Losses passed through to S shareholders are limited by the various loss limitation provisions in the following order (Temp. Regs. Sec. 1.469-2T(d)(6)):
- Basis limitations (Sec. 1366(d)(1));
- The at-risk rules (Sec. 465(a)(1));
- The passive activity loss (PAL) rules (Sec. 469(a)(1)); and
- For tax years beginning after 2020 and before 2029, the excess business loss limitation (Sec. 461(l)).
Shareholder basis and other applicable loss limitations must be applied in a specified order, with differing rules.
Law change: Enacted on Aug. 16, 2022, the Inflation Reduction Act of 2022, P.L. 117-169, extended the effective date of the Sec. 461(l) excess business loss limitation by two years. Prior to the Inflation Reduction Act’s enactment, the excess business loss limitation applied to tax years beginning after 2020 and before 2027. Section 13903(b)(1) of the Inflation Reduction Act extended the effective date to apply to tax years beginning before 2029.
The at-risk rules apply only to individuals and closely held C corporations, meaning that the limits are imposed at the shareholder level in the case of an S corporation. The excess business loss limitation also applies at the shareholder level.
Example 1: Calculating deductible losses under the basis, at-risk, and PAL limitation rules: P invests cash of $10,000 in exchange for 15% of the stock of a new S corporation that raises cattle. (The $10,000 is made up of $6,000 from P’s personal savings and $4,000 that he borrowed from R, a 25% shareholder in the company.) P, who does not materially participate in the company’s operations, is allocated an $11,000 passthrough loss at the end of the first year. He does not receive passive income from any other source.
P’s basis limitation restricts his deductible loss to $10,000. The at-risk rules then limit his deductible loss to $6,000 (the amount not borrowed from a person who has an interest in the company). The PAL rules reduce his deductible loss to zero. Thus, his entire $11,000 first-year loss will be suspended and carried over as follows: $1,000 under the basis limitation rules, $4,000 under the at-risk rules, and $6,000 under the PAL rules.
Increasing at-risk basis by gain from stock disposition
Gain from the disposition of stock increases at-risk basis, allowing shareholders to use all or part of their losses that have been deferred under the at-risk rules. Similarly, a taxable disposition of stock in a passive activity to an unrelated party allows the use of any PALs from the activity that may have been previously suspended because of insufficient passive activity income. However, gain on the sale of S corporation stock does not affect stock or debt basis. Thus, losses suspended because of a lack of basis expire and are not deductible when stock with no basis is sold.
Example 2: Effect of stock sales on the basis, at-risk, and PAL limitation:
The facts are the same as in Example 1. Assume also that the corporation uses a calendar tax year and P sells all of his stock to an unrelated person for $20,000 on Jan. 1 of the following year. The first-year passthrough loss reduced his stock basis to zero, so P will recognize a $20,000 gain from the sale. The gain does not increase stock basis, so P cannot deduct the $1,000 loss suspended under the basis limitation rules. Gain on the sale of stock does, however, increase at-risk basis and allows P to deduct the $4,000 loss suspended under the at-risk rules. Furthermore, the $6,000 loss suspended under the PAL rules can be deducted because P disposed of his entire interest in the passive activity to an unrelated party.
Deducting S corporation losses that are restricted by at-risk limitations
A shareholder may claim deductions from an activity only to the extent of the aggregate amount for which the taxpayer is at risk at the close of the S corporation’s (not the shareholder’s) tax year (Sec. 465(a)(1); Prop. Regs. Sec. 1.465-1(a)). Since the measuring date is the last day of the year, changes in the amount at risk during the S corporation’s tax year do not adversely affect the shareholder. A shareholder of an S corporation is at risk for money and the adjusted basis of property contributed to the corporation.
Loans to S corporation may provide at-risk basis: An S corporation shareholder has at-risk basis to the extent of amounts loaned directly to the S corporation (assuming the shareholder’s source of the funds was not a prohibited one, such as nonrecourse borrowing). Shareholders do not receive an increase in their at-risk amount for their share of corporate-level liabilities. And, as with the rules applying to stock basis, an S shareholder does not receive an increase in their at-risk amount for corporate-level debt that is personally guaranteed (Prop. Regs. Sec. 1.465-6(d)).
Sec. 465(b)(2) provides that a tax-payer is considered at risk with respect to borrowed amounts only if the tax-payer is personally liable for repayment (i.e., it is a recourse obligation) or, in the case of a nonrecourse obligation, if the taxpayer has pledged property, other than property used in the activity, as security for the borrowed amount. In the case of nonrecourse borrowings secured by pledged property, the at-risk amount is limited to the net fair market value of the taxpayer’s interest in the pledged property. The S corporation stock is considered to be “property used in the activity,” meaning that a shareholder is not considered at risk for amounts contributed or loaned to an S corporation when the amounts were obtained by nonrecourse borrowings secured by the corporation’s stock (Prop. Regs. Sec. 1.465-25(b)).
