chapter 6

© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Taxation of Business Entities

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Chapter 6

Losses and Loss Limitations

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The Big Picture (slide 1 of 3)

• Robyn is nearing the end of a year that she would like to forget.

• Several years ago she loaned a friend $25,000 to enable him to start a business. – The friend had made scheduled payments of $7,000 ($1,000 of this

was interest) when he unexpectedly died in January. • At the time of his death, he was insolvent.

– Robyn’s attempts to collect on the debt were fruitless.

• Last year Robyn invested $60,000 in the stock of a company started by her brother. – The company declared bankruptcy in May of this year. – Robyn is notified by the bankruptcy trustee that she can expect to

receive nothing from the company.

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• Robyn has owned and operated a bookstore as a sole proprietorship for the past 10 years. – The bookstore previously has produced annual profits of

about $75,000. – Due to a chain bookstore opening down the street, Robyn’s

bookstore sustained a net loss of $180,000 this year.• In September, a tornado caused a large oak tree to

blow over onto Robyn’s house. – The cost of removing the tree and making repairs was

$32,000. – Robyn received a check for $25,000 from her insurance

company in final settlement of the claim. – Her adjusted basis for the house was $280,000.

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• Robyn invested $20,000 for a 10% interest in a limited partnership that owns and operates orange groves in Florida.– Due to a hard freeze that damaged much of the

fruit, the partnership lost $200,000 and allocated $20,000 of ordinary loss to Robyn.

• Robyn comes to you for tax advice and would like to know the tax ramifications of each of the transactions listed above.

• Read the chapter and formulate your response.

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Bad Debts

• If an account receivable arising from credit sale of goods or services becomes worthless– A bad debt deduction is permitted only if income

arising from creation of the receivable was previously included in income

– No deduction is allowed if taxpayer is on the cash basis since no income is reported until the cash has been collected

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Business Bad Debts (slide 1 of 4)

• Specific charge-off method must be used– Exception: Reserve method is allowed for some

financial institutions

• Deduct as ordinary loss in the year when debt is partially or wholly worthless

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• If a business bad debt previously deducted as partially worthless becomes totally worthless in a future year– Only the remainder not previously deducted can be

deducted in the future year

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• In the case of total worthlessness, deduction is allowed for entire amount in the year the debt becomes worthless

• Deductible amount depends on basis in bad debt– If debt arose from sale of services or products and the face

amount was previously included in income• That amount is deductible

– If the taxpayer purchased the debt• Deduction is equal to amount paid for debt instrument

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• If a receivable has been written off – The collection of the receivable in a later tax year

may result in income being recognized– Income will result if the deduction yielded a tax

benefit in the year it was taken

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Nonbusiness Bad Debts (slide 1 of 2)

• Nonbusiness bad debt– Debt unrelated to the taxpayer’s trade or business

• Deduct as short-term capital loss in year amount of worthlessness is known with certainty– No deduction is allowed for partial worthlessness

of a nonbusiness bad debt

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Nonbusiness Bad Debts (slide 2 of 2)

• Related party (individuals) bad debts are generally suspect and may be treated as gifts– Regulations state that a bona fide debt arises from

a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money

– Thus, individual circumstances must be examined to determine whether advances between related parties are gifts or loans

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Classification of Bad Debts

• Individuals will generally have nonbusiness bad debts unless:– In the business of loaning money, or – Bad debt is associated with the individual’s trade

or business

• Determination is made either at the time the debt was created or when it became worthless

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The Big Picture - Example 4

Nonbusiness Bad Debts• Return to the facts of The Big Picture on p. 6-2.

• Robyn loaned her friend, Jamil, $25,000. – Jamil used the money to start a business, which

subsequently failed. – When Jamil died after having made principal

payments of $6,000 on the loan, he was insolvent.

• Even though the proceeds of the loan were used in a business, the loan is a nonbusiness bad debt – The business was Jamil’s, not Robyn’s.

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Worthless Securities (slide 1 of 2)

• Loss on worthless securities is deductible in the year they become completely worthless– These losses are capital losses deemed to have

occurred on the last day of the year in which the securities became worthless

– Capital losses may be of limited benefit due to the $3,000 capital loss limitation

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• Example of worthless securities– On December 1, 2010, Sally purchased stock for

$10,000. The stock became worthless on June 1, 2011. Sally’s loss is treated as having occurred on December 31, 2011. The result is a long-term capital loss.

