What are basis, at-risk, and passive activity limits? How are these limits applied in a return?
Partners and shareholders may not be able to deduct the entire loss or deduction that was reported on Schedule K-1 on their own return. Basis, at-risk, and passive activity limits are applied to partner/shareholder deductions or losses in that specific order based on IRS guidelines. The following article discusses each limit type in more detail and how it is figured in Drake Tax based on the entries that you make. The order is also discussed in the following section of Publication 925:
"Four separate limits may apply to a partner's or shareholder's distributive share of an item of deduction or loss from a partnership or S corporation, respectively. The limits determine the amount each partner or shareholder can deduct on their own return. These limits and the order in which they apply are:
- The adjusted basis of:
- The partner's partnership interest, or
- The shareholder's stock plus any loans the shareholder makes to the corporation,
- The at-risk rules, and
- The passive activity rules."
To summarize, the limits imposed by IRS rules dealing with basis, at-risk activity, and passive activity are always applied in that specific order. Only the amount that does not exceed the limit should be carried to the next step. Some shareholders/partners may not be subject to all limitations depending on their participation in the S corporation or partnership.
Basis Limits
Generally your deductions cannot exceed your basis. Basis is more or less the amount you have invested in an activity. If you bought into a partnership or S corporation for $10,000, your basis is $10,000. If the entity passes losses and deductions out to you of $1,000, your basis goes down to $9,000. Next year, when there is a profit and your K-1 shows $5,000 of income, your basis becomes $14,000, and so forth. You cannot deduct losses once your basis reaches zero because you cannot lose more than you invested in the first place. Losses that are suspended due to lack of basis are carried forward on the basis worksheet. They will not show on any other form or schedule until the year that basis is restored. Then they will carry to the appropriate forms along with any current year amounts.
See Publication 551, Basis of Assets for details.
Losses in excess of basis (stock or debt) are not allowed in the current year. If the preparer does not provide basis calculations with the return when required, the taxpayer will get a Letter 5969 in the mail.
Note: In Drake18 and future, when there is debt basis that can be applied against the losses and deductions, it will automatically be applied per IRS guidelines. You can review the calculations on Wks K1S IRS Debt Basis in view mode for details. See the IRS' S Corporation Stock and Debt Basis page and Code Section 1366 for more information.
For information about distributions in excess of basis, see Related Links below.
Basis Worksheet Differences between 1065/1120-S and 1040 Return
Basis is tracked at both the 1065/1120-S level and the 1040 level, however, the worksheets are not always the same between the business and individual returns. The "inside basis" is calculated at the partnership/S corp level, while the "outside basis" is calculated at the partner/shareholder level. Therefore, the basis worksheet in the 1065/1120-S package is just an estimate of how the basis may be calculated at the individual level. All the final calculations and limitations are applied at the individual (1040) level.
The K1 that is issued to the partner/shareholder is not limited by any basis calculation that has been done at the 1065/1120-S level and may show negative amounts where applicable.
At-Risk Limits
Generally, your deductions cannot exceed the amount you have at risk. Roughly, an amount at risk is an amount you invested and could lose. An amount not at risk exists when there is a part of your investment basis that you are protected from losing.
This might occur because:
- You bought your interest in the business with money that you borrowed through a non-recourse loan. Since you are not personally responsible for the debt, you are considered not at risk for that borrowed amount.
- You have a “stop loss” agreement in which the other partners have agreed to reimburse you for a portion of any losses you might have in relation to the business.
- You borrowed some of the money you have invested in the business from one of the other partners.
The amount you have at-risk is similar to basis in that you cannot deduct losses in excess of your at risk amount. The amount at-risk, however, is not the same as basis. In many cases, a taxpayer can still have basis, but their losses are not deductible because they are limited by the amount at risk.
Passive activity Limits
Generally, you cannot deduct expenses from a passive activity against income that is not from a passive activity.
A passive activity is:
- a trade or business activity in which you do not materially participate during the year.
- a rental activity, even if you do materially participate, unless you are a real estate professional.
For more information, see: