In general, the tax code allows a taxpayer to take as a loss and therefore reduce his tax liability for those losses tied to business investments. To qualify, the taxpayer must have ‘Risk’ in his investment. If none or limited risk, then the taxpayer is limited in how much he may take as a deduction on his return. We all have heard about how 95% of all new business ventures fail. Well, those failures had money invested in them to some degree. Congress desires investment into new businesses as a tool to maintain or increase the nation’s productivity. In exchange for this investment, Congress authorizes the taxpayer to take as a loss any investment in a legitimate venture. Thus, the taxpayer is able to reduce their loss by the value of the tax savings. A good example is a taxpayer in a 27% tax bracket at the federal level and a 5.5% income tax bracket at their state level. If the taxpayer invests $10,000 into a new venture and the venture goes bankrupt after two years, the taxpayer is entitled to a $10,000 loss on their tax return. Therefore, the taxpayer will reduce their corresponding tax liability by $3,250 ((27% + 5.5%) X $10,000). The effect is a reduced tax exposure and the net after tax loss is $6,750 ($10,000 investment less $3,250 tax savings).
To ensure that these losses are legitimate, Congress defined the term ‘At-Risk’. This article will explain these rules. Individual taxpayers use Form 6198 to substantiate the respective loss(es). I will first explain how the taxpayer is notified of their loss and the respective activities that are covered by the At-Risk rules. The next section will describe the basic rules related to the definition of At-Risk. The third section will explain the year to year accounting process for the taxpayer and finally, I’ll explain ‘Recapture’ and issues related to disposition of the investment.
I caution the reader, this is a mere introduction to this subject matter. There are volumes of books and articles related to this subject. There are many court cases too that address this subject matter. Most of this other material deals with very high end investments and significant dollar values. This article is designed for the small business entrepreneur and introduces them to the terms and basic concepts used. If you are investing more than $100,000 into a business, I strongly encourage you to seek out professional advice from a Certified Public Accountant that practices in the area of taxation. You should still read this article as it will introduce you to the overall concept and terminology used. Let’s begin:
Notification and Legal Activities for At-Risk Investments
Whenever you invest in a business, you generally sign some form of a legal document that sets your rights as an investor. Typical legal entities and their respective documents are as follows:
- Partnerships – Partnership Agreement
- S-Corporation – Shareholder Agreement
- Limited Liability Company – Membership Agreement
- Trust – Trust Document or Court Authorization
- Estate – Court Order or an Irrevocable Trust Document
All of these entities are referred to as Pass-Through entities as the respective tax issues are passed along to the respective investor. The most commonly used reporting tool is Form K-1 from the entity’s tax return. As an example, a partnership will file Form 1065 with the IRS and attach a copy of all the K-1’s listing the respective partner’s name, address, social security number and their assigned tax attributes. In addition, the K-1 will provide the tax basis balance of the respective partner to the IRS. This is a key to you as an investor, as long as that tax basis is positive and this entity has assigned you losses, you are generally allowed to deduct those losses on your personal tax return.
One of the primary tests to be able to take this assigned loss is the legitimacy of the business activity. Code Section 465 defines this as any activity engaged in as a trade or business for the production of income. However, the activity must be legal as defined by the state and the federal code. If the activity is a drug distribution system, the losses will not be allowed as this is against federal law. Currently, the only activity that is in question will be those marijuana stores selling under Colorado law. I’m pretty confident there will be federal court case and ultimately a Supreme Court decision related to losses from those investments.
There are some restrictions as defined by the Code and it relates to investments prior to 1987. If this is your situation, seek out professional advice.
The first step in the at-risk rules scenario is defining your position within the financial structure of the business investment. There are two types of investors – Active and Passive. Typically active investors are involved in the day to day operations of the business. This is the more common type of investment owner and pretty much normal. Passive investors are usually referred to as limited investors and are only involved in the management hiring process. The rules are slightly different related to the two different types of investors.
For those investors defined as passive, you have an additional set of rules to follow. These are referred to as passive activity limits. This is discussed in a separate article; suffice it to say that the losses sustained can only be deducted against income from a similar activity. In effect, passive investors have a more restrictive ability to deduct the loss.
