If you think a business loss can always be deducted on your income tax return, you might be in for a surprise. Beware that there are rules that limit this deduction. The bottom line is that the IRS insists taxpayers risk their own money in an enterprise when claiming a tax-deductible loss. Consider the following limits as you prepare to deduct a loss.
At-risk limitations apply to individual sole proprietors, partners, and shareholders in S corporations. If your business has more allowable expenses than income, the excess money spent is limited from the deduction on your tax return. You must be losing your own money or borrowed funds that you are personally liable to repay.
Borrowing money from a friend or family member may result in business funds for which you are not at risk. To qualify as being at risk, any loan should have a formal promissory note that bears interest and has a specified due date for repayment.
Keep track of how much money you invest in your business. If you do have a deductible loss, it reduces the amount you still have at risk. Any money or other property you withdraw from your company for personal use decreases your at-risk amount.
A loss of other people’s money that is denied as a tax deduction carries over to subsequent years. That carryover loss can be deducted against future year profits.
Shareholder Basis Limit
Business owners of S corporations are confronted by an even greater burden known as the basis limitation.
Meticulous records for each shareholder are necessary to account for cash and property contributed to an S corporation. Added to these amounts is a shareholder’s proportional share of profit. The sum comprises the shareholder’s stock basis in the S corporation. But some of the profit is typically distributed to shareholders. These distributions reduce the stock basis.
Additionally, corporate profit for tax purposes is not profit in your bookkeeping. Some expenses paid by a business are not deductible on the income tax return. Nondeductible expenses reduce shareholder basis, just like distributions of profit.
Moreover, certain types of income and deductions are not included in an S corporation’s profit. Capital gains, for instance, retain their distinctive character and pass through to S corporation shareholders as a category of income that’s different from business profit. A Section 179 tax deduction is also separate from other business expenses. These and more are additions or subtractions from a shareholder basis.
Lastly, shareholders may loan money to their S corporations and establish “loan basis” as a different figure from stock basis. But loans are only valid when they bear interest. A minimal amount of interest must be calculated, even if it’s not being paid every year.
The upshot: losses triggering negative amounts of basis are nondeductible. This typically arises from borrowing to acquire fixed assets, such as machinery or equipment. When the cost of these items is rapidly deducted as depreciation, the business has a loss. But the loan still has an unpaid balance. The loss reduces shareholder basis.
Keep in mind that nondeductible losses carry over to future years. They are deducted when basis is restored by a shareholder’s cash investments or loans to the company or by future profit.