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.
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 your are personally at risk of losing counts towards your at-risk basis, which is also called 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. The total of your stock basis and loan basis (if any) is your tax basis and also your at-risk basis.
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 filerss, 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.
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).
- In tax year 2014 you invest $10,000 in the stock of your S corporation (this would give you a stock basis of $10,000, which is also your tax basis and at-risk basis). In other words, it's what you stand to lose if the company fails.
- In 2014 the S corporation has a $12,000 loss.
- For tax year 2014, the maximum amount of the loss you may deduct is $10,000, your tax basis (at-risk basis).
- Your $10,000 tax basis would be reduced by the $10,000 loss, resulting in a zero tax basis.
- Since your 2014 tax basis was only $10,000 at the time of the $12,000 loss, the remaining $2,000 cannot be claimed in 2014.
- The remaining $2,000 loss is called a suspended loss.
The suspended $2,000 loss may be carried over to future years indefinitely and deducted in a year you have sufficient tax basis to absorb the loss.
Increasing Your Tax Basis
Continuing with the above example. Say you wanted to deduct the entire $12,000 loss in 2014 instead of just $10,000. To accomplish this, you would have to increase your tax basis by at least $2,000 during 2014. 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. This would increase your tax basis from $10,000 to $12,000 for 2014, sufficient to deduct the entire $12,000 loss in 2014
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 a tax basis of $12,000, sufficient to deduct the entire $12,000 loss in 2014. In other words, your tax basis is the total of your stock basis plus your loan basis.
TIP: If you expect a loss in any given tax year, you should check your stock basis and loan basis (if any) prior to the end of the year to see if your tax basis is sufficient to absorb the entire loss. If your tax basis is not sufficient, and if you want to deduct the entire loss, you'll have time to increase your tax basis by either investing more money in the company or lending the company money.
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.