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Deducting Losses

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Last updated: 23 Nov, 2018
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By Jason Watson ()
Posted November 23, 2018

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).

Depreciation Losses
How does a loss in an S corporation happen? Most one-person S corporations are cash based and don’t have a lot of equipment. However, for the sake of argument we will assume you bought a piece of equipment for $100,000 and borrowed $100,000 to pay for it. The equipment also qualified for Section 179 depreciation deduction allowing you to deduct (or attempt to deduct) the full amount against business income. Great! The benevolent IRS king is alive.

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.

Taxable Income Prior to Depreciation

60,000

Depreciation

100,000

Shareholder Basis

10,000

 -

Business Income on K-1

60,000

Section 179 Depreciation on K-1

70,000

 -

Loss Taken on Personal Tax Return

-70,000

 -

Section 179 Depreciation Carryforward

30,000

Business Loans
Another example that can really blow up your world is a loan. Let’s say the S corporation borrows $100,000 regardless if you personally sign and guarantee it. If you withdraw this $100,000 as a shareholder distribution to buy a lightly used Porsche 911 for your teenage daughter. The amount in excess of your shareholder basis would be taxed as capital gains to you. This gets complicated right quick, but can also be a big problem. If you are flirting with this scenario please tread lightly.

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
Any additional money injected into your S Corp should be treated as additional paid-in-capital which adds to your shareholder basis, rather than calling the money a shareholder loan. If your S Corp fails, you may deduct the additional investment as a capital loss. However, any loan you made to the S corporation becomes a miscellaneous deduction subject to thresholds, limitations and alternative minimum tax (AMT) on Schedule A. Yuck. The Tax Cuts and Jobs Act of 2017 might have eliminated this deduction altogether (we’ll have to wait until the dust settles).

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-

No Owner Loan

With Owner Loan

Income

25,000

25,000

Interest Expense on Owner Loan

0

5,000

Taxable Business Income

25,000

20,000

 -

Taxable Interest Income

0

5,000

 -

Income Taxes @ 25%

6,250

6,250

SE Taxes @ 15.3%

3,825

3,060

Total Tax

10,075

9,310

 -

Savings

765

Not a huge amount, but you get the idea.

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