Limitations on Losses — Instruction 1120-S (Schedule K-1)

There are potential limitations on corporate losses that you can deduct on your return. These limitations and the order in which you must apply them are as follows: the basis limitations, the at-risk limitations, the passive activity limitations, and the excess business loss limitations. These limitations are discussed below.

Other limitations may apply to specific deductions (for example, the section 179 expense deduction). Specific limitations generally apply before at-risk and passive loss limitations.

Basis Limitations Generally, the deduction for your share of aggregate losses and deductions reported on Schedule K-1 is limited to the basis of your stock and loans from you to the corporation. For details and exceptions, see section 1366(d). The basis of your stock is generally figured at the end of the corporation’s tax year. Any losses and deductions not allowed this year because of the basis limit can be carried forward indefinitely and deducted in a later year subject to the basis limit for that year.

You are responsible for keeping the information needed to figure the basis of your stock in the corporation. Schedule K-1 provides information to help you figure your stock basis at the end of each corporate tax year. The basis of your stock (generally, its cost) is adjusted annually as follows and, except as noted, in the order listed. In addition, basis may be adjusted under other provisions of the Internal Revenue Code. You should generally use Form 7203, S Corporation Shareholder

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Stock and Debt Basis Limitations, to figure your aggregate stock and debt basis.

Basis is increased by (a) all income (including tax-exempt income) reported on Schedule K-1, and (b) the excess of the deduction for depletion (other than oil and gas depletion) over the basis of the property subject to depletion.

Caution: You must report on your return (if you are required to file one) any amount required to be included in gross income for it to increase your basis.

Basis is decreased (but not below zero) by (a) property distributions (including cash) made by the corporation reported in box 16, code D, of Schedule K-1, minus (b) the amount of such distributions in excess of the basis in your stock.

At-Risk Limitations Generally, if you have (a) a loss or other deduction from any activity carried on as a trade or business or for the production of income by the corporation, and (b) amounts in the activity for which you aren’t at risk, you will have to complete Form 6198, At-Risk Limitations, to figure your allowable loss for the activity.

The at-risk rules generally limit the amount of loss and other deductions that you can claim to the amount you could actually lose in the activity. These losses and deductions include a loss on the disposition of assets and the section 179 expense deduction. However, if you acquired your stock before 1987, the at-risk rules don’t apply to losses from an activity of holding real property placed in service before 1987 by the corporation. The activity of holding mineral property doesn’t qualify for this exception.

Basis is decreased (but not below zero) by (a) nondeductible expenses; and (b) the depletion deduction for any oil and gas property held by the corporation, but only to the extent your share of the property’s adjusted basis exceeds that deduction.
Basis is decreased (but not below zero) by all losses and deductions reported on Schedule K-1.

You may elect to decrease your basis under (4) prior to decreasing your basis under (3). If you make this election, any amount described under (3) that exceeds the basis of your stock and debt owed to you by the corporation is treated as an amount described under (3) for the following tax year.

To make the election, attach a statement to your timely filed original or amended return that states you agree to the carryover rule of Regulations section 1.1367-1(g) and the name of the S corporation to which the rule applies. Once made, the election applies to the year for which it is made and all future tax years for that S corporation, unless the IRS agrees to revoke your election.

The basis of each share of stock is increased or decreased (but not below zero) based on its pro rata share of the above adjustments. If the total decreases in basis attributable to a share exceed that share’s basis, the excess reduces (but not below zero) the remaining bases of all other shares of stock in proportion to the remaining basis of each of those shares.

Basis of loans. The basis of your loans to the corporation is generally the balance the corporation owes you, adjusted for any reductions and restorations of loan basis (see the instructions for box 16, code E). Any amounts described in (3) and (4), earlier, not used to offset amounts in (1), earlier, or to reduce your stock basis, are used to reduce your loan basis (to the extent of such basis prior to such reduction).

Caution: When determining your basis in loans to the corporation, remember that:

Distributions don’t reduce loan basis, and
Loans that a shareholder guarantees or co-signs aren’t part of a shareholder’s loan basis. Shareholders only obtain basis from acting as a guarantee or in a similar capacity to the extent the shareholder makes a payment pursuant to the guarantee.

See the Instructions for Form 7203 for more details.

Generally, you aren’t at risk for amounts such as the following.

