Can I deduct my K-1 loss?
Losing money in your business is no fun, but that dark cloud can have a silver lining at tax time. Many small businesses are "pass-throughs" taxed as S corporations or partnerships (often in the form of "limited liability companies," or LLCs). As the income of these businesses is taxed on the owners' 1040s, the owners get to deduct the business losses reported on the business Schedule K-1 -- right?
It depends. There are three hurdles that a K-1 recipient has to clear to deduct K-1 losses.
The first hurdle is basis. Your basis starts with your investment in the K-1 business; it is increased by income and cash contributions and decreased by losses and distributions. In partnerships -- but not S corporations -- an owner's basis may include a portion of the company's borrowings from third parties.
Unfortunately, the K-1s do a poor job of tracking owner basis. You, or your tax preparer, may need to keep a separate schedule of your basis to determine whether you might deduct K-1 losses.
The next hurdle is whether your basis is "at-risk." The "at-risk" rules are an obscure leftover of tax shelter battles of the 1970s, but they still apply.They can be very complex, but their gist is that if your basis is attributable to borrowings that are "non-recourse" -- that you aren't personally liable for -- it is not "at risk," and losses attributable to that basis must be deferred. You may also not be considered "at risk" for related-party borrowing, especially if you borrow from your business or from a business associate to fund your ownership in the K-1 issuer.
Partnership K-1s provide some useful information in determining whether you have an "at-risk" issue. If you have losses in excess of your cash investment, and your share of debt on the K-1 part K is on the "nonrecourse" line, you are likely to have an at-risk problem. You will have to go to IRS Form 6198 to figure out whether you have to defer losses under the at-risk rules.
The "passive loss rules" are the final hurdle for deducting K-1 losses. These rules were enacted in 1986 to shut down that era's tax shelters. If you have "passive" losses in excess of "passive" income, you have to defer the losses until you have passive income in a future year, or until you dispose of the "passive activity" in a taxable transaction.
A loss is "passive" if you don't "materially participate" in the business. There are a number of tests that you can use to determine whether you materially participate, but the most common is working at least 500 hours in the business in a year.
Real estate rental is passive by law, unless you are a "qualifying real property professional." Special rules keep you from generating "passive" income to allow you to deduct passive losses. For example, land rent and most investment income is not considered "passive" under these rules. The passive loss limitation is computed on Form 8582.
These rules are complicated, even for tax pros. If you aren't sure where you stand, and the losses are significant to you, get in touch with a tax pro who works with small businesses.