Not all losses from S corporations, partnerships or LLCs are deductible.  Losses are subject to basis and material participation tests.

Material Participation

In order to deduct losses from a partnership, LLC, S corporation or sole proprietorship in the tax year the loss in incurred, you must materially participate in the business.

Though there are more in-depth rules, basically material participation means that you spend a significant amount of time working for the business. Generally that means at least 500 annual hours of regular, continuous, and substantial work. Though the IRS prefers you keep a log or diary of the work you perform to substantiate material participation, recent court decisions indicate that if you can prove you materially participated by other means, such as services performed or appointment books – that will also suffice.

Material participation has now become important with respect to profitable activities as a result of the new 3.8 percent net investment income tax on interest, dividends and passive activities. If you materially participate in the business, the tax doesn’t apply.

If You Have a Second Business – Document Carefully

If you only have one source of income — your business — it’s unlikely the IRS will challenge your participation. If you have a side business, you should be prepared to substantiate your hours worked. The closer you are to the material participation requirement thresholds, the more cautious you should be.

Equity and Debt Basis

Your equity basis in an S corporation, partnership, LLC or even a sole proprietorship is usually uncomplicated. Simply speaking, equity basis is made up of initial capital contributions made to the company, increased by net income and additional contributions, reduced by losses and distributions.

The rules with respect to debt basis are subtler. To generate debt basis in an S corporation, a true economic outlay must be made. A direct loan to the corporation is required. One option is for the shareholder to borrow from a bank or other party and loan the funds to the corporation. But funds you borrow from another shareholder don’t count.

If You Didn’t Do the Work and You Don’t Have Basis – You Can’t Claim the Loss

Poor planning can result in the worst of both worlds. It’s not unusual for a parent to advance most, if not all, the funds for a venture, but not participate in the activity. The son or daughter does all the work. The parent or other investor can’t deduct the losses in the year the losses are incurred because he or she doesn’t materially participate and the son or daughter can’t deduct them because he or she has no basis.

Planning for the End of the Year

There are some steps you can take if you’re approaching the end of the year and you have insufficient basis to take the losses. PDM’s tax experts can help advise you on the best course of action. Contact us; with our years of technical experience, advanced training, and cutting edge technology, we are your financial partner.