Your business losses are not always deductible? S corporation losses. C regular Corporation losses.

S corporation losses are not always deductible. When are S corporation losses not deductible?

By Jeffrey Brooks, CPA, CFP, MBA for Jbrooks Wealth Advisors, PC, a Professional CPA and CFP Firm jeff@jbrookswa.com 602-687-9900 x101

The best way to explain when you can’t deduct losses from your S corporation is to give you a definition as well as examples of what is “BASIS”. Don’t leave this site yet! I will try to simplify.

“Basis” occurs when you start a business and put money into the business.

Example: You put in $100,000 into an S Corporation while your friend puts in zero but works the business and gets a 49% ownership.
In year 1, unfortunately there is a $100,000 loss. Since you have invested $100K, you get to deduct a loss of $51,000 (51% of the loss) .
Your friend cannot deduct anything because she does not have any “skin in the game”. Your friend cannot take a loss more than what her “basis” is which is Zero!
When did this rule change? Back in the 1980’s before the Tax Reform Act of 1986, tree farm partnerships and S corporations were being sold due to the big tax write off! An investor could invest $20,000 and get a $200,000 write off. You cannot do that anymore!

What if your friend needs the big loss? What can she do? She could either invest money by the end of the year or loan money to your S corporation by the end of the year.

However, let us say on the first day of January, she has the S corporation pay her back? What would happen if she is caught? The IRS would argue that the loan was not a bona fide loan and she should not get the loss in the year she made the loan.

If your S corporation gets a loan from the bank on 12-31 and you and your friend guarantee the debt, does this give you “basis”? Unfortunately NO! Interestingly enough if you and your friend owned a partnership instead, the answer would be YES! However, as the loan is paid back and you and your friend do not put new money in, there are negative tax ramifications to you and your friend.

What if you and your friend started what is called a “C” corporation? Can you claim a loss personally? No, a “C” or Regular Corporation’s loss does not flow down to the shareholders but remains at the corporate level.

When can you take a loss from a “C” Corporation? When the “C” corporation (filed on form 1120) has profits or possibly” when you close out your corporation. This would get into what is called “Section 1244” property. This situation can be very tricky. All of the rules must be followed carefully.

Getting back to S corporations. What if your corporation was once a “C” corporation that had earnings retained of $30,000 (these earnings were not paid out as dividends) while your S corporation had a $20,000 loss in the current year? Without an election, the $20,000 loss would be fully allowable up to the amount of “basis”. If “basis” was $12,000, only $12,000 of loss would be deductible in the current year.

But what if you had a bad year and you have negative adjusted gross income and negative taxable income and you do not want to take the $12,000 loss because you would just waste it? Your CPA could make an election to treat any dividends as taxable income. The dividends would just reduce the taxable loss while increasing your “basis” in future years.
This is called a “deemed distribution election”.

I hope that this has been helpful.

I

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About Jeffrey Brooks

Jeffrey Brooks, CPA, CFP, MBA since 1976 has specialized in helping clients save significant taxes, help businesses increase their cash flow, revenues and profits while increasing their control and satisfaction. Jeff and his accounting firm sincerely cares about the happiness of his clients.

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Address: 4647 N 32nd Street, Suite B245
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Email: jeff@jbrookswa.com