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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

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taxation of business entities
Taxation of Business Entities

Losses and Loss Limitations

Text: Chapter 6

  • Bad Debts
  • Worthless Securities
  • Casualty Losses
  • NOL Deductions
  • At-risk and Passive Loss Rules
bad debts in general
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
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 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 debt6
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
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
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
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 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 definition11
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
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).
casualty and theft losses business property
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
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
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 & 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
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
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
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
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
  • 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 rules23
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
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 limitation25
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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?