With an S corporation or partnership you need sufficient shareholder / partnership basis in your business to deduct losses. For example, if you invested $10,000 into your business but the business lost $30,000, as an S Corp shareholder you can only deduct losses up to the amount of your shareholder basis (in this example, $10,000).
Think of Google. You invested $10,000 into Google stock and they go out of business, you only loose $10,000. Remember that with an S corporation you wear two hats- one as an employee, and one as an investor (shareholder).
Let’s assume that the business income prior to depreciation was $60,000 (and depreciation was $100,000). The S corporation tax return would still show a $60,000 net business income amount, but your K-1 would show a $70,000 amount for Section 179 deduction. Why $70,000? You had $10,000 in basis (using the example above) plus the $60,000 net business income. 10k + 60k = 70k, even in Canada.
You would be able to deduct $70,000 as a loss. The $30,000 remainder of the Section 179 deduction that was not taken or used would be carried forward to future years. Yuck! Sorry, the once-benevolent IRS king is now an imposter.
Here is a table to demonstrate the depreciation conundrum more clearly. We love tables.
Sidebar: If we have a capital gains issue because a shareholder received distributions in excess of shareholder basis we stop and ask some basic questions. Does it make sense? Are there loans on the books? If so, can the shareholder put the money back? If not, does the basis make sense given the facts and circumstances (for example, perhaps the basis information was messed up several years ago on an old tax return. If the basis does make sense, can we justify a shareholder loan?
Partners in partnerships who are responsible for partnership debt might be able to add the loan amount to their partnership basis, and the above distributions would not be problematic (commonly referred to as recourse debt).
As a single-member LLC without the S Corp election, business losses have no theoretical limit on your personal tax return since the entity is disregarded. Technically this assumes that all your money into the business is “at-risk” but that is usually the case.
The net-net is that business debt needs to be handled carefully.
Shareholder Loans and Tax Planning
Everyone wants to label a cash injection into a business as a loan to the S corporation. This is absolutely silly. If you materially participate in your S Corp there is no tax benefit or advantage. This is a bad debt versus capital injection scenario- money goes from you to the business, but is treated differently depending on what you call it. Oftentimes we’ll convert shareholder loans from prior tax returns into additional paid in capital to better position the client.
Let’s not forget that the IRS hates shareholder loans. Is there a promissory note? Payment schedule? Appropriate interest? If not, you could technically be in some trouble. We recently had a revenue agent say that the IRS uses Lines 7 (loans to shareholders) and 19 (loans from shareholders) on Schedule L on the S corporation tax return (Form 1120S) to flag this. Who knows? Blowing smoke? Perhaps.
Again, don’t do shareholder loans! Having demanded that, many accountants face the reality of balance sheet issues from ghosts of lousy accounting past and must book imbalances to shareholder loans. This is not elegant, but at the same time a balance sheet must… well... balance, as the name implies. Regardless, promissory notes and payment schedules need to be drafted if this occurs.
Sidebar: If you lend money to your garden-variety LLC that has not elected S Corp status, the interest paid to you is taxable at the income tax level of course but the overall LLC income is reduced by the interest expense and therefore you save self-employment taxes if you can justifiably reduce your salary. You are essentially pulling money out of the LLC without paying self-employment taxes. There might be a Medicare surtax trigger, but generally this is a great tax saving technique if your LLC is not earning above the magical $30,000 net income threshold.
Here is another table that pertains to a garden-variety LLC with a loan from the owner-
Not a huge amount, but you get the idea.
Taxpayer's Comprehensive Guide to LLCs and S Corps : 2019 Edition