The basis of your stock in the corporation or the basis of your loans to the corporation if the cash or other property used to purchase the stock or make the loans was from a source (a) covered by nonrecourse indebtedness (except for certain qualified nonrecourse financing, as defined in section 465(b)(6)); (b) protected against loss by a guarantee, stop-loss agreement, or other similar arrangement; or (c) that is covered by indebtedness from a person who has an interest in the activity or from a person related to a person (except you) having such an interest, other than a creditor.
Any cash or property contributed to a corporate activity, or your interest in the corporate activity, that is (a) covered by nonrecourse indebtedness (except for certain qualified nonrecourse financing, as defined in section 465(b)(6)); (b) protected against loss by a guarantee, stop-loss agreement, or other similar arrangement; or (c) covered by indebtedness from a person who has an interest in the activity or from a person related to a person (except you) having such an interest, other than a creditor.

Any loss from a section 465 activity not allowed for this tax year will be treated as a deduction allocable to the activity in the next tax year.

Since at-risk limitations apply for each activity, you should get a separate statement of income, expenses, and other items for each activity from the corporation.

Note: Box 18 of Schedule K-1 will be checked when a statement is attached.

Passive Activity Limitations Section 469 provides rules that limit the deduction of certain losses and credits. These rules apply to shareholders who:

Are individuals, estates, or trusts; and
Have a passive activity loss or credit for the tax year.

Generally, passive activities include:

Trade or business activities in which you didn’t materially participate, and
Activities that meet the definition of rental activities under Temporary Regulations section 1.469-1T(e)(3) and Regulations section 1.469-1(e)(3).

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Passive activities don’t include the following.

Trade or business activities in which you materially participated.
Rental real estate activities in which you materially participated if you were a real estate professional for the tax year. You were a real estate professional only if you met both of the following conditions.

a. More than half of the personal services you performed in trades or businesses were performed in real property trades or businesses in which you materially participated.

b. You performed more than 750 hours of services in real property trades or businesses in which you materially participated.

If you are married filing jointly, either you or your spouse must separately meet both (a) and (b) of the above conditions, without taking into account services performed by the other spouse.

A real property trade or business is any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. Services you performed as an employee aren’t treated as performed in a real property trade or business unless you owned more than 5% of the stock (or more than 5% of the capital or profits interest) in the employer.

Material participation standards for shareholders who are individuals are listed below. Special rules apply to certain retired or disabled farmers and to the surviving spouses of farmers. See the Instructions for Form 8582 for details.

Your participation in the activity for the tax year constituted substantially all the participation in the activity of all individuals (including individuals who aren’t owners of interests in the activity).
You participated in the activity for more than 100 hours during the tax year, and your participation in the activity for the tax year wasn’t less than the participation in the activity of any other individual (including individuals who weren’t owners of interests in the activity) for the tax year.
The activity was a significant participation activity for the tax year, and you participated in all significant participation activities (including activities outside the corporation) during the year for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests (other than this test).

Individuals. If you are an individual, you materially participated in an activity only if one or more of the following apply.

You participated in the activity for more than 500 hours during the tax year.
The rental of a dwelling unit any shareholder used for personal purposes during the year for more than the greater of 14 days or 10% of the number of days that the residence was rented at fair rental value.
You materially participated in the activity for any 5 tax years (whether or not consecutive) during the 10 tax years that immediately precede the tax year.
Activities of trading personal property for the account of owners of interests in the activities.

If you have a passive activity loss or credit, use Form 8582, Passive Activity Loss Limitations, to figure your allowable passive losses, and Form 8582-CR, Passive Activity Credit Limitations, to figure your allowable passive credits. See the instructions for these forms for details.

If the corporation has more than one activity, it will attach a statement to your Schedule K-1 that identifies each activity (trade or business activity, rental real estate activity, rental activity other than rental real estate, portfolio income, etc.) and specifies the income (loss), deductions, and credits from each activity.

Note: Box 19 of Schedule K-1 will be checked when a statement is attached.

Material participation. You must determine if you materially participated (a) in each trade or business activity held through the corporation; and (b) if you were a real estate professional (defined earlier), in each rental real estate activity held through the corporation.

Each interest in rental real estate is a separate activity, unless you elect to treat all interests in rental real estate as one activity. For details on making this election, see the Instructions for Schedule E (Form 1040), Supplemental Income and Loss.

All determinations of material participation are based on your participation during the corporation’s tax year.

The activity was a personal service activity and you materially participated in the activity for any 3 tax years (whether or not consecutive) preceding the tax year. A personal service activity involves the performance of personal services in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, or any other trade or business in which capital isn’t a material income-producing factor.

a. Studying and reviewing financial statements or reports on operations of the activity,

Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the tax year.

Work counted toward material participation. Generally, any work that you or your spouse does in connection with an activity held through an S corporation (where you own your stock at the time the work is done) is counted toward material participation. However, work in connection with the activity isn’t counted toward material participation if either of the following applies.

