Overview

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 or 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:

1. The adjusted basis of:

   1. The partner's partnership interest, or

   2. The shareholder's stock plus any loans the shareholder makes to the corporation,

2. The at-risk rules, and

3. 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 and partners may not be subject to all limitations depending on their participation in the S corporation or partnership.

Basis Limits

Generally the taxpayer's deductions cannot exceed their basis. Basis is more or less the amount they have invested in an activity. If the taxpayer bought into a partnership or S corporation for $10,000, their basis is $10,000. If the entity passes losses and deductions out to the taxpayer of $1,000, their basis goes down to $9,000. Next year, when there is a profit and the Schedule K-1 shows $5,000 of income, their basis becomes $14,000, and so forth. The taxpayer cannot deduct losses once their basis reaches zero because they cannot lose more than they 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 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 Letter 5969 in the mail.

For information about distributions in excess of basis, see Drake Tax - 1040 - Distributions in Excess of Basis from 1065 and Drake Tax - 1040 - Distributions in Excess of Basis from 1120-S.

Basis Worksheet Differences

Basis is tracked at the 1065 and 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 or S corp level, while the "outside basis" is calculated at the partner or shareholder level. Therefore, the basis worksheet in the 1065 or 1120-S return type 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.

At-Risk Limits

Generally, the taxpayer's deductions cannot exceed the amount they have at risk. Roughly, an amount at risk is an amount the taxpayer invested and could lose. An amount not at risk exists when there is a part of their investment basis that they are protected from losing.

This might occur because:

• The taxpayer bought their interest in the business with money that they borrowed through a non-recourse loan. The taxpayer is not personally responsible for the debt, they are considered not at risk for that borrowed amount.

• The taxpayer has a “stop loss” agreement in which the other partners have agreed to reimburse them for a portion of any losses they might have in relation to the business.

• The taxpayer borrowed some of the money they have invested in the business from one of the other partners.

The amount the taxpayer has at-risk is similar to basis in that they cannot deduct losses in excess of their 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, the taxpayer 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 the taxpayer does not materially participate during the year.

• a rental activity, even if the taxpayer does materially participate, unless they are a real estate professional.

Links

• Publication 925

• Publication 551

• Schedule K-1 (1065) Instructions

• S Corporation Stock and Debt Basis

• Schedule K-1 (1120-S) Instructions