, and a charitable contribution passing through on line 12 (code A) of $1,000.
You have $5,000 in basis to deduct your $10,000 in in expenses – the opening $3,000 in basis plus the positive $2,000 interest income. You pro-rate the $10,000 expenses — you can (potentially) deduct $4,500 of line 1 loss and $500 of charitable contributions. The remaining deductions carry forward until you increase your basis via contributions, loans, or future income.
Even if you have basis, that just gets you past one hurdle. Your basis still has to be “at-risk,” and you can’t deduct a loss that’s “passive.” More on that later this week.
This is, of course, a simple example. It gets more complicated if there are distributions during the year (they count first), and if there are non-deductible expenses, like meals and entertainment. Shareholders can count direct loans they make to an S corporation in basis — but not borrowings by the S corporation from anybody else, and not guarantees of S corporation debt. You can learn more about S corporation basis at the IRS web site.
Come back for more 2013 filing season tips through April 15!