Claiming Business Losses on Your Personal Return

Claiming Business Losses on Your Personal Return

Authored by Haynie & Company Partner Bernard Abercrombie, CPA

A taxpayer’s ability to claim certain business and investment losses on their personal returns has been a significant topic over the last few years. Due to perceived abuses, the IRS initiated several reporting requirements to monitor the accuracy of taxpayers’ claimed deductions.

For a taxpayer to claim a deduction for losses reported in businesses they own or invest in several hurdles must be overcome.

Passive Activity Limitations

One of the first hurdles usually involves the requirement that the taxpayer is materially and actively participating in the business. The rules for participation requirements can be complex but generally involve the amount of time they participate and the type of work they perform for the business. There are exceptions to the basic rule requiring 500 hours to be treated as materially participating. There are seven possible measurements including the 500-hour rule above. If a taxpayer doesn’t meet those standards, the activity is deemed to be passive which can severely limit the deductibility of the losses. These standards are measured each year, so an activity level in one year may allow deduction in one year, but not in another. If losses are limited by the Passive Activity rules, those losses are suspended and may be allowed in a future year.

Basis Limitations

Whether a taxpayer passes the Passive Activity Limitations or not, another mutually exclusive level of restriction comes into play. If a taxpayer exceeds the Passive Activity Limitation requirements, they must also have a basis in the activity to claim any of these deductions. In simple terms, having a basis means that the taxpayer has money invested in the activity or has recognized income from the investment and has not received distributions for all of those amounts over the period they have been involved.

The IRS has made changes in the reporting requirements for Partnerships and S Corporations to easily scrutinize the level of the basis a taxpayer may have. Partnerships were required to report a partner’s capital accounts on a cash basis beginning with the 2020 tax return year. The IRS views this as a relatively easy method to obtain a reasonable approximation of basis.

For the 2021 tax return year, the IRS instituted similar rules for S Corporations by creating Form 7203-S Corporation Shareholder Stock and Debt Basis Limitations. This new form must be filed by S Corporation shareholders who are claiming a loss for the tax year. There are other reasons this form must be filed, but the main issue is to identify whether there is a basis available to claim a loss.

In addition to the limitations identified above, there are two limitations that were imposed by the Tax Cuts and Jobs Act of 2017. The CARES Act temporarily rescinded these provisions for the calendar years through December 31, 2020.

Excess Business Loss Limitations

This limitation allows a business loss to the extent of the business’s gross income plus a threshold amount. The threshold amount for 2021 for married filing joint is $524,000 and half that amount for a single person. For example, if a married filing joint taxpayer has a business and the gross income for that business is $300,000, then the loss limitation under this provision would be $824,000 for 2021. Any loss in excess of that amount will be treated as a net operating loss carryover to 2022.

These limitations apply at the partner/shareholder level for pass-through entities and are applied after the impact of the Passive Loss limitations and Basis Limitations discussed above.

Net Operating Losses

If a taxpayer still has a net trade or business loss after all the above limitations, the amount that can be utilized in the current year incurs an additional limitation. Once the overall Net Operating Loss (NOL) is calculated for the year, the loss deduction is limited to 80% of the year’s taxable income. The result is an NOL in the current year, or carried forward into future years, can no longer zero out taxable income.

Excess Net Operating Losses can be carried forward until they are fully utilized.

The scope of the article does not allow for addressing intricacies and exceptions. The rules for these limitations are very complex. Consult your Haynie & Company tax advisor for more information related to the associated rules and regulations.

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