To determine if a taxpayer can deduct a loss from a partnership there are a number of loss limitation rules that need to be considered. These include:
- Tax basis in the partnership
- The amount of the investment at-risk in the partnership
- If the taxpayers are actively involved in the day-to-day operations of the business
- Are the taxpayers just considered as passive investors in the partnership
- The Excess Business Loss limitation rules
Basis is the first component to be analyzed to determine if a loss is deductible. The starting point to determine a partner’s tax basis in the partnership interest is the initial contribution in the partnership. The partnership tax basis is increased every year by the partner’s distributive share of partnership income and gain (including tax-exempt income), plus additional contributions by the partner, minus the partner’s distributive share of partnership loss and deductions (including nondeductible, noncapital expenditures), minus distributions, and other increases or decreases using tax basis principles.
In addition, a partner’s basis is increased by the share of debt for both recourse and non-recourse liabilities, and qualified non-recourse liabilities. Recourse debt is the share of partnership debt the partner is personally liable for; non-recourse debt the partner is not personally liable for; and non-qualified recourse debt is debt the partner is not personally liable for, but the debt is secured by real property. The debt is treated as a deemed contribution made by the partner to the partnership and any increases in debt will increase a partner’s tax basis. Any decreases in debt are deemed distributions to the partner and will decrease a partner’s tax basis in the partnership.
The task of computing a partner’s tax basis used to be a difficult, time consuming, and in some cases, an impossible computation due to limited access of a partner’s historical data. The good news is this information is now provided to individuals on the Schedule K-1 (Form 1065).
Beginning in tax year 2020, the IRS required all partnership capital accountants to be reported on tax basis. Previously many partner capital accounts were reported on GAAP basis, IRC Section 704(b), hybrid methods, or not a true transactional tax basis method. While the initial year of converting all capital accounts was indeed a painful year for tax preparers, the new tax basis regulations provided basis transparency going forward. The Schedule K-1 (Form 1065) is used to report a partner’s share of income/(loss). Each partner’s year-end tax capital accounts are located on the face of the schedule K-1, box L. The simple calculation of the partner’s ending capital account balance plus the ending liabilities, located in box K, of the Schedule K-1 (Form 1065) will now equal the partner’s tax basis, except for any outside tax basis the partner may have. Outside basis refers to a partner’s interest in the partnership while inside basis refers to a partnership’s basis in its assets. For example, if a partner contributes machinery and equipment to a partnership with a tax cost of $1,000, and has tax depreciation of $500, but the fair market value of the asset is $5,000 when contributed to the partnership for a 50% interest in the partnership, the outside basis would be $250 ($1,000 cost – accumulated depreciation $500 x 50% interest), but the inside basis would be $2,500 ($5,000 FMV X 50% interest).
Once the partners’ tax basis is known, the next step is to apply the at-risk rules. A taxpayer can only deduct losses that are lessor or equal to the actual economic investment at stake in the business, plus any personally liable loans. At-risk applies many of the same components as tax basis calculations except non-recourse debts do not generate basis for purposes of the at-risk rules. Most recourse debts and qualified non-recourse debts are included in at-risk basis. In many cases, a partner’s tax basis less any non-recourse liabilities will determine if the at-risk test is passed.
A positive basis suggests the loss passed the at-risk test, while a negative basis is the amount of loss that will be disallowed and suspended until the partner has enough at-risk basis. At-risk basis is increased annually by any amount of income more than deductions, plus additional contributions, and is decreased annually by the amount by which deductions exceed income and distributions. For purposes of adjusting at-risk basis, income includes tax-exempt income, and deductions include nondeductible expenses which is no different than tax basis adjustments. Generally, the amount the taxpayer has at-risk is measured annually at the end of the year and the same goes for tax basis.
After the at-risk test is satisfied, the passive activity loss rules need to be considered. Passive activity is any business or rental activity in which the taxpayer does not materially participate under Internal Revenue code section 469. A taxpayer is considered to materially participate if one of the following two tests is satisfied:
- Their participation is more than five hundred hours
- Their participation constitutes substantially all of the participation in the activity by all individuals (including non-owners) for the tax year
The numbers we are concerned with in these set of rules are ordinary business loss and rental loss (Found on Box 1 & 2 of a Schedule K-1) and are not to be confused with portfolio income such as interest, dividends, capital gains, etc., which are classified as a separate type of income and subject to different rules. Although the classification of income is determined at the partnership level, sometimes this information should be available in the footnotes of the K-1. Other times the partner must make the determination at the individual level.
An exception to the passive activity rule is a disposition of an entire interest in a passive activity allows both the current and suspended losses to be deducted. The reason or this is in the year of disposition the activity is considered active, and not passive.
The passive activity rules allow for a rental real estate loss allowance of up to $25,000 for real estate nonprofessionals who actively participate in rental activities and if modified adjusted gross income is below the modified adjusted gross income limitations. This deduction phases out $1 for every $2 of MAGI above $100,000 until $150,000 when it is completely phased out (limits apply to both single and married filing jointly). Otherwise, passive activity is only allowed up to the passive income including passive activity income from other activities, while any excess loss will be carried forward to future years.
The last limitation to consider is the Excess Business Loss (EBL) limitation enacted in the Tax Cuts and Jobs Act of 2017 (TCJA). The Coronavirus Aid, Relief, and Economic Security (CARES) retroactively delayed the implementation, but it will be in effect for the 2021 tax year and beyond. This provision limits the non-passive or “active” business loss to maximum loss allowed of $262,000 for single taxpayers and $524,000 for married filing jointly taxpayer, indexed for inflation, with any losses in excess disallowed and carried forward.
To recap, although the rules and limitations on the utilization of loses are indeed complex, some of the burden is now placed on the business entity level to report income classification dealing with, and computing, tax capital accounts.
Analyzing Schedule K-1s at the individual Income tax level to determine if a loss is deductible is now simpler compared to prior years!
