The Basis Limitation on Deducting Business Losses

Owners of pass-through businesses, such as S corporations and partnerships, can often use business losses to offset other personal income. This benefit is governed by the basis limitation, a tax rule ensuring an owner cannot deduct losses that exceed their total economic investment, or “basis,” in the company. The basis limitation acts as a ceiling on the amount of business losses an owner can claim, connecting the tax deduction to what the owner has financially at risk.

Calculating Shareholder and Partner Basis

An owner’s basis in a pass-through entity is a running tally of their financial stake, tracked annually. This figure determines the amount of business losses that can be deducted and distributions that can be received tax-free. The calculation methods differ between S corporations and partnerships, primarily in how business debt is treated.

S Corporation Basis

An S corporation shareholder has two distinct types of basis: stock basis and debt basis. It is the shareholder’s responsibility, not the corporation’s, to track this figure using Form 7203, S Corporation Shareholder Stock and Debt Basis Limitations, filed with their personal tax return. This form is generally required when a shareholder is claiming a loss, receiving a distribution, disposing of stock, or receiving a loan repayment from the corporation.

Stock basis begins with the initial investment of cash and the adjusted basis of any property contributed for shares. This amount is then adjusted each year. It increases by the shareholder’s pro-rata share of corporate income and gains. Stock basis decreases for any distributions received and for the shareholder’s share of corporate losses and non-deductible expenses.

Debt basis is created only when a shareholder lends money directly to the corporation. Personally guaranteeing a third-party loan, such as a bank loan to the corporation, does not create debt basis for the shareholder. If losses exceed a shareholder’s stock basis, they can then deduct losses up to their debt basis. Once debt basis is used to deduct losses, it is reduced, and any future loan repayments from the corporation may become taxable.

Partnership Basis

A partner in a partnership has a single basis figure, often called “outside basis.” A partner’s initial outside basis is the amount of cash and the adjusted basis of property they contribute to the partnership. This figure is then adjusted for the partnership’s annual activity.

A partner’s basis increases by their share of partnership income and additional contributions and decreases for distributions and their share of losses. A partner’s outside basis also includes their allocable share of the partnership’s liabilities. An increase in partnership debt is treated as a cash contribution by the partner, increasing their basis, while a decrease in debt is treated as a cash distribution.

The Loss Limitation Rule and Carryovers

Under Internal Revenue Code Section 1366 for S corporations and Section 704 for partnerships, a business owner can only deduct losses up to their adjusted basis. Any losses that exceed this limit are not permanently lost but are instead suspended and carried forward to subsequent tax years indefinitely.

In a future year, if the owner generates sufficient basis, they can use the carried-over losses to offset income. For example, if an owner has a $50,000 loss from their business but only $30,000 of basis, they can deduct $30,000 in the current year. The remaining $20,000 loss is suspended.

The year-end order of basis adjustments is important for determining the deductible loss. Basis is first increased by all income items, then decreased for any distributions made during the year. Finally, basis is reduced by non-deductible expenses and then by deductible losses. This ordering means that distributions can reduce the basis available to absorb losses.

Methods to Increase Basis

Owners facing the basis limitation can take actions to increase their basis and deduct suspended losses. These actions must be completed by the last day of the business’s tax year to be effective for that year. The available methods differ between S corporations and partnerships.

An owner can increase basis by making an additional capital contribution of cash or property to the business. This action increases an S corporation shareholder’s stock basis or a partner’s outside basis, providing a direct lift to the amount of losses they can deduct.

For an S corporation shareholder, another way to increase basis is to make a direct loan to the corporation. This creates debt basis, which can absorb losses after stock basis has been reduced to zero. The loan must be a direct transaction between the shareholder and the S corporation.

Partners have more flexibility. A partner can increase their outside basis if the partnership takes on more debt, as each partner’s basis includes their share of those liabilities. A partner can also increase basis by personally guaranteeing a partnership’s debt, which is treated as them taking on personal liability for that amount.