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• Return to the facts of The Big Picture on p. 6-2.

• Robyn, a calendar year taxpayer, owned stock in Owl Corporation. – She acquired the stock on October 1, 2010

• Cost was $60,000.

– On May 31, 2011, the stock became worthless as the company declared bankruptcy.

• The stock is deemed to have become worthless as of December 31, 2011– Robyn has a long-term capital loss

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• Alternatively, if the stock is § 1244 small business stock (see below).– She has a $50,000 ordinary loss and a $10,000

long-term capital loss.

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Bad Debt Deductions Summary

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Section 1244 Stock(slide 1 of 3)

• Sale or worthlessness of § 1244 stock results in ordinary loss rather than capital loss for individuals– Ordinary loss treatment (per year) is limited to

$50,000 ($100,000 for MFJ taxpayers)• Loss in excess of per year limit is treated as capital loss

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• Section 1244 loss treatment is limited to stock owned by original purchaser who acquired the stock from the corporation

• Corporation must meet certain requirements for stock to qualify– Major requirement is limit of $1 million of capital

contributions

• Section 1244 does not apply to gains

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• Example of § 1244 loss– In 2008, Sam purchases from XYZ Corp. stock

costing $150,000. (Total XYZ stock outstanding is $800,000.) In 2011, Sam sells the stock for $65,000.

– Sam, a single taxpayer, has the following tax consequences:

• $50,000 ordinary loss

• $35,000 long-term capital loss

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Definition of Casualty & Theft (C & T)

• Losses or damages to the taxpayer’s property that arise from fire, storm, shipwreck, or other casualty or theft– Loss is from event that is identifiable, damaging to

taxpayer’s property, and sudden, unexpected, and unusual in nature

– Events not treated as casualties include losses from disease and insect damage

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Definition of Theft

• Theft includes robbery, burglary, embezzlement, etc.– Does not include misplaced items

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When Casualty & Theft Is Deductible

• Casualties: year in which loss is sustained– Exception: If declared “disaster area” by President,

can elect to deduct loss in year prior to year of occurrence

• Thefts: year in which loss is discovered

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Disaster Area Losses• Return to the facts of The Big Picture on p. 6-2.

• On September 28, 2011, Robyn’s personal residence was damaged when a tornado caused an oak tree to fall onto the house. – The amount of her uninsured loss was $7,000. – Because of the extent of the damage in the area, the President of the

United States designated the area a disaster area.• Because Robyn’s loss is a disaster area loss, Robyn has 2

options.– She may elect to file an amended return for 2010 and take the loss in

that year.• The amount of the loss will be reduced first by $100 and then by 10% of

her 2010 AGI. – Alternatively, she may take the loss on her 2011 income tax return.

• The amount of the loss will be reduced first by $100 and then by 10% of her 2011 AGI.

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Effect of Claim for Reimbursement

• If reasonable prospect of full recovery:– No casualty loss is permitted– Deduct in year of settlement any amount not

reimbursed

• If only partial recovery is expected, deduct in year of loss any amount not covered– Remainder is deducted in year claim is settled

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Amount of C&T Deduction

• Amount of loss and its deductibility depends on whether:– Loss is from nonpersonal (business or production

of income) or personal property– Loss is partial or complete

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Amount of Nonpersonal C&T Losses

• Theft or complete casualty (FMV after = 0)– Adjusted basis in property less insurance proceeds

• Partial casualty– Lesser of decline in value or adjusted basis in

property, less insurance proceeds

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C&T Examples

• Business and production of income losses (no insurance proceeds received) Adjusted FMV FMV

Item Basis Before After Loss

A 6,000 8,000 5,000 3,000

B 6,000 8,000 1,000 6,000

C 6,000 4,000 0 6,000

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Nonpersonal C&T Losses

• Losses on business, rental, and royalty properties– Deduction will be for AGI

– Not subject to the $100 per event and the 10% of AGI limitation

• Losses not connected with business, rental, and royalty properties – Deduction will be from AGI

– Example - theft of a security• Theft losses of investment property are not subject to the 2% of

