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 § 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. § 1.469-2T(d)(6)):
The basis limitations of IRC § 1366(d),
The at-risk limitations of section 465, and
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. Although Congress primarily intended to stop a perceived abusive use of tax shelters caused by nonrecourse financing, application of the at-risk rules is not limited to tax shelter activity.
To correctly analyze the pass-through loss deductibility of at-risk amounts, shareholders must maintain annual records of basis in their interest, both in shares and monies lent to the S corporation. While a shareholder’s at-risk amount often parallels basis in stock and loans, there are important differences under the at-risk rules involving nonrecourse loans and amounts borrowed from other “non-creditors” to the activity. The at-risk limitations must be computed as of the end of the S corporation’s year for each activity conducted by the S corporation, taking into account situations where activities are aggregated. See Prop. Treas. Reg. § 1.465-1(a).
At-risk rules are similar in operation to the stock-basis rules. Under the latter, shareholders may deduct their pro rata share of the S corporation’s losses and deductions only to the extent of their adjusted basis in the corporation’s stock (decreased by any nondividend distributions during the year) and their adjusted basis in debt of the corporation owed to them. Also similar to the stock-basis and passive activity limitations, losses that are currently limited because they exceed the shareholder’s amount at risk may be carried over indefinitely until at-risk amounts are generated in future years. The at-risk rules differ from the stock-basis rules, however, in that the determination of amounts at risk occurs for each activity conducted by the S corporation, although certain activities may be aggregated.
What provides an S corporation shareholder with at-risk basis?
Contributions to capital of the corporation.
Unencumbered funds lent by the share holder or funds borrowed by the shareholder for use in the corporation’s activities. Section 465(b)(2) holds that a shareholder is at risk with respect to borrowed amounts only if the shareholder is personally liable for repayment (in other words, it is a recourse obligation).
Monies borrowed by the shareholder and then lent to the corporation for use in the corporation’s activities, where the shareholder has borrowed the funds on a nonrecourse basis, as long as the shareholder has pledged property (other than that used in the activity) as security for the borrowed amount. In the case of nonrecourse borrowings secured by pledged property, the at-risk amount is limited to the net fair market value of the taxpayer’s interest in the pledged property. The S corporation stock is considered to be “property used in the activity,” meaning that a shareholder is not considered at risk for amounts contributed or loaned to an S corporation when the amounts were obtained by nonrecourse borrowings secured by the corporation’s stock. See General Explanation of the Tax Reform Act of 1976 (the “Committee Report”), prepared by the staff of the Joint Committee on Taxation (HR 10612, PL 94-455).
Loans secured by real property used in the activity of holding real property. This is similar to the “qualified nonrecourse debt” analysis that allows partners to be at risk in partnerships. See Treas. Reg. § 1.465-27.
Shares received as compensation, equal to the value of the S corporation stock received. See Private Letter Ruling 8752006.
Similar to the basis rules for S corporations, shareholders are not at risk for any amounts they guarantee on behalf of the corporation. Further, amounts are generally not considered at risk if borrowed from a person who has an interest (other than as a creditor) in the activity (section 465(b)(3)). However, shareholders may increase their at-risk basis by borrowing from a family member, as long as the debt is recourse and the family member is not a shareholder as well (Treas. Reg. § 1.465-8(a)(1)).
Treatment of activities of the S corporation. An activity is a trade or business conducted by the S corporation. As discussed later, Congress established certain categories of activities that it wanted to treat separately. However, any businesses outside those particular activities are not distinguishable by law when shareholder participation levels are met. The at-risk limitation must be applied to each activity of the S corporation separately, although some may be aggregated at the shareholder level. If the shareholder actively participates in the activities, section 465(c)(3)(B) allows activities constituting a trade or business to be treated as a single activity when (1) the taxpayer actively participates in the management of the trade or business, or (2) the trade or business is carried on by a partnership or an S corporation and 65% or more of the losses for the year are allocable to persons who actively participate in the management of the trade or business.
This is referred to as the “general aggregation” rule. So for example, if the S corporation owns a car repair shop as one activity and provides seasonal accounting services as another activity, as long as the sole shareholder actively participates in both businesses, they may be aggregated for determining his or her at-risk amount.