To determine the amount available or at-risk, the investment must pass certain tests. They are as follows:
- The investment must be with after tax dollars or with property purchased with after tax dollars. As an example, you are not allowed as basis in the investment the unrealized gain of stock donated to the business entity. To extend this, if you use a stock investment and transfer this stock to the business for your share of the investment and you purchased the stock for $2,000 and it is now worth $8,500, your maximum loss for tax purposes is the $2,000 you invested. However, if you include the gain of the additional $6,500 and pay the taxes on the $6,500, you are then entitled to deduct the entire $8,500 if assigned losses meet this amount. The key is the tax basis of the particular investment.
- For borrowed money the business takes out a loan for in the normal course of operations, only that amount which is recourse to the investor is deductible as losses should the business sustain that amount. In addition, if the loan is a Qualified Non-Recourse Loan, the investor will most likely have a prorated share of this debt as a deduction if losses should occur. This gets a little tricky as it becomes imperative that basis is tracked between the two distinct groups of the amounts with after tax dollars and those amounts attributable to recourse and qualified nonrecourse debt.
Now that you have established your investment basis and their corresponding tax attributes, you need to understand how to track this investment from year to year.
Accounting for Losses
It is essential to track your basis and the yearly losses in order to account for them to the IRS. Most individuals let their CPA handle this but I can assure you, that you are the best qualified to track this information. Use a simple spreadsheet to track the information. Your rows act in the form of time periods, and the columns break out the respective tax attributes related to the investment. For example, one column will be labeled cash investment, another stock and other brokerage investments, a third will represent any physical assets and the corresponding undepreciated value. A fourth column should represent the various different types of loans. Have a separate column for each loan document. Finally, create a total column.
Make notes below this information related to the physical assets. Indicate the fair market value and the corresponding partnership value. Then you will describe or illustrate to yourself the difference between the partnership contribution value and the tax basis. This is essential in that it establishes the tax basis, the inside basis to the partnership and the outside basis for your purposes. This is a relatively simple spreadsheet but extremely beneficial for documentation purposes.
As each year passes, the K-1’s from the business will assign incomes in the different formats: regular, rental, interest, capital gains/losses and other types of gains/losses. Track these in your spreadsheet in the respective columns. The key is that your total balance should match the tax basis reported to the IRS.
Sometimes losses are not allowed due to the passive activity rules and these losses can be carried over to following years. Track this information. If you need to, send the spreadsheet to your accountant and he can make necessary adjustments so that your total losses match the accumulated balances via the respective Form 6198’s.
Recapture and Disposition
Sometimes, the accumulated losses exceed your existing tax basis. This often happens when a business is headed toward bankruptcy and its debts exceed its assets. This gets tricky because you are not allowed to take these losses beyond your legal basis (tax basis including recourse and qualified non-recourse debt). If you do, you will have to ‘RECAPTURE’ the dollar value and pay taxes on any losses you take in excess of the tax basis. This does happen and it sounds complicated but in reality it is relatively simple. For you, monitor your tax basis, as it heads towards zero I would be asking questions of management as to why the business is losing money. You didn’t invest in an operation to lose money.
No matter what happens, at some point in the future there will be a termination of the business or you will sell your ownership position. This is referred to as ‘Disposition’. Upon disposition, the accumulated basis is used against the sell price to determine gain. With your simpler types of transactions, most gains or losses associated with disposition are ordinary. But sometimes, the investor is a limited investor and therefore the gain/loss is also passive. In these cases, these gains/losses at disposition are generally capital in nature. Most often it ends up being a combination of both ordinary and capital and this is why you track your basis in the respective columns as suggested above. I have seen suspended losses recaptured against the final gain reported. The following is a typical example:
The investment was into a business that was writing software for the Air Force. The limited investor purchased a $40,000 position and was able to take all $40,000 as losses over a course of 3 years. In addition, the business had assigned him an additional $3,700 of losses due to using the cash basis of tax reporting. This $3,700 was suspended and not taken on the taxpayer’s tax return as there was nothing at-risk. In year 4, the business sold out due to proprietary knowledge to a larger national contractor desiring this type of work with the Air Force. The value received by the taxpayer was $84,500 after all costs associated with the sale. The $3,700 of unused losses reduced the final taxable gain by $3,700 and the taxpayer paid taxes on $80,800.
In summation, you as a small business entrepreneur should track your investments in the business. Separate the investment into the respective types of tax basis and keep this spreadsheet up to date. This will help you minimize your tax exposure and in addition substantiate your position in business dealings. Remember, to be able to take a deduction as a loss on your tax return, you must have basis, basically be ‘At-Risk’ for the investment. Act on Knowledge.