AGI floor on certain miscellaneous itemized deductions

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Nonpersonal C&T Gains

• Depending on the property, gain can be ordinary or capital

• Amount of nonpersonal gains– Insurance proceeds less adjusted basis in property

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Personal C&T Gains and Losses (slide 1 of 4)

• Casualty and theft losses attributable to personal use property are subject to the $100 per event and the 10% of AGI limitations– These losses are itemized deductions, but they are not

subject to the 2% of AGI floor

• Amount of personal C&T losses– Lesser of decline in value or adjusted basis in property, less

insurance proceeds

• Insurance proceeds may result in gain recognition on certain casualty and thefts

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• If a taxpayer has both personal casualty and theft gains as well as losses, a special set of rules applies– A personal casualty gain is the recognized gain from a

casualty or theft of personal use property

– A personal casualty loss for this purpose is a casualty or theft loss of personal use property after the application of the $100 floor

• Taxpayer must first net (offset) the personal casualty gains and personal casualty losses– Tax treatment depends on the results of this netting process

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• If netting personal casualty gains and losses results in a net gain– Treat as gains and losses from the sale of capital

assets• Short term or long term, depending on holding period

• Personal casualty and theft gains and losses are not netted with the gains and losses on business and income-producing property

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• If netting personal casualty gains and losses results in a net loss – All gains and losses are treated as ordinary items

• The gains—and the losses to the extent of gains—are treated as ordinary income and ordinary loss in computing AGI

• Losses in excess of gains are deducted as itemized deductions to the extent the losses exceed 10% of AGI

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Example of C&T Limitation (slide 1 of 2)

• Karen (AGI = $40,000) has the following C&T in 2011 (amounts are lesser of decline in value or adjusted basis):

1. Car stolen ($6,000) with camera inside ($500)

• Earthquake damage: house ($2,000), furniture ($1,000)

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Example of C&T Limitation (slide 2 of 2)

• Example of C&T limitation (cont’d)

• Karen has no insurance coverage for either loss:

1. $6,000 + $500 = $6,500 – $100 = $6,400

2. $2,000 + $1,000 = $3,000 – $100 = $2,900

• Karen’s deductible C&T loss is $5,300 [$6,400 + $2,900 – (10% $40,000)]

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Net Operating Losses(slide 1 of 4)

• NOLs from any one year can be offset against taxable income of other years– The NOL provision is intended as a form of relief

for business income and losses– Only losses from trade or business operations,

casualty and theft losses, or losses from foreign government confiscations can create a NOL

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• No nonbusiness (personal) losses or deductions may be used in computing NOL

• Exception: personal casualty and theft losses

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• Carryover period– Must carryback to 2 prior years, then carryforward to 20

future years• May make an irrevocable election to just carryforward

• When there are NOLs from two or more years, use on a FIFO basis

– 3 year carryback is available for:• Individuals with NOL from casualty or thefts

• Small businesses with NOLs from Presidentially declared disasters

– 5-year carryback period and a 20-year carryover period are allowed for a farming loss

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• Example of NOL carryovers– Ken has a NOL for 2011– Ken must carryover his NOL in the following

order:• Carryback to 2009 and 2010, then carryforward to 2012,

2012, ..., 2031

– Ken can elect to just carryforward his NOL• Carryover would be to 2012, 2013, ..., 2031

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Passive Loss Rules (slide 1 of 2)

• Require income and losses to be separated into three categories:– Active– Portfolio– Passive

• Generally, disallow the deduction of passive losses against active or portfolio income

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Passive Loss Rules (slide 2 of 2)

• In general, passive losses can only offset passive income

• Passive losses are also subject to the at-risk rules– Designed to prevent taxpayers from deducting

losses in excess of their economic investment in an activity

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At-Risk Limits (slide 1 of 4)

• At-risk defined– The amount of a taxpayer’s economic investment

in an activity• Amount of cash and adjusted basis of property

contributed to the activity plus amounts borrowed for which taxpayer is personally liable (recourse debt)

