S Corporation Loss Limitation Rules

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A Subchapter S corporation acts as a pass-through entity, which allows its shareholders to take the company earnings and losses directly. In past years, some shareholders in S corporations have used losses from these businesses to offset their profits from other ventures in an effort to reduce their tax burdens. However, tax laws now limit the manner and amount of losses that S corporation investors can claim.

Structure of an S Corporation

Subchapter S of Chapter 1 of the Internal Revenue Code allows for the creation of corporations that pass their profits and losses directly to their shareholders. Unlike the better-known Subchapter C corporations, a Subchapter S corporation does not pay corporate income taxes. Instead, the company's shareholders receive those profits and losses as personal income in proportion to the percentage of shares they own in the company. As a result, these shareholders must claim these earnings and losses on their personal tax returns.

Passive Activity Loss Limitation

Some shareholders in S corporations do not take an active interest in the day-to-day activities of the company. The income or losses their shares incur are known as passive activity income or passive activity losses. In previous years, these shareholders could deduct their passive activity losses from either active or passive income. Tax law changes have closed that loophole so that passive activity losses can only be deducted from passive activity income. If the company earned no passive activity income, the passive activity losses cannot be deducted.

Read More: S Corporation Passive Income Restrictions

Adjusted Basis Loss Limitation

A shareholder’s portion of an S Corporation's losses is limited by his adjusted stock basis. The shareholder's basis is adjusted upward with any additional investments that shareholder makes in the company and adjusted downward with any distributions the shareholder receives. If the shareholder's losses exceed his adjusted basis, the shareholder can only claim losses up to the amount of the adjusted basis. For instance, if the shareholder's adjusted basis is $5,000, but his share of the losses is $8,000, he can only claim $5,000 in losses on this year's taxes.

At-Risk Loss Limitations

At-risk loss limitation rules function in similar ways to those for adjusted stock basis. While the basis rules measure loss limitations by the funds the stockholder has in the company, the at risk rules use the amounts of financial risk the shareholder employs to invest in the S corporation's operations. Risk levels can be measured by either capital contributions or secured or unsecured debt the shareholder extends to the company. Since the shareholder places his funds at risk for the good of the company, he is allowed to take losses to the extent of those contributions.

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