Interaction of S shareholders' loss limitations.

AuthorHunley, Shaun M.

Losses passed through to S shareholders are limited by the various loss limitation provisions in the following order (Temp. Regs. Sec. 1.469-2T(d)(6)):

  1. Basis limitations (Sec. 1366(d)(1));

  2. The at-risk rules (Sec. 465(a)(1));

  3. The passive activity loss (PAL) rules (Sec. 469(a)(1)); and

  4. For tax years beginning after 2020 and before 2029, the excess business loss limitation (Sec. 461(1)).

Law change: Enacted on Aug. 16, 2022, the Inflation Reduction Act of 2022, P.L. 117-169, extended the effective date of the Sec. 461(1) excess business loss limitation by two years. Prior to the Inflation Reduction Act's enactment, the excess business loss limitation applied to tax years beginning after 2020 and before 2027. Section 13903(b)(1) of the Inflation Reduction Act extended the effective date to apply to tax years beginning before 2029.

The at-risk rules apply only to individuals and closely held C corporations, meaning that the limits are imposed at the shareholder level in the case of an S corporation. The excess business loss limitation also applies at the shareholder level.

Example 1: Calculating deductible losses under the basis, at-risk, and PAL limitation rules: P invests cash of $10,000 in exchange for 15% of the stock of a new S corporation that raises cattle. (The $10,000 is made up of $6,000 from P's personal savings and $4,000 that he borrowed from R, a 25% shareholder in the company.) P, who does not materially participate in the company's operations, is allocated an $11,000 passthrough loss at the end of the first year. He does not receive passive income from any other source.

P's basis limitation restricts his deductible loss to $10,000. The at-risk rules then limit his deductible loss to $6,000 (the amount not borrowed from a person who has an interest in the company). The PAL rules reduce his deductible loss to zero. Thus, his entire $11,000 first-year loss will be suspended and carried over as follows: $1,000 under the basis limitation rules, $4,000 under the at-risk rules, and $6,000 under the PAL rules.

Increasing at-risk basis by gain from stock disposition

Gain from the disposition of stock increases at-risk basis, allowing shareholders to use all or part of their losses that have been deferred under the at-risk rules. Similarly, a taxable disposition of stock in a passive activity to an unrelated party allows the use of any PALs from the activity that may have been previously suspended because of insufficient passive activity...

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