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• At-risk defined– At-risk amount does not include nonrecourse debt

unless the activity involves real estate• For real estate activities, qualified nonrecourse debt is

included in determining at-risk limitation

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• At-risk limitation– Can deduct losses from activity only to extent

taxpayer is at-risk– Any losses disallowed due to at-risk limitation are

carried forward until at-risk amount is increased– Previously allowed losses must be recaptured to

the extent the at-risk amount is reduced below zero– At-risk limitations must be computed for each

activity of the taxpayer separately

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• Interaction of at-risk rules with passive loss rules– At-risk limitation is applied FIRST to each activity

to determine maximum amount of loss allowed for year

– THEN, passive loss limitation applied to ALL losses from ALL passive activities to determine actual amount of loss deductible for year

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Calculation of At-Risk Amount

• Increases to a taxpayer’s at-risk amount:– Cash and the adjusted basis of

property contributed to the activity

– Amounts borrowed for use in the activity for which the taxpayer is personally liable or has pledged as security property not used in the activity

– Taxpayer’s share of amounts borrowed for use in the activity that are qualified nonrecourse financing

– Taxpayer’s share of the activity’s income

• Decreases to a taxpayer’s at-risk amount:– Withdrawals from the activity– Taxpayer’s share of the activity’s

loss– Taxpayer’s share of any

reductions of debt for which recourse against the taxpayer exists or reductions of qualified nonrecourse debt

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Passive Loss Limits(slide 1 of 8)

• Active income– Wages, salary, and other payments for services

rendered– Profit from trade or business activity in which

taxpayer materially participates– Gain from sale or disposition of assets used in an

active trade or business– Income from intangible property created by

taxpayer

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• Portfolio income– Interest, dividends, annuities, and certain royalties

not derived in the ordinary course of business– Gains/losses from disposition of assets that

produce portfolio income or held for investment

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• Passive losses defined– Losses from trade or business activities in which

taxpayer does not materially participate, and – Certain rental activities

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• Limitations on passive losses– Generally, passive losses can only offset passive

income, i.e., they cannot reduce active or portfolio income

– Disallowed losses are suspended and carried forward

• Suspended losses must be allocated to specific activities

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• Suspended losses are deductible in year related activity is disposed of in a fully taxable transaction

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• Example - Roy sells an apartment building, a passive activity, with an adjusted basis of $200,000 for $360,000. In addition, he has suspended losses of $120,000 associated with the building.

• His total gain, and his taxable gain, are calculated as follows:

Net sales price $ 360,000Less: Adjusted basis (200,000)Total gain $ 160,000Less: Suspended losses (120,000)Taxable gain (passive) $ 40,000

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• Passive credits– Credits from passive activities are subject to loss

limitation– Utilize passive credits to the extent of tax

attributable to passive income– Credits disallowed are suspended and carried

forward similar to losses• Suspended credits can be used to offset tax from

disposition of activity but any credits left after activity is disposed of are lost forever

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• Taxpayers subject to rules– Individuals, estates, trusts, personal service

corporations– Closely-held corporations

• Can deduct passive losses against active income

– S Corp and partnership passive losses flow through to owners and limits applied at the owner level

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Passive Loss Issues

• Passive losses are losses from trade or business activities in which taxpayer does not materially participate and certain rental activities

• What constitutes an activity?

• What is “material participation"?

• When is an activity a rental activity?

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Identification of Activities(slide 1 of 2)

• Taxpayers with complex business operations must determine if segments of their business are separate activities or entire business is treated as a single activity

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Identification of Activities(slide 2 of 2)

• Regs allow grouping multiple trade or businesses if they form an appropriate economic unit for measuring gain or loss– Once activities are grouped, can’t regroup unless:

• Original groups were clearly inappropriate, or

• Material change in circumstances

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Material Participation Tests(slide 1 of 8)

• An activity is treated as active rather than passive (thus, not subject to the passive loss limits) if taxpayer meets one of 7 material participation tests

• Participation is generally defined as work performed by an owner

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• Test 1– Taxpayer participates in the activity more than 500

hours during the year

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• Test 2– Taxpayer’s participation in the activity is

substantially all of the participation in the activity of all individuals for the year

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• Test 3– Taxpayer participates in the activity more than 100

hours during the year and not less than the participation of any other individual in the activity

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• Test 4– Taxpayer’s participation in the activity is

significant and taxpayer’s aggregate participation in all significant participation activities during the year exceeds 500 hours

