Taxation of Business Entities

Taxation of Business Entities Losses and Loss Limitations Text: Chapter 6

Outline • Bad Debts • Worthless Securities • Casualty Losses • NOL Deductions • At-risk and Passive Loss Rules

Bad Debts-In General • Bad Debt Deduction is allowed for: • Bona-fide debts that are not repaid • Unpaid accounts receivable for accrual-basis taxpayers • Cash-basis taxpayers have not recognized income from the creation of an A/R; thus, these taxpayers can not deduct a bad debt expense

Specific Charge-Off Method • Must be used by most taxpayers. • Under the specific charge-off method, a deduction is allowed when: • A business bad debt becomes wholly or partially worthless. • A non-business bad debt becomes wholly worthless. • Collection of a receivable previously written off bad debt requires recognition of income to the extent of the tax benefit from the previous write-off.

Business vs. Nonbusiness Debt • Business bad debt • Debt related to taxpayer’s trade or business • Deductible as an ordinary loss • Non-business bad debt • Debt not related to the taxpayer’s trade or business • Deductible as a short-term capital loss

Business vs. Nonbusiness Debt • Example: A taxpayer (an individual) has ordinary income of $40,000, and a bad debt write-off of $10,000. • What is the taxpayer’s AGI if bad debt is business bad debt? • What is the taxpayer’s AGI if bad debt is non-business bad debt? • What if the taxpayer was a C-Corporation instead of an individual?

Loans Between Related Parties • Primary issue is whether the transaction was a bona fide loan or a gift. • Factors determining loan vs. gift status • Was a note properly executed? • Was there a reasonable rate of interest? • Was collateral provided? • What collection efforts were made? • What was the intent of the parties?

Worthless Securities • Securities include stocks, bonds, and registered notes. • Loss is allowed in tax year that securities become completely worthless. • Losses are treated as capital losses deemed to have occurred on the last day of the tax year (regardless of the actual date of worthlessness).

Small Business Stock (§ 1244) • § 1244 exception • Ordinary loss treatment on sale (or worthlessness) of small business stock by individuals. • Applies to first $1,000,000 of stock issued by corporation. • Up to $50,000 per year ($100,000 for Married Filing Jointly) can be treated as ordinary loss. • Only individuals who acquired the stock from the issuing corporation qualify. • Example – A single taxpayer sells 1244 stock in December 2009, with a basis of $110,000 for $40,000. • What is the amount and character of loss recognized in 2009? • Any tax planning suggestions?

Casualty Loss Definition • Casualty losses include those caused by: • Fire, storm, shipwreck, theft • “Other” casualty (e.g. plane crash, car crash etc.) • The event that causes the casualty must be: • Identifiable • Damaging to property • Sudden, unexpected, and unusual in nature • Theft includes, but is not limited to: • Larceny • Embezzlement • Robbery

Casualty Loss Definition • Events that are not casualties: • Damage resulting from progressive deterioration (e.g., erosion, wind, rain). • Insect damage (unless sudden, unexpected, and unusual in nature). • An event that causes a decline in value rather than an actual loss (e.g., a flood that reduces value of property because of its location). • Theft does NOT include misplaced property.

When to Deduct Casualty and Theft Losses • Generally, a casualty loss is deducted in the year incurred. • Disaster area losses may be deducted in the tax year prior to the year the loss occurred (at the election of the taxpayer). • Theft losses are deducted in the year of discovery (not the year of the theft, if earlier).

Amount of Casualty & Theft Deductions

Casualty and Theft Losses: Business Property • Example 1—Complete Destruction • Corporation’s warehouse was destroyed by fire; basis was $100,000; FMV was $90,000. • How much is deductible casualty loss? • Example 2—Partial Destruction • Corporation’s warehouse was damaged by fire; adjusted basis was $100,000; FMV was $150,000 before, $80,000 after fire. • How much is deductible casualty loss? • What is corporation’s adj. basis in warehouse after deducting casualty loss?

Casualty and Theft Losses: Personal Use Property • Example 1—Complete Destruction • Individual’s residence was destroyed by flood; basis was $100,000; FMV was $90,000. • How much is deductible casualty loss (before AGI limitations)? • Example 2—Partial Destruction • Individual’s residence was damaged by flood; basis was $100,000; FMV was $150,000 before, $80,000 after flood. • How much is deductible casualty loss (before AGI limitations)?