For activities not meeting the participation rules and therefore outside this general aggregation rule of sections 465(c)(3)(A) and (B), the S corporation must report each activity’s profit and loss to its shareholders. Section 465(c)(2)(A) further requires that for five categories of property, activity with respect to each asset or property is to be treated as a separate activity:
Section 1245 property (subject to recapture of depreciation as ordinary income upon disposition) that is leased or held for leasing,
Oil and gas property, and
At the S corporation level, all of these activities of the same type (for example, all those related to motion picture films and videotapes) are to be treated as one activity. S corporations engaged in two or more types of these activities, such as movies and equipment leasing, or movies and farming, are to be treated as having that number of activities, and the at-risk limitation is determined separately for each activity (see the Committee Report).
At the shareholder level, the shareholder who holds multiple assets or properties within categories 1, 3, 4 and 5 is permitted to aggregate the assets or properties within each category as a single activity (Temp. Treas. Reg. § 1.465-1T; IRS Notice 89-39). This aggregation is permissible because the Treasury Department recognized the record keeping nightmare that would occur if an individual taxpayer had to allocate activities among each property.
“Active participation” not same as in section 469. Congress’ definition of “active participation” for section 465 is not the same as the nonpassive participation definitions under section 469. The official guidance on defining active participation for section 465 is in the 1976 Committee Report when section 465 was enacted. The report states that the following indicators point to active participation:
Participation in decisions involving the operation or management of the trade or business,
Performing services for the trade or business, or
Hiring and discharging employees (other than the person in charge of the trade or business).
Conversely, the Committee Report states that the following factors tend to indicate a lack of active participation for purposes of the at-risk rules:
Lack of control of management and operation of the trade or business,
Authority only to discharge the manager of the trade or business,
Having an independent contractor (rather than an employee) as the manager of the trade or business.
APPLYING THE AT-RISK RULES
To plan for these potential loss deduction limitations, the practitioner should be careful to advise the client on the active participation in trade or business rule, to ensure that the client may group those activities together. While shareholders may have basis overall in their S corporation shares, if they do not have amounts at risk in each activity, then their loss deduction may be limited. To determine the at-risk amount in each activity, the shareholder may apply tracing rules (similar to the interest expense tracing rules of section 163) for monies invested and/or lent to fund the activity. Here again, there is no clear authority on the subject; a reasonable attempt at tracing would seem to comply with the intent of the rules.
Example. Taxpayer A had the following facts:
Outside basis in S corporation B’s common stock: $100,000
B’s two activities, in which A has the following amounts at risk, as determined by investment tracing:
Dry cleaning—A actively participates: $25,000
Billboard rental—A does not actively participate: $15,000
The activities generate the following losses for 2009:
Dry cleaning: ($10,000)
Billboard rental: ($25,000)
The two active businesses cannot be combined because they are separate types of businesses. See section 465(c)(3)(A) and Private Letter Ruling 9035005. Under the at-risk rules, Taxpayer A will be able to deduct $10,000 related to the dry cleaning activity and $15,000 related to the billboard rental (see Exhibit 1). The billboard rental will be separately stated as rental income on the S corporation Schedule K and is not combined with the other activities for at-risk purposes. Note that this conclusion pertains to the section 465 at-risk testing; the passive activity rules of section 469 may apply to further limit the loss deduction related to the billboard rental activity.
Presume the same facts as above for S corporation B, but also say that Taxpayer A has another wholly owned S corporation, C, in which he actively participates, with the following attributes:
Outside basis in C: $40,000
At-risk amount in C’s dry cleaning business: $25,000
Taxable loss in dry cleaning for 2009: ($50,000)
The loss was funded partially by a nonrecourse banking line of credit; the at-risk amount is less than shareholder basis because the shareholder made cash contributions that included $15,000 obtained from nonrecourse loans secured by the corporate stock.
In this example, the two active dry cleaning businesses would be combined to produce a loss of $60,000, of which $50,000 is deductible under the stock-basis limitation—$10,000 from B and $40,000 from C. The entire $50,000 would be deductible under the at-risk limitation rules, by aggregating active businesses in the same activity (see Exhibit 2). The remaining $10,000 loss will carry over on Taxpayer A’s individual return as a loss suspended due to at-risk limitations. This example shows the importance of analyzing the client’s business activities and looking for grouping opportunities at the shareholder level, not just within the corporate entity.
See Exhibit 3 for a decision tree illustrating how S corporation owners may apply the at-risk rules to losses under section 465.
STRATEGY TO USE SUSPENDED LOSS CARRYOVER
In addition to scrubbing the composition of the at-risk amounts and potential groupings of S corporation activities, the practitioner may consider applying the following merger technique to combine one S corporation with at-risk capacity with another in which the shareholder has no at-risk amounts. This is particularly useful when there may be suspended loss carryovers due to at-risk limitations. In summary, the shareholder or shareholders may contribute the shares of the “loss” S corporation to the capital of the “income” S corporation, followed by a qualifying S subsidiary (“QSub”) election. Presuming that the shareholder or shareholders have active participation in both operations (as defined above) and that their shareholdings are such that a section 351 contribution is effective, the attributes of the loss corporation are carried over to the activities passed through to the shareholder by the income S corporation.
