At the end of the year we do a lot of planning to mitigate tax liabilities and to prepare for what may be due to the government come next spring.  Most of our clients operate in flow through entities such as S-Corporations and LLC’s treated as partnerships.  The items of income and loss on these entities are reported on the owners’ returns where the incidence of tax is recognized.  The ability to use a loss on your return is contingent on a number of different factors depending on the nature of the loss and the amount and nature of your investment in the activity.

The first hurdle to jump are the passive activity rules.  If the activity is a business that you are directly involved in (i.e. where you work) then it will be considered active and you pass the first test.  If it is something that you are merely an investor or it is a rental activity (and you are not a real estate professional) then it will be considered passive and limitations will prevent an immediate recognition of the loss.  If you have other passive activities with income then you can offset losses against gains.  This is what we call PIG’s and PAL’s – passive income generators and passive activity losses.  If you do not have any PIG’s then the loss will be suspended until you make money in the future or you dispose of the activity, at which time all your suspended losses are freed up to be used in the year of the disposal.

One of the problems we are faced with is that many of our clients have rental activity related to their operating entities.  This presents a problem if the rental activity generates a profit it will be re-characterized as non-passive while it remains passive if it is a loss.  Heads the IRS wins, tails you lose.  To the extent our clients can control the profitability within the realm of an arm’s length transaction, we prefer the rental activity to make money and the related operating activity show reduced income.

Now that we have passed the passive activity hurdle we have to determine whether we have enough skin in the game to deduct a loss.  In an S-Corporation you can only take losses up to the amount you have invested in the company or have directly loaned to the company.  Funds borrowed directly from a third party, even if you guarantee the loans, will not count towards debt basis.  If you run out of investment basis and debt basis then excess losses are suspended to future years.  When the company returns to profitability the suspended losses are then used to offset those profits.  If debt is used to deduct a loss, that debt is now considered reduced basis debt and when the company repays this reduced basis debt it will trigger the recognition of capital gains.  S-Corporation distributions in excess of basis will also trigger capital gains.  This can get very tricky as S-Corporations must follow strict rules in that distributions must be made using a per share per day calculation.  S-Corporations with shareholders with significantly differing bases can make planning very complicated.  When we send out our S- Corporation returns to our clients at tax time we generally include a basis schedule so each shareholder knows where they stand both from their investment in the activity and any debt basis they may have.

Partnerships are much more flexible in what can be used for deducting a loss.  The basis on which to deduct a loss starts with the direct investment in the partnership followed by any amounts directly loaned to the partnership.  To the extent that a partner guarantees third party debt this will count as recourse debt and a loss may be allowed.  This means that you pledge to the bank that you will make good on the loan in the event of a partnership default so that you are at risk for the activity.  LLC’s generally limit a member’s liability for general obligations of the LLC so this would not be included in the definition of recourse debt.  Third party debt not guaranteed by a partner is considered nonrecourse debt.  This type of debt generally will not give a partner sufficient basis for sustaining a loss from the activity.  The exception to this is qualified non-recourse debt.  This is a partnership with real estate secured by a mortgage and is referred to as qualified non-recourse debt and may allow a partner basis for taking a loss.

Similar to an S-Corporation a loss that is limited due to insufficient basis in a partnership is suspended until basis is restored.  Repayment of the reduced basis debt is also subject to capital gains.  What we see quite often is that when a real estate partnership supported primarily by non-recourse debt is sold it triggers a tremendous amount of capital gain but not necessarily a great deal of cash.  This creates quite a dilemma in that you have taxable income and very little if any cash to pay the tax bill.  Remember that non-recourse debt is used primarily in real estate partnerships and these activities are generally passive in nature.  While we may have passed the at-risk rules for sustaining a loss we did not pass the passive activity test so, in theory, these losses should all be suspended until the activity is sold.  What should happen is that you will have capital gain on the satisfaction of the zero basis debt that is offset by the release of the suspended loses from the passive activity.

The passive activity and at-risk rules for S-Corporations and partnerships are quite complicated. We often have entities where some owners are passive and others are active.  On top of this some may have plenty of basis while others have very little or none.  Trying to sort these out and make sure there is enough to pay the tax man can be an exciting mathematical exercise.  When it comes to planning with flow through the ability to use a loss can get complicated.  In order to avoid unpleasant surprises, please contact your DB&B tax professional to help work through those complications.

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.