Casualty & Theft Losses: Insurance Recoveries • Losses on property are reduced by insurance or other type of recovery (e.g., FEMA payment) • An insurance recovery will result in a casualty gain if the proceeds exceed the adjusted basis of the property (see Chapter 8 for treatment of gain)

Casualty & Theft Losses: Personal Use Property Floors • Casualty losses on personal use property are further reduced by: • $100 per casualty ($500 per casualty in 2009) • 10% of adjusted gross income (applies to aggregate losses of the individual) • Occasionally this limitation is lifted for “presidentially declared disaster areas” • Whatever amount remains (if any) is then deducted as an itemized deduction.

Casualty & Theft Losses: Additional Examples • In 2009, Taxpayer’s property (Basis = $50,000; FMV = $60,000) is completely destroyed by fire. Insurance reimbursement = $30,000. Before consideration of this loss, taxpayer’s AGI = 100,000. • How much can the taxpayer deduct if property is business property? Where is it deducted? • How much can the taxpayer deduct if property is personal-use property? Where is it deducted?

Net Operating Loss (NOL) • An NOL occurs when business expenses exceed business income • Length of carryback and carryforward periods • 2-year carryback • 20-year carryforward • 3-year carryback is available in limited cases • For 2008-2010, certain businesses may elect to increase the carryback to up to 5 years • Special rules and limitations apply • May elect to forgo carryback

Effect of NOL Deductions • The NOL is offset against taxable income • Carry-back • NOL generates a refund if tax was paid in carryback years • Carry-forward • NOL reduces taxable income in carry forward years • Only C corporations and individuals are allowed to deduct NOLs • WHY???

Computation of NOL for Individual • NOL = Taxable Income + Net Capital Loss + Personal and Dependency Exemptions + (Non-Business Deductions in excess of Non-Business Income) • Allowed Business Deductions include: • Moving expenses • Loss on rental property • 1244 losses • ½ self–employment tax • Losses from Sole Proprietorships, partnerships and S Corps • Personal (and Business) Casualty Losses

At-Risk and Passive Loss Rules • At-risk and passive loss rules were designed to solve the “tax shelter” problem that was prevalent in the 1970s and early 1980s. • Tax shelters were attractive to investors for the following reasons: • Large (ordinary) loss deductions (through use of nonrecourse debt, accelerated depreciation, etc.) in the early years of the tax shelter allowed for the deferral of taxes. • Tax-favored treatment applied to long-term capital gain upon the eventual sale of the tax shelter investment.

At-risk and Passive Loss Rules • Tax provisions aimed at tax shelters • At-risk limitation • Limits taxpayer’s deductions to amount taxpayer could actually lose from the investment (the amount “at-risk”). • Passive loss rules • Limit an investor’s ability to deduct losses from so-called “passive” activities against income from non-passive sources (e.g. active trade/business income and portfolio income).

The At-Risk Limitation • A taxpayer’s deductible loss from an activity for any taxable year is limited to the amount the taxpayer has at-risk at the end of the taxable year. • A taxpayer’s at-risk amount fluctuates over time • Losses suspended under the at-risk rules can be deducted in later years when the taxpayer has a positive at-risk amount in the activity. • Initial amount at-risk includes: • Cash and property contributed to the investment/activity . • Amounts borrowed for use in the activity for which the taxpayer is personally liable. • Adjusted basis of property not used in the activity that is pledged as security for debts of the activity.

The At-Risk Limitation • At Risk amount is adjusted each year by: • Income recognized by taxpayer • Losses deducted by the taxpayer • Distributions received by the taxpayer • The taxpayer’s share of debt incurred by entity (sometimes).

The At-Risk Limitation –Example • 1/1/2008 – Rich contributes $10,000 to be 1/3 owner in 3R Partnership (no debt). He actively participates in the partnership’s business. • 12/31/2008 – 3R Partnership reports $90,000 Ordinary Income for the year. Rich reports $30,000 on HIS tax return, he receives NO distributions from partnership. • How much is Rich’s at-risk basis at 12/31/08? • During 2009, 3R Partnership takes out a recourse loan with bank of $30,000 (partners guarantee loan.) • 12/31/2009 – 3R reports $60,000 ordinary income for the year. Each partner receives a distribution of $5,000. Rich dutifully reports his $20,000 share of partnership income on his tax return. • How much is Rich’s at-risk basis at 12/31/09? • 12/31/2010 – 3R Partnership reports a loss of $240,000. There is no change in liabilities and the partners received no distributions during the year. • How much is Rich’s at-risk basis at 12/31/10? How much of 3R’s loss can he deduct on his 2010 tax return?

Passive Loss Limits • The passive loss rules require income and loss to be classified into three “categories”: • Active • Portfolio • Passive • General rule— Losses generated by passive activities can only be deducted to the extent of income from passive activities.

