Suspended Losses in a Partnership: What Happens When the Business Closes?

When a partnership operates at a loss, those losses don’t always provide an immediate tax benefit to the partners. In some cases, they are suspended and carried forward until certain conditions are met. This can create complications when the business shuts down, as partners may wonder what happens to any unused losses.

Distinction Between Passive and Non-Passive Activities

The tax treatment of suspended losses depends on whether the activity generating the loss is passive or non-passive. The IRS defines passive activities as business ventures in which a taxpayer does not materially participate, such as rental real estate or businesses where the partner is not actively involved. Losses from passive activities can only be deducted against passive income and may be suspended if there isn’t enough passive income to offset them.

Non-passive activities involve material participation, which the IRS measures using specific criteria under the Internal Revenue Code. A partner materially participates if they work more than 500 hours in the business during the year or are the primary decision-maker. Losses from non-passive activities can generally be deducted against other types of income without restriction.

For example, a limited partner in a real estate venture is usually subject to passive loss limitations, while a general partner actively managing a business may be able to deduct losses without restriction.

Requirements for Losses to Be Suspended

A partner’s share of a partnership’s losses is suspended when specific tax limitations prevent immediate deduction. One restriction is the at-risk limitation under the Internal Revenue Code, which ensures a partner cannot deduct losses exceeding their economic investment in the partnership. This rule considers cash and property contributions, as well as debts for which the partner is personally liable. If a partner’s at-risk amount is insufficient to absorb their share of losses, the excess is suspended and carried forward until their at-risk basis increases.

Another restriction is the excess business loss limitation, which caps the amount of business losses a non-corporate taxpayer can deduct against non-business income. As of 2024, this cap is $610,000 for joint filers and $305,000 for single filers. Any loss exceeding this threshold is treated as a net operating loss and carried forward.

Importance of Partner’s Basis

A partner’s basis in a partnership determines how much of the partnership’s losses they can deduct. This basis fluctuates each year based on contributions, income, distributions, and liabilities allocated under the Internal Revenue Code. When basis is insufficient to absorb losses, those losses are suspended and carried forward until the partner has enough basis to utilize them.

Liabilities significantly affect basis calculations. An increase in a partner’s share of partnership debt raises their basis, allowing for greater loss deductions. If a partner guarantees a partnership loan, that debt is included in their basis, potentially unlocking suspended losses. However, recourse debt, where the partner is personally liable, increases basis differently than nonrecourse debt, which is typically allocated based on profit-sharing ratios.

Releasing Suspended Losses After Partnership Dissolution

When a partnership dissolves, any suspended losses that remain unused must be evaluated for deductibility in the final year. These losses do not disappear; they become deductible in full if the partner has sufficient remaining basis at dissolution. Since a partner’s basis is adjusted for final-year income, losses, and distributions, accurately calculating the ending basis is essential.

Liquidation often includes cash or property distributions, which can impact the ability to claim suspended losses. If a partner receives a cash distribution exceeding their basis, a taxable gain is recognized, potentially offsetting some or all of the suspended losses. If no excess distribution occurs, the losses generally become fully deductible in the dissolution year.

Tax Implications When Suspended Losses Are Released

Once suspended losses are released after a partnership dissolves, their tax treatment depends on the nature of the losses and the partner’s tax situation. If the losses stem from passive activities, they become fully deductible against any income in the year the partnership terminates. This allows a partner who previously couldn’t use these losses due to insufficient passive income to apply them against wages, investment earnings, or other taxable income. This final-year deduction can significantly reduce taxable income or even create a net operating loss that can be carried forward.

If the losses originate from non-passive activities, they are deducted as ordinary losses in the final year, subject to any remaining at-risk or excess business loss limitations.

If a partner receives a liquidating distribution exceeding their basis, triggering a capital gain, the released losses can offset this gain. For example, if a partner recognizes a $50,000 capital gain from liquidation but also releases $50,000 in suspended losses, the net tax effect may be neutral. Understanding these interactions helps structure the dissolution to minimize tax burdens while maximizing available deductions.