The work isn’t the type of work that owners of the activity would usually do, and one of the principal purposes of the work that you or your spouse does is to avoid the passive loss or credit limitations.
You do the work in your capacity as an investor and you aren’t directly involved in the day-to-day operations of the activity. Examples of work done as an investor that wouldn’t count toward material participation include:

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b. Preparing or compiling summaries or analyses of the finances or operations of the activity for your own use, and

c. Monitoring the finances or operations of the activity in a nonmanagerial capacity.

Effect of determination. Income (loss), deductions, and credits from an activity are nonpassive if you determine that:

You materially participated in a trade or business activity of the corporation, or
You were a real estate professional (defined earlier) in a rental real estate activity of the corporation.

If you determine that you didn’t materially participate in a trade or business activity of the corporation or if you have income (loss), deductions, or credits from a rental activity of the corporation (other than a rental real estate activity in which you materially participated as a real estate professional), the amounts from that activity are passive. Report passive income (losses), deductions, and credits as follows.

If you have an overall gain (the excess of income over deductions and losses, including any prior-year unallowed loss) from a passive activity, report the income, deductions, and losses from the activity as indicated in these instructions.
If you have an overall loss (the excess of deductions and losses, including any prior-year unallowed loss, over income) or credits from a passive activity, report the income, deductions, losses, and credits from all passive activities using the Instructions for Form 8582 or the Instructions for Form 8582-CR to see if your deductions, losses, and credits are limited under the passive activity rules.

Special allowance for a rental real estate activity. If you actively participated in a rental real estate activity, you may be able to deduct up to $25,000 of the loss (or credit equivalent to a $25,000 deduction) from the activity from nonpassive income. This “special allowance” is an exception to the general rule disallowing losses in excess of income from passive activities. The special allowance isn’t available if you were married, file a separate return for the year, and didn’t live apart from your spouse at all times during the year.

Only individuals can actively participate in a rental real estate activity. However, a decedent’s estate (including a qualified revocable trust for which a section 645 election has been made) is treated as actively participating for its tax years ending less than 2 years after the decedent’s death, if the decedent would have satisfied the active participation requirement for the activity for the tax year the decedent died.

You aren’t considered to actively participate in a rental real estate activity if, at any time during the tax year, your interest (including your spouse’s interest) in the activity was less than 10% (by value) of all interests in the activity.

Active participation is a less stringent requirement than material participation. You may be treated as actively participating if you participated, for example, in making management decisions or arranging for others to provide services (such as repairs) in a significant and bona fide

sense. Management decisions that can count as active participation include approving new tenants, deciding rental terms, approving capital or repair expenditures, and other similar decisions.

Modified adjusted gross income (MAGI) limitation. The maximum special allowance that single individuals and married individuals filing a joint return can qualify for is $25,000. The maximum is $12,500 for married individuals who file separate returns and who lived apart at all times during the year. The maximum special allowance for which an estate can qualify is $25,000 reduced by the special allowance for which the surviving spouse qualifies.

If your MAGI is $100,000 or less ($50,000 or less if married filing separately), your loss is deductible up to the maximum special allowance referred to in the preceding paragraph. If your MAGI is more than $100,000 (more than $50,000 if married filing separately), the special allowance is limited to 50% of the difference between $150,000 ($75,000 if married filing separately) and your MAGI. When MAGI is $150,000 or more ($75,000 or more if married filing separately), there is no special allowance.

For a definition of “MAGI,” see Special $25,000 allowance in Pub. 925. Also see Line 6 in the Instructions for Form 8582.

Special rules for certain other activities. If you have net income (loss), deductions, or credits from any activity to which special rules apply, the corporation will identify the activity and all amounts relating to it on Schedule K-1 or on an attached statement.

If you have net income subject to recharacterization under Temporary Regulations section 1.469-2T(f) and Regulations section 1.469-2(f), report such amounts according to the Instructions for Form 8582.

If you have net income (loss), deductions, or credits from either of the following activities, treat such amounts as nonpassive and report them as indicated in these instructions.

The rental of a dwelling unit any shareholder used for personal purposes during the year for more than the greater of 14 days or 10% of the number of days that the residence was rented at fair rental value.
Trading personal property for the account of owners of interests in the activity.

Self-charged interest. The corporation will report any “self-charged” interest income or expense that resulted from loans between you and the corporation (or between the corporation and another S corporation or partnership if both entities have the same owners with the same proportional interest in each entity). If there was more than one activity, the corporation will provide a statement allocating the interest income or expense with respect to each activity. The self-charged interest rules don’t apply to your interest in the S corporation if the corporation made an election under Regulations section 1.469-7(g) to avoid the application of these rules. See the Instructions for Form 8582 for details.

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Excess Business Loss Limitations Losses attributable to your trade or business may be limited, pursuant to section 461(l). See Form 461, Limitation on Business Losses, and its instructions for more information.