– Significant participation is more than 100 hours

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• Test 5– Taxpayer materially participated in the activity for

any 5 years during the last 10 year period

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• Test 6– The activity is a personal service activity in which

the taxpayer materially participated for any 3 preceding years

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• Test 7– Based on the facts and circumstances, taxpayer

participated in the activity on a regular, continuous, and substantial basis

• Regular, continuous, and substantial are not specifically defined in the Regulations

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Participation Defined

• Participation generally includes any work done by an individual in an activity that he or she owns– Does not include work if of a type not customarily done by

owners and if one of its principal purposes is to avoid the disallowance of passive losses or credits

– Work done in an individual’s capacity as an investor is not counted in applying the material participation tests

– Participation by an owner’s spouse counts as participation by the owner

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Rental Activities

• Rental of tangible (real or personal) property is automatically passive activity unless it meets one of the 6 exceptions (Regs)

• If exception applies, activity is subject to the material participation tests

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Interaction of At-Risk and Passive Loss Limits

• Passive loss rules are applied after the at-risk rules– Losses not allowed under the at-risk rules are

suspended under the at-risk rules, not the passive loss rules

– Basis is reduced by deductions even if not currently usable due to passive loss rules

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Real Estate Passive Loss Limits(slide 1 of 4)

• Generally, losses from rental real estate are treated like other passive losses

• There are two significant exceptions to the general rule

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• Exception 1: Real estate professionals– Rental real estate losses are not treated as passive

if the following requirements are met:• Taxpayer performs more than half of his/her personal

services in real property businesses in which the taxpayer materially participates, and

• Taxpayer performs more than 750 hours of services in these real property businesses as a material participant

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• Exception 2: Real estate rental activities– Taxpayer can deduct up to $25,000 of losses on

real estate rental activities against active or portfolio income

– Benefit is reduced by 50% of taxpayer’s AGI in excess of $100,000

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• Exception 2: Real estate rental activities– To qualify for this exception the taxpayer must:

• Actively participate in rental activity, and

• Own at least 10% of all interests in activity

– Active participation defined:• Requires only participation in making management

decisions in a significant and bona fide sense

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Suspended Losses

• Losses can be suspended due to the passive loss limits or the at-risk limits

• Losses suspended due to at-risk limitations are investment specific, thus no allocation of suspended losses is necessary

• Suspended at-risk and passive losses can be carried forward indefinitely

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Disposition of Passive Interests

• Disposition at death: suspended loss deductible on decedent’s final tax return to extent of excess over any step-up in basis

• Disposition by gift: suspended loss increases donee’s basis in property

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Refocus On The Big Picture (slide 1 of 3)

• Robyn can receive tax benefits associated with her unfortunate occurrences during the current tax year.

• Bad Debt – It appears that Robyn’s loan to her friend was a bona fide debt.

• The amount of the deduction is the unpaid principal balance of $19,000 ($25,000 - $6,000).

• Since the bad debt is a nonbusiness bad debt, it is classified as a short-term capital loss.

• Loss from stock investment – If Robyn purchased the stock directly from the company, the stock may

qualify as small business stock under § 1244. • If this is the case, the first $50,000 of the loss is an ordinary loss, and the

remaining $10,000 loss is treated as a long-term capital loss. • If the stock is not § 1244 stock, the entire $60,000 loss is treated as a long-

term capital loss

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• Loss from Bookstore – The $180,000 loss from the bookstore is reported on

Schedule C of Form 1040. • It is an ordinary loss, and it qualifies for NOL treatment. • Robyn can carry the $180,000 net loss back and offset it against the

net income of the bookstore for the past two years. – Any amount not offset can be carried forward for the next 20 years. – The carryback will produce a claim for a tax refund.

• Casualty Loss – The loss on the damage to Robyn’s personal residence is a

personal casualty loss. • Using the cost of repairs method, the amount of the casualty loss is

$7,000 ($32,000 - $25,000). • This amount must be reduced by $100 and 10% of AGI.

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• Passive activity loss. – The $20,000 loss on the limited partnership is not

deductible currently due to the passive loss limitation. – However, the loss can be carried forward and utilized in the

future to offset any passive income generated from the venture.

What If?• What if instead of operating orange groves the

partnership owns and rents apartments to college students and Robyn actively participates in the venture? – In this case, Robyn may qualify for a $20,000 ordinary loss

deduction under the rental real estate exception.

© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 80

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA [email protected]

SUNY Oneonta

chapter 6

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