Chapter 6
Losses and Loss Limitations
Taxation of Business Entities
Copyright ©2010 Cengage Learning
Taxation of Business Entities
C6-1
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
Taxation of Business Entities
C6-2
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
– Cash basis taxpayer does not have bad debt
deduction for unpaid receivables
Taxation of Business Entities
C6-3
Business Bad Debts
(slide 2 of 4)
• If a business 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
Taxation of Business Entities
C6-4
Business Bad Debts
(slide 3 of 4)
• 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 taxpayer paid for debt instrument
Taxation of Business Entities
C6-5
Business Bad Debts
(slide 4 of 4)
• 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
Taxation of Business Entities
C6-6
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
Taxation of Business Entities
C6-7
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
Taxation of Business Entities
C6-8
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
Taxation of Business Entities
C6-9
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
Taxation of Business Entities
C6-10
Worthless Securities
(slide 2 of 2)
• Example of worthless securities
– On December 1, 2008, Falcon Company
purchased stock for $10,000. The stock
became worthless on June 1, 2009. Falcon
Company’s loss is treated as having occurred
on December 31, 2009. The result is a longterm capital loss.
Taxation of Business Entities
C6-11
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
Taxation of Business Entities
C6-12
Section 1244 Stock
(slide 2 of 3)
• Section 1244 loss treatment is limited to
stock owned by original purchaser
• 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
Taxation of Business Entities
C6-13
Section 1244 Stock
(slide 3 of 3)
• Example of § 1244 loss
– In 2004, Sam purchases from XYZ Corp. stock
costing $150,000. (Total XYZ stock
outstanding is $800,000.) In 2009, 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
Taxation of Business Entities
C6-14
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
Taxation of Business Entities
C6-15
Definition of Theft
• Theft includes robbery, burglary,
embezzlement, etc.
– Does not include misplaced items
Taxation of Business Entities
C6-16
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
Taxation of Business Entities
C6-17
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
Taxation of Business Entities
C6-18
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
Taxation of Business Entities
C6-19
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
Taxation of Business Entities
C6-20
C&T Examples
• Business and production of income losses
(no insurance proceeds received)
Adjusted
Item Basis
A
6,000
B
6,000
C
6,000
Taxation of Business Entities
FMV
Before
8,000
8,000
4,000
FMV
After
5,000
1,000
0
Loss
3,000
6,000
6,000
C6-21
Nonpersonal C&T Losses
• Losses on business, rental, and royalty properties
– Deduction will be for AGI
– Not subject to the $100 ($500 for 2009) 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
Taxation of Business Entities
C6-22
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
Taxation of Business Entities
C6-23
Personal C&T Gains and Losses
(slide 1 of 4)
• Casualty and theft losses attributable to personal
use property are subject to the $100 ($500 for
2009) 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
Taxation of Business Entities
C6-24
Personal C&T Gains and Losses
(slide 2 of 4)
• 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 ($500) floor
• Taxpayer must first net (offset) the personal
casualty gains and personal casualty losses
– Tax treatment depends on the results of this netting
process
Taxation of Business Entities
C6-25
Personal C&T Gains and Losses
(slide 3 of 4)
• 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
Taxation of Business Entities
C6-26
Personal C&T Gains and Losses
(slide 4 of 4)
• 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
Taxation of Business Entities
C6-27
Example of C&T Limitation
(slide 1 of 2)
•
Karen (AGI = $40,000) has the following
C&T in 2009 (amounts are lesser of
decline in value or adjusted basis):
1. Car stolen ($6,000) with camera inside ($500)
2. Earthquake damage: house ($2,000), furniture
($1,000)
Taxation of Business Entities
C6-28
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 – $500 = $6,000
2. $2,000 + $1,000 = $3,000 – $500 = $2,500
Karen’s deductible C&T loss is $4,500
[$6,000 + $2,500 – (10% $40,000)]
Taxation of Business Entities
C6-29
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
Taxation of Business Entities
C6-30
Net Operating Losses
(slide 2 of 4)
• No nonbusiness (personal) losses or
deductions may be used in computing NOL
• Exception: personal casualty and theft losses
Taxation of Business Entities
C6-31
Net Operating Losses
(slide 3 of 4)
• 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
Taxation of Business Entities
C6-32