Income Definition • Active income or loss includes: • Wages, salary, commissions, bonuses • Profit /(loss) from a trade or business in which the taxpayer is a “material participant”. • Portfolio income or loss includes: • Interest, dividends, annuities and royalties not derived in the ordinary course of a trade or business. • Gain or loss from the disposition of property that produces portfolio income or is held for investment purposes. • Passive income or loss arises from the following activities: • Any trade or business or income-producing activity in which the taxpayer does not “materially participate”. • Subject to certain exceptions, all rental activities, regardless of taxpayer’s level of participation are considered passive activities.

Suspended Passive Losses • Passive losses that are not deductible in the year incurred are suspended. • Suspended passive losses may be carried forward and used to offset: • Passive income in future years. • Passive income and other types of income in the year in which the passive activity is disposed.

Passive Loss Limits: Examples • Example: Joe has active income of $60,000 and a passive loss of $20,000 in 2009. • Can Joe deduct passive loss in 2009? • Example, continued: Joe has active income of $70,000 and passive income of $25,000 in 2010. • What is Joe’s 2010 AGI? (what happens to 2009 suspended loss?)

Multiple Passive Activities • When a taxpayer owns more than one passive activity with losses, the total suspended loss must be allocated among the activities. • The total disallowed loss for the year is allocated among the loss activities using the following fraction: • Loss from activity/Sum of losses from all activities having losses.

Passive Loss Allocation: Example • Example: Taxpayer has wages of $100,000 and 3 passive activities, which produced income (losses) as follows: Activity A ($40,000) Activity B ( 10,000) Activity C 20,000 Total ($30,000) • What is the taxpayer’s AGI and how much of the losses are suspended?? • How much of the suspended loss is allocated to each Activity? Why does it matter?

Taxpayers Subject to the Passive Loss Rules • The passive loss rules apply to: • Individuals • Estates and trusts • Personal service corporations (PSCs) • Closely held C corporations • Net passive losses can offset active income, but not portfolio income. • Income/losses from partnership and S corps flow through to owners and passive loss rules apply to owners.

Identifying Passive Activities • Identification of what constitutes an “activity” is necessary to apply the passive loss rules • If taxpayer is involved in more than one trade or business, grouping may be possible IF the activities form an “appropriate economic unit.” • A trade or business is treated as: • Active if the taxpayer is a material participant • Passive if the taxpayer is not a material participant • Materialparticipation is defined as participation that is “regular, continuous, and substantial”. Regulations identify 7 tests for determining if the taxpayer is a material participant (see pgs 6-23 thru 6-26).

Rental Activities Defined • A rental activity is any activity where payments are received principally for the use of tangible (real or personal) property . • Regulations identify six exceptions where activities involving rentals are not to be treated as “rental activities.” • General rule—rental activities are automatically treated as passive activities, even if the taxpayer would meet the material participation definition. • There are two special rules related to real estate rental activities: • Real estate professionals may qualify for non-passive treatment under material participation rules. • “Small” landlords may deduct up to $25,000 loss from rental activity against active or portfolio income.

Real Estate Professional Exception • To qualify as an active trade or business the taxpayer must satisfy both of the following requirements: • More than half of the personal services that the taxpayer performs are performed in real property businesses in which the taxpayer materially participates. • The taxpayer performs more than 750 hours of services in these real property trades or businesses as a material participant.

Small Landlord Exception • To qualify for the $25,000 exception, the taxpayer must: • Actively participate in the real estate rental activity. • Own 10 percent or more (in value) of all interests in the activity. • Active participation requires participation in making management decisions in a significant and bona fide sense. • The potential $25,000 deduction is reduced by 50% of the amount by which the taxpayer’s AGI exceeds $100,000 (so if AGI > $150,000, no “small landlord” loss allowed).

Small Landlord Example • In 2009, Ryan has income(losses) from the following sources: • Salary $90,000 • Passive Rental Income $20,000 • Loss from Rental Real Estate activity ($50,000) • How much is Ryan’s AGI for 2009? • What if his salary was $110,000 instead?

Interaction of At-Risk and Passive Activity Limits • The passive loss rules are applied after application of the at-risk rules. • A loss that is allowable under the at-risk rules may still be suspended under the passive loss rules. • Example: • A taxpayer has $10,000 at risk basis in an activity and the activity results in a $15,000 passive loss for the year. His only other income is $100,000 salary. • How much can be deducted against other income? • How much is suspended and what future events have to occur to be able to deduct suspended loss?

Taxation of Business Entities