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S Corporation losses: the basics

S corporations have soared in popularity in recent years, to the point where they are probably the preferred entity choice for closely-held businesses.  S corporations generally don't pay their own taxes; instead, their income passes through to their shareholders' returns. 

Why would you do such a silly thing as elect to pay extra taxes on your 1040?  There are two main reasons.

First, S corporation income is only taxed once - when it is earned.  Distributions of S corporation income are generally tax-free.  This contrasts with C corporations; they pay tax on the income as it is earned, and the shareholders pay tax again when it is distributed.

Second, S corporation losses can deductible on the owners returns.  But you have to be careful.  S corporation losses may be deductible, but maybe not this year, or not in full, or to all shareholders.  The tax law has many traps to limit loss deductions - some easily avoidable, some not so much.

The first limit to losses is your basisTaxpayers can deduct losses to the extent they have basis in S Corporation stock or in loans they have made to their S corporation.  Basis starts with what you pay for your stock; it increases for S corporation earnings and capital contributions, and it declines for losses and distributions.  If you make a loan to an S corporation, losses can reduce your basis in the loan; if you repay the loan before income has restored the basis, the repayment can trigger taxable income.  And remember: you don't get basis in an S corporation just by guaranteeing its borrowings.

Next, the basis has to be "at-risk."  The at-risk rules are horrendously complex - so much so that the IRS hasn't been able to write final regulations for them in the 30 years since they were enacted.  In general terms, is "at-risk" to the person ultimately "on the hook" for payment.  But if you borrow the money from a related party, the tax law might say you aren't "at-risk" -- even if you borrowed from a cruel and unforgiving sibling.  If you need to be "at-risk," borrow from your banker, not your relative or business associate.

Finally, "passive" losses aren't deductible, even if you have plenty of basis and you are "at-risk."  Congress enacted the passive activity rules in 1986 to shut down the retail tax shelter industry.  You can only deduct "passive" losses to the extent of "passive" income in any year.  If you can't deduct them, the passive losses carry forward to future years to offset other passive income; when you sell your interest in a "passive activity," you can deduct any remaining losses from that activity.

So what makes a loss "passive"?  The passive loss rules work against taxpayers who don't work in a business, or who invest in rental real estate.  As an individual taxpayer, you are passive unless you pass one of these tests during the tax year:

  • You participate at least 500 hours in one activity; or
  • You participate at least 100 hours and at least 500 hours in more than one "100 hour" activities; or
  • You participate at least 100 hours and more than anybody else, or
  • You are the only participant; or
  • You materially participated in five of the past ten years) or in any three years for a service activity).

There is also a "facts and circumstances" test, but that's a last resort. 

Rental real estate is "passive" unless you are a "real estate professional," which is another set of rules altogether.

Bottom line? The ability to deduct business losses is a good reason for many taxpayers to use S corporations.  If you expect S corporation losses, talk to your tax pro before year-end to make sure you are eligible to deduct them.

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