Net Operating Losses
(slide 4 of 4)
• Example of NOL carryovers
– Wren Corp. has a NOL for 2009
– Wren must carryover its NOL in the following
order:
• Carryback to 2007 and 2008, then carryforward to
20010, 2011, ..., 2029
– Wren can elect to just carryforward the NOL
• Carryover would be to 2010, 2011, ..., 2029
Taxation of Business Entities
C6-33
Passive Losses 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
Taxation of Business Entities
C6-34
Passive Losses 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
Taxation of Business Entities
C6-35
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)
Taxation of Business Entities
C6-36
At-Risk Limits
(slide 2 of 4)
• 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
Taxation of Business Entities
C6-37
At-Risk Limits
(slide 3 of 4)
• 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
Taxation of Business Entities
C6-38
At-Risk Limits
(slide 4 of 4)
• 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
Taxation of Business Entities
C6-39
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
Taxation of Business Entities
• Decreases to a taxpayer’s atrisk 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
C6-40
Passive Loss Limits
(slide 1 of 7)
• 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
Taxation of Business Entities
C6-41
Passive Loss Limits
(slide 2 of 7)
• 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
Taxation of Business Entities
C6-42
Passive Loss Limits
(slide 3 of 7)
• Passive losses defined
– Losses from trade or business activities in
which taxpayer does not materially participate,
and
– Certain rental activities
Taxation of Business Entities
C6-43
Passive Loss Limits
(slide 4 of 7)
• 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
Taxation of Business Entities
C6-44
Passive Loss Limits
(slide 5 of 7)
• Suspended losses are deductible in year
related activity is disposed of in a fully
taxable transaction
Taxation of Business Entities
C6-45
Passive Loss Limits
(slide 6 of 7)
• 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
Taxation of Business Entities
C6-46
Passive Loss Limits
(slide 7 of 7)
• 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
Taxation of Business Entities
C6-47
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?
Taxation of Business Entities
C6-48
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
Taxation of Business Entities
C6-49
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
Taxation of Business Entities
C6-50
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
Taxation of Business Entities
C6-51
Material Participation Tests
(slide 2 of 8)
• Test 1
– Taxpayer participates in the activity more than
500 hours during the year
Taxation of Business Entities
C6-52
Material Participation Tests
(slide 3 of 8)
• Test 2
– Taxpayer’s participation in the activity is
substantially all of the participation in the
activity of all individuals for the year
Taxation of Business Entities
C6-53
Material Participation Tests
(slide 4 of 8)
• 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
Taxation of Business Entities
C6-54
Material Participation Tests
(slide 5 of 8)
• 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
Taxation of Business Entities
C6-55
Material Participation Tests
(slide 6 of 8)
• Test 5
– Taxpayer materially participated in the activity
for any 5 years during the last 10 year period
Taxation of Business Entities
C6-56
Material Participation Tests
(slide 7 of 8)
• Test 6
– The activity is a personal service activity in
which the taxpayer materially participated for
any 3 preceding years
Taxation of Business Entities
C6-57
Material Participation Tests
(slide 8 of 8)
• 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
Taxation of Business Entities
C6-58
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
Taxation of Business Entities
C6-59
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
Taxation of Business Entities
C6-60
Interaction of At-Risk and
Passive Loss Limits
• Passive loss rules are applied after the atrisk 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
Taxation of Business Entities
C6-61
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
Taxation of Business Entities
C6-62
Real Estate Passive Loss Limits
(slide 2 of 4)
• 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
Taxation of Business Entities
C6-63
Real Estate Passive Loss Limits
(slide 3 of 4)
• Exception 2: Rental real estate 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
Taxation of Business Entities
C6-64
Real Estate Passive Loss Limits
(slide 4 of 4)
• Exception 2: Rental real estate 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
Taxation of Business Entities
C6-65
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
Taxation of Business Entities
C6-66
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
Taxation of Business Entities
C6-67
If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta
Taxation of Business Entities
C6-68