Module 15
Business Losses and
Limitations
Business Losses &
Related Restrictions
Key Learning Objectives
How losses fit into the statutory framework
that authorizes deductions
 How the laws limit taxpayers' abilities to
deduct losses realized in certain types of
transactions.

Definition of Loss
Excess of current period deductions over
current period gross income
 A realized decline in the value of a
taxpayer's assets used for




Trade or business
Production of income
Personal use if casualty or theft
Net Operating Loss Deduction
(NOL)
Key Learning Objectives
Compute an NOL
 Decide when and how to take the NOL

NOL Calculation

Limited to losses from a trade or business
 Includes

employee business expenses
Add back to negative taxable income:
 NOLs
from other years
 Personal and dependency exemptions
 Capital losses
 Excess of nonbusiness deduction over
nonbusiness income

AMT NOL is a different calculation
NOL Elections Made
on Timely Filed Return
For tax years beginning after 8-5-97
 First choice


2 years back, then 20 forward
Other choice

Forward only for 20 years
Default is 2 back/20 forward
 Irrevocable election

NOL Elections Made
on Timely Filed Return
For tax years beginning before 8-5-97
 First choice


3 years back, then 15 forward
Other choice

Forward only for 15 years
Default is 3 back/15 forward
 Irrevocable election

Compliance Query

T reported the following this year:
 Loss
from sole proprietorship: <$15,100>
 Wages from part-time job: $2,300
 Interest income from savings: $400
 Mortgage interest and real estate taxes: $8,000
 Personal exemption: $2,700
 Taxable income: <$23,100>

What is T’s NOL?
Solution--Compliance Query
Start with taxable income of <$23,100>
 Add back $2,700 personal exemption
 Add back excess of nonbusiness deductions
over nonbusiness income ($8,000 - $400 =
$7,600)
 NOL = <$12,800>

Research Query

T claimed the following losses on her
current year tax return:
 $22,000
loss on sale of Section 1244 stock
 $13,000 deductible personal casualty loss

Are either of these losses allowable in
determining T’s NOL?
Solution--Research Query

The loss on the sale of the Section 1244
stock is allowable.
 Code

Sec. 1244(d)(3); Reg § 1.1244(d)-4(a).
Personal casualty losses are “business”
deductions for net operating loss purposes.
 Code
Sec. 172(d)(4)(C).
The Bad Debt Deduction
Key Learning Objectives
Identify eligible bad debts
 Amount of the deduction
 Timing of the deduction
 Classification of the deduction

Eligible Bad Debt
Good Loan in Past
Bona fide debt
 Promise to pay fixed & determinable
 Sum enforceable under state law
 Related party loans--suspected gifts

 Written
note?
 Adequate security?
 Interest reasonable & reported annually
Amount of the Deduction
A Question of Basis

Cash basis


Unrecoverable out-of-pocket costs
Accrual basis


Accounts Receivable
Other amount previously included in income
Timing of the Deduction
A Question of Values



Based on
facts/circumstances
Legal action not
required if cost
prohibitive
Documentation is
crucial
No money in
your future
Classification of the Deduction
Business Bad Debt
Ordinary loss for full/partial worthlessness
 Arises in connection with T/B
 Must be closely related to business activity






Uncollected A/R
To secure source of material
Loans/advances to employees
Loans by Employee to protect employment
T/B of making loans
Classification of the Deduction
Non-Business Bad Debt
Short term capital loss
 Deduction only when totally worthlessness
 Personal loans
 Investment loans

 Not

in T/B of loaning money
Shareholder loan to keep business going
Research Query:
T’s former spouse was $5,000 in arrears in
child support payments. Because of this, T
had to spend $5,000 of her own funds to
support her children.
 Can T claim a nonbusiness bad debt of
$5,000?

Solution--Research Query

A spouse's failure to make required alimony
or child support payments does not give rise
to a bad debt deduction.
 Rev
897.
Rul 93-27; Swenson, Dale, (1965) 43 TC
Casualty and Theft Loss
Deductions
Key Learning Objectives
Which losses qualify
 Amount of the deduction
 Timing of the deduction

Which Losses Qualify?
Personal Use Property
Losses from personal use property not
deductible w/o §165(c)
 Sudden, unusual, unexpected event
 Not normal wear and tear
 Not everyday accidents
 Not erosion/termites
 OK if at fault if not willful

Amount of the Deduction
Personal Use Property
Decline in FMV, limited to adjusted
basis
 Decline in FMV measured by




Appraisal value before & after
Repairs to return to original condition
Not amounts that increase FMV
Amount of the Deduction
Personal Use Property

Each personal loss is reduced by $100
floor
 Each


occurrence = one $100 floor
Total for year is reduced by 10% AGI
Net personal casualty loss


From AGI
Not 2% or 3% limited
Amount of the Deduction
Business Use Property
Decline in FMV, limited to adjusted
basis
 If completely destroyed ,get adjusted
basis
 Not subject to 100 floor
 Not subject to 10% AGI offset

Compliance Query
T’s auto (basis = $12,000) completely
destroyed
 Blue book value right before the accident
$6,000
 No other casualty events during year
 What is T’s loss deduction if auto is
personal? business?

Solution--Compliance Query
PERSONAL USE
 Loss base is $6,000
 Reduce by
insurance proceeds
 Reduce by $100
 Reduce by 10% of
AGI
 Deduct from AGI
BUSINESS USE
 Loss base is
$12,000
 Reduce by
insurance proceeds
 N/A
 N/A

Deduct for AGI
Business & Personal Property
Must apply for insurance reimbursement
 Insurance may cause realized gain

 Treated
as an involuntary conversion
Timing of the Deduction

Casualty deductible in
year of loss
 If
National Disaster
Area can use preceding
year

Theft deductible in
year discovered
Special Restrictions on
Business Loss Deductions
Key Learning Objective
Identify transactions and deductions subject
to special limitations
 Amount of the deduction
 Timing of the deduction.

Hobby Loss--Work or Fun?


Is activity inherently
personal or profit
motivated
Facts and
circumstances control
If Hobby,
Deductions May Be Limited
Deductions from AGI
 "Otherwise allowable" deductions allowed
in full
 Other deductions limited to remaining gross
income from activity

 Income
reduced by "otherwise allowables" first
If Hobby,
Deductions May Be Limited
All deductions except "otherwise allowable"
treated as miscellaneous 2% deductions
 Excess deductions do not carryover

§267(a) Disallows Losses on
Related Party Sales
Includes immediate family
 Ancestors
 Lineal descendants
 Brothers & sisters
 > 50% Owned corporations/partnerships
 Special attribution rules also apply

§267(a) Disallows Losses on
Related Party Sales
Disallowed loss can be used by related party
if subsequent gain on sale of same property
 If property not sold for gain, disallowed loss
is never utilized
 §267(a) applies even if sale is at FMV

Passive Activity Losses (PAL)
Current law makes several income
classifications
 Active--T/B w/material participation
 Portfolio--§212 except rentals
 Passive activities

Passive Activity Defined
All rental activities unless material services
provided
 All T/B in which taxpayer does not
materially participate
 Material participation only if regular,
continuous, substantial

PAL Netting Procedures
Record income/loss for each passive
activity
 Net all passive activities
 If overall net passive income--report in full
 If overall loss--report zero

PAL--Suspended Losses
$25,000 rental real estate loss exception
may apply
 Use an activity's carryover in full if
disposition
 Suspended losses carry over to future years
by activity