A special exception allows at-risk investment for nonrecourse loans secured by real property used in the activity of holding real property (Sec. 465(b)(6); Regs. Sec. 1.465-27). To meet this “qualified nonrecourse financing” exception, no person can be personally liable for repayment, and the debt generally must be (1) borrowed by the taxpayer with respect to the activity of holding real property; (2) secured by real property used in the activity; and (3) borrowed from a commercial lender.
Planning tip: The qualified non-recourse financing privilege generally will be of limited benefit in connection with an S corporation because an S shareholder is not permitted to increase either basis or amount at risk for corporate-level debt. However, if a loan to a shareholder is secured by qualified nonrecourse financing associated with realty, it is possible to take advantage of this rule.
Amounts borrowed, whether recourse or nonrecourse, are not considered to be at risk if they are from any person who has an interest in the activity or is related to a person having such an interest in the activity (Sec. 465(b)(3); Regs. Sec. 1.465-8; Van Wyk, 113 T.C. 440 (1999)). However, a person who has an interest only as a creditor with respect to the activity is not a prohibited party.
Amounts borrowed from party with an interest in the activity: For amounts borrowed after May 3, 2004, loans from persons involved in the activity will not increase at-risk limitations if the lender is involved in any activity engaged in by the taxpayer (1) in carrying on a trade or business or (2) for the production of income (Secs. 465(b)(3) and (c)(3); Regs. Secs. 1.465-8 and -20).
Example 3: Applying the at-risk rules to stock and debt basis: D and several of her business associates formed W, a calendar-year S corporation, on Jan. 1 to operate a retail store selling wool products. D contributed $60,000 of her own funds to W in exchange for her portion of the stock. She also borrowed $100,000 from her parents and loaned the funds to the corporation (in return for a written corporate note bearing a market rate of interest). At the same time, D’s father purchased 10% of the stock.
During the year, W allocated a loss of $100,000 to D. Her use of the $100,000 loss ordinarily would result in the basis adjustments shown in the chart, “Basis Adjustments for Loss,” below, (D’s share of the annual loss first reduces stock basis and then reduces debt basis).
Thus, D has basis under the normal S corporation rules for both her stock investment and her loan to W. However, for at-risk purposes, she is not considered to be at risk in the amount she loaned to the corporation because the funds she invested were borrowed from a person who has an interest in the activity.
Her father’s stock ownership in the S corporation is considered to make D not at risk with respect to the funds she borrowed from him. This same result would occur if D had borrowed from any other shareholder in the corporation or from a person related to someone (other than D) who has an interest in the activity.
Without application of the at-risk rules, D would have used the $100,000 loss in its entirety by first applying $60,000 of the loss to reduce stock basis and then applying the remaining portion of the loss to reduce the debt basis from $100,000 to $60,000 (Sec. 1367(b)(2)(A)). However, since D is not considered at risk with respect to her loan to W, she encounters a limit under Sec. 465 at the shareholder level. The unused loss carries over to the following year.
Amounts borrowed from related party with no interest in the activity: The rule disregarding at-risk basis for amounts borrowed from a person with an interest in the activity does not apply to amounts borrowed from a member of the shareholder’s family who holds no stock in the S corporation (Sec. 465(b)(3)).
Example 4: Claiming at-risk basis for certain loans from a related party: Assume the same facts as in Example 3. D’s loans to W with funds borrowed from her father would be considered to be at risk if her father were not a shareholder. Accordingly, a redemption of her father’s shares might be an appropriate remedy if D is faced with continuing restrictions on the deductibility of future losses.
Carrying over losses limited by at-risk rules
Any loss not allowed under the at-risk limits for a particular tax year is treated as a deduction allocable to the activity in the first succeeding tax year (Sec. 465(a)(2)). The practical effect of this rule is to allow an unlimited carryover for losses and deductions that were not currently used because of the at-risk limits. The carryforward of suspended at-risk losses is indefinite.
Comparing at-risk amounts with stock and debt basis
It is important to recognize that the amount at risk may differ from basis under the general S corporation basis computations of Sec. 1367. Examples of such differences include loans from other investors in the activity, loans from a person related to a person (other than the taxpayer) having an interest in the activity, loans secured by property transferred to the S corporation, and nonrecourse loans secured by the corporate stock. When an at-risk limitation is encountered, the practitioner will need to monitor any carryover losses subject to the at-risk rules, as well as the normal stock basis rules.
Shaun M. Hunley, J.D., LL.M., is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact firstname.lastname@example.org. This case study has been adapted from Checkpoint Tax Planning and Advisory Guide’s S Corporations topic. Published by Thomson Reuters, Carrollton, Texas 2023 (800-431-9025; tax.thomsonreuters.com).