Example. A calendar-year taxpayer wholly owns two S corporations with active operations in the same line of manufacturing and wholesale distribution business, but with different product brands. S corporation A generates profits and has a positive accumulated adjustment account (AAA); the taxpayer has positive outside basis in his shares. S corporation B generates losses and has zero AAA; the taxpayer has no more outside basis and, in fact, has suspended losses accumulated on his personal tax return due to at-risk limitations related to B. The liabilities of B exceed the adjusted basis of its assets. The taxpayer actively participates in both businesses.
The taxpayer would like to use his at-risk suspended losses related to B to offset the taxable income generated by A. To accomplish this, the taxpayer contributes his shares of corporation B to corporation A in a nontaxable contribution to capital, qualifying under section 351. An advantageous date for the transaction for a calendar-year taxpayer is Jan. 1, to coincide with the beginning of the tax year and balance sheet closing on Dec. 31. He received no cash or property in exchange (that is, no “boot” on the transaction). Immediately after, A elects to treat B as a QSub.
On the taxpayer’s individual income tax return for the tax year, he carries over the suspended losses to offset A’s taxable income and, potentially, other sources of income to the extent of his share basis and at-risk basis in A.
Under Treas. Reg. § 1.1361-4, Example 3, when an individual contributes all of the outstanding stock of Y corporation to his wholly owned S corporation X and immediately causes X to make a QSub election for Y, the transaction is treated as a reorganization under IRC § 368(a)(1)(D). Note that such reorganizations are nontaxable with the exception of boot, which in this fact pattern the taxpayer did not receive.
The regulation’s example goes on to say that if Y’s liabilities exceed its assets, then section 357(c) would apply to cause gain recognition. This would be the expected result in any transaction to which section 351 originally applies. However, note that the QSub regulations specifically recharacterize the section 351 transaction as a nontaxable section 368(a)(1)(D) reorganization (essentially an exchange of assets for stock). This is consistent with the intent for QSubs to be treated as disregarded entities, where their separate existence is ignored for federal income tax purposes.
This regulation has not been updated for the American Jobs Creation Act of 2004, wherein Congress decided that acquisitive D reorganizations, including those under section 368(a)(1)(D), are no longer subject to section 357(c) because the shareholder was not relieved of any liabilities. This is further clarified in Revenue Ruling 2007-8. In this fact pattern, the taxpayer indeed was not relieved of any liabilities.
As the transaction is now characterized as a nontaxable event, the regulations under section 1366 address what happens to attributes of the legacy QSub. Under Treas. Reg. § 1.1366-2(c), if a corporation acquires the assets of an S corporation in a transaction to which section 381(a) applies (which covers D reorganizations), any loss or deduction disallowed under paragraph (a) of the regulation (limiting such losses or deductions to the shareholder’s adjusted basis in stock or debt of the corporation) with respect to a shareholder of the distributor or transferor S corporation is available to that shareholder as a shareholder of the acquiring corporation. Thus, where the acquiring corporation is an S corporation, a loss or deduction of a shareholder of the distributor or transferor S corporation disallowed before or during the taxable year of the transaction is treated as incurred by the acquiring S corporation with respect to that shareholder if the shareholder is a shareholder of the acquiring S corporation after the transaction.
In summary, the taxpayer transferred his shares in B to A in a section 351 transaction, which is recharacterized by the regulations as a section 368(a)(1)(D) nontaxable asset transfer as QSub elections where made immediately after for B. Even though B’s balance sheet at Jan. 1 shows liabilities in excess of assets, section 357(c) no longer applies to cause gain recognition because the taxpayer was not relieved of any liabilities.
Before the merger, the taxpayer had a significant suspended loss carryover attributable to B. Under Treas. Reg. § 1.366-2(c), he is allowed to carry that forward to A, as he is the 100% shareholder before and after of all entities involved.
Losses passed through to S corporation shareholders are limited first by shareholder basis limits under IRC § 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 carry over 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.
Elizabeth Murphy (email@example.com) is a tax partner at Dixon Hughes PLLC, a large regional CPA firm in the southeastern United States.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at 919-402-4434 or firstname.lastname@example.org.
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General Explanation of the Tax Reform Act of 1976