What Are At-Risk Rules?
The at-risk rules deal with the amount of your investment in a business that you are PERSOANLLY at risk of losing if the business fails. In other words, these rules have nothing to do with whether the business itself is at risk but rather, what you, personally, are at risk of losing.
Purpose of the At-Risk Rules
The purpose of the at-risk rules is to prevent you from claiming a loss in excess of what you actually stand to lose. Only the amount you are personally at risk of losing counts towards your at-risk basis, which is also called your tax basis.
Your Tax Basis
Your tax basis is equal to your investment in the business plus loans you make to the business.
For example, if you own an S corporation and invest $10,000 in the stock of the S corporation and also lend the S corporation $5,000, your tax basis (the amount you have at risk) would be $15,000. The amount you invest in the stock is called your stock basis and the amount you lend the company is called your loan basis. Therefore, the total of your stock basis and loan basis (if any) is your tax basis and also your at-risk basis.
If you invest in an S corporation or partnership, the amount of a loss incurred by these entities that you may deduct is limited to the amount of your investment you personally have at risk (your at-risk basis).
- You start an S corporation In 2016.
- You invest $10,000 in the stock of your S corporation.
- You are the sole shareholder/employee.
- You have not made any loans to the S corporation.
- In 2016 the S corporation has a $12,000 loss.
- Your tax basis EQUALS your stock basis PLUS your loan basis.
- You did not make any loans to the S corporation during 2016, therefore, your tax basis equals your stock basis, $10,000.
- Since you did not make any loans to the S corporation during 2016, your at-risk basis is also $10,000.
- So for 2016, your stock basis, tax basis, and at-risk basis are the same amount, $10,000.
- Since your 2016 tax basis is $10,000, you may only deduct $10,000 of the $12,000
- The $10,000 loss deduction is subtracted from your stock basis, reducing your tax basis to zero (stock basis $10,000 minus $10,000 loss deduction).
- Since you're only allowed to deduct $10,000 of the $12,000 loss for 2016, the remaining $2,000 is called a suspended loss.
A suspended loss may be carried over to future years indefinitely and deducted when there is sufficient basis.
Increasing Your Tax Basis
Continuing with the above example:
Say you wanted to deduct the entire $12,000 loss in 2016 instead of just $10,000.
Here's what you could do:
- Increase your tax basis by at least $2,000 during 2016.
- You may do this by investing an additional $2,000 in the stock of the S corporation or by lending the S corporation $2,000.
If you were to lend $2,000 to the S corporation instead on investing $2,000 in S corporation stock, you would have a loan basis of $2,000 and a stock basis of $10,000 which would equal your tax basis of $12,000, sufficient to deduct the entire $12,000 loss in 2016.
TIP: If you expect a loss in any given tax year, check your stock basis and loan basis (if any) prior to the end of the year to see if you will have enough basis to absorb the entire loss. If you won't have enough basis, give yourself the time needed to increase your tax basis before the end of the year.
If you have a business loss and if any part of your investment in the business is not at risk, you must complete Form 6198, At-Risk Limitations.
Passive Activity Rules: If you merely invest in a business and do not actively participate in the day-to-day operations, losses are classified as passive losses. Passive losses may only be deducted from passive income. If a passive loss exceeds passive income in any tax year, the excess loss may be carried over to the following tax year.
If you're a sole proprietor, you and your business are not considered separate entities; you and the entity are considered one and the same and you would file Schedule C (Schedule F for farming) to report business income and expenses.
For Schedule C filers, at risk means you are using your own money for the business. Only check Box 32a if "All investment is at risk". Check box 32b if "Some investment is not at risk". A loss may only be deducted up to the amount you personally have at risk, and no more. If a loss exceeds your at-risk investment, the excess is called a suspended loss and may be deducted in a future year, indefinitely, until you have sufficient at-risk basis to absorb the loss.
Amounts invested in the business for which you would NOT be at risk may include the following:
- Non-recourse loans used to finance the business
- Cash, property or borrowed amounts used in the business that are protected against loss by a guarantee, stop-loss agreement, or other similar arrangement (excluding casualty insurance and insurance against tort liability).
- Amounts borrowed for use in the business from a person who has an interest in the business, other than as a creditor.
In other words, if you have absolutely no money at risk in your business, you may not deduct any part of a Schedule C loss. The amount of a loss you may deduct must be equal to or less than the amount you personally stand to lose.
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