Academic journal article Journal of Accountancy

Managing S Corporation At-Risk Loss Limitations: Grouping or QSub Elections Can Maximize Loss Recognition

Academic journal article Journal of Accountancy

Managing S Corporation At-Risk Loss Limitations: Grouping or QSub Elections Can Maximize Loss Recognition

Article excerpt

EXECUTIVE SUMMARY

* Losses passed through to S corporation shareholders are limited first by shareholder basis limits under IRC [section] 1366, next by the at-risk requirements of section 465, and finally by the passive activity limits of section 469. Practitioners tend to focus on the first and last of these three and may overlook special provisions of the at-risk rules that can allow some taxpayers to recognize more of their losses sooner.

* An S corporation shareholder has at-risk basis to the extent of contributions to the corporation and unencumbered funds lent by the shareholder to the corporation, if the lent funds are borrowed by the shareholder, they create at-risk basis to the extent the shareholder is personally responsible for their repayment. In the case of nonrecourse borrowings, as long as the shareholder has pledged property (other than that used in the activity, which includes the S corporation stock) as security, the at-risk amount is limited to the net fair market value of the taxpayer's interest in the pledged property.

* One strategy for increasing an S corporation shareholder's at-risk loss limitation is aggregating business activities across more than one asset or property. Taxpayers may aggregate most activities in which they actively participate. Certain types of activities can be aggregated only with the same activity carried on with respect to more than one asset or property.

* Another strategy is merging one S corporation into another by a qualifying S subsidiary (QSub) election. A shareholder who has a suspended loss carryover because of an at-risk limitation may contribute shares of a "loss" corporation to one without a loss, followed by a QSub election-provided the shareholder actively participates in both operations. The transaction can be structured as a tax-free reorganization.

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[ILLUSTRATION OMITTED]

Today's economic climate may be dealing your clients a loss. It's bad enough, especially for small business owners, to have to wonder when they might return to profitability Beyond that, tax recognition of their losses is limited.

One of those limitations is that a taxpayer's loss deductions are limited to amounts "at risk" in a trade or business or income-producing activity under IRC [section] 465. This article focuses on the at-risk limitations and their application to S corporation shareholders. It explores some options that may help such clients recognize those losses in a way that minimizes their federal taxes. It shows how grouping trade or business activities in which a shareholder actively participates or a QSub election can help where loss recognition by one activity or S corporation is limited but another is not. Understanding such strategies is important not just for CPA tax practitioners but for tax lawyers, consultants, corporate in-house tax executives and government regulators.

AT-RISK LIMITATION RULES

It's important to note at the outset that the at-risk loss limitation isn't the only such limit imposed on shareholders of S corporations. They are also subject to similar types of loss limitations as partners in a partnership. Losses passed through to S corporation shareholders are limited by the following provisions in the order listed (Temp. Treas. Reg. [section] 1.469-2T(d)(6)):

1. The basis limitations of IRC [section] 1366(d),

2. The at-risk limitations of section 465, and

3. The passive activity loss limitation of section 469.

In planning for clients' business losses, many practitioners tend to focus on the shareholder basis limitations and passive activity rules. Yet, it is important not to forget about the intermediate step: analysis of the at-risk rules.

Congress enacted the at-risk rules of section 465 as part of the 1976 Tax Reform Act, effective for years beginning in 1976, to limit a taxpayer's ability to use nonrecourse financing to generate tax losses in excess of the taxpayer's economic risk. …

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