What Are the S Corp Loss Limitations?

An S corporation provides owners with liability protection while allowing business income and losses to be taxed at the individual shareholder level. This pass-through nature means that if the company incurs a net loss, shareholders receive a proportional share of that loss on their personal tax returns, which can offset other sources of income. This can be particularly advantageous during the start-up phase of a business.

The ability to deduct these business losses is not unlimited. The Internal Revenue Service (IRS) has established a sequence of four limitations that a shareholder must clear before a loss can be claimed. These hurdles are applied in a specific order, and a loss must pass through each one to be deductible in the current year.

The Stock and Debt Basis Limitation

The first hurdle for deducting S corporation losses is the basis limitation. A shareholder can only deduct losses up to their total investment in the corporation, which is tracked as “basis.” The shareholder is responsible for tracking this figure annually, often with the help of an accountant. The process begins with stock basis, and only after that is exhausted can a shareholder use their debt basis.

A shareholder’s initial stock basis is the amount of cash or the adjusted basis of property they contribute for stock. Each year, this basis increases with corporate income, gains, and additional capital contributions. The basis decreases with corporate distributions and the shareholder’s share of losses. A shareholder’s basis cannot be negative; once it reaches zero, losses can no longer be deducted against it.

For example, assume a shareholder starts a year with a stock basis of $20,000. The S corporation allocates $5,000 of income to them and they also receive a $2,000 distribution. Their basis first increases to $25,000 ($20,000 + $5,000) and then decreases to $23,000 ($25,000 – $2,000). If the corporation then allocates a $30,000 loss to the shareholder, they can only deduct $23,000 of that loss, reducing their stock basis to zero. The remaining $7,000 loss is suspended.

After a shareholder’s stock basis is zero, they can deduct additional losses up to their debt basis. 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. The loan must be a direct transaction between the shareholder and the S corporation to count.

An ordering rule governs how basis is restored. If the corporation becomes profitable, net income first restores the shareholder’s debt basis to its original principal amount. After debt basis is fully restored, any further income increases the shareholder’s stock basis.

The At-Risk Limitation

After a loss clears the basis limitation, it must pass the at-risk test under Internal Revenue Code Section 465. This rule is designed to prevent taxpayers from deducting losses that exceed the amount they are personally at financial risk to lose. For most S corporation shareholders, their at-risk amount is identical to their combined stock and debt basis. The at-risk amount includes cash and property contributed to the corporation, plus any amounts borrowed for which the shareholder is personally liable.

The primary scenario where the at-risk amount differs from basis involves nonrecourse financing. A nonrecourse loan is a type of debt where the lender’s only remedy in case of default is to seize the collateral securing the loan; the lender cannot pursue the borrower’s other assets.

If a shareholder contributes property subject to nonrecourse debt, that debt amount is not considered “at risk.” This is because the shareholder is not personally liable for it.

The Passive Activity Loss Limitation

A loss that has cleared the basis and at-risk hurdles next faces the passive activity loss limitation under Internal Revenue Code Section 469. This rule shifts the focus from the shareholder’s financial investment to their level of involvement in the business’s operations.

If a shareholder does not “materially participate” in the business, any losses are considered passive. Passive losses can only be used to offset income from other passive activities, not non-passive income like wages or portfolio income.

Material participation means involvement in the business on a regular, continuous, and substantial basis. Common tests for material participation include:

• Participating for more than 500 hours during the tax year.
• The shareholder’s participation constitutes nearly all of the participation in the activity from all individuals.
• Participating for more than 100 hours, and that participation is not less than the participation of any other individual.

If a shareholder fails to meet a material participation test, the loss is suspended. This suspended loss can be used in future years to offset passive income or is fully released when the shareholder disposes of their entire interest in the activity.

The Excess Business Loss Limitation

The final hurdle is the excess business loss limitation under Internal Revenue Code Section 461. This rule applies at the individual taxpayer level and aggregates all business income and losses from all sources. It limits the total net business loss a noncorporate taxpayer can deduct in a single year.

This limitation is applied after the basis, at-risk, and passive activity rules. For 2025, the threshold for disallowed losses is $313,000 for single filers and $626,000 for those married filing jointly.

Any total business loss from all sources that exceeds this annual threshold is disallowed for the current tax year. To calculate this, a taxpayer sums all business income and gains and subtracts all business deductions and losses. If the result is a loss greater than the threshold, the excess is not deductible.

Treatment of Suspended Losses

Losses disallowed by any of the four limitations are not permanently lost. Instead, they are suspended and carried forward to future tax years. These suspended losses are released under different circumstances depending on which rule caused the suspension. Because each limitation has a different release mechanism, meticulous record-keeping is necessary to properly account for and utilize suspended losses in future periods.

A loss suspended by the basis limitation can be deducted in a future year once the shareholder increases their stock or debt basis. This can be done through new capital contributions or when the corporation generates income. A loss suspended by the at-risk rules becomes deductible if the shareholder’s at-risk amount increases.

A loss suspended by the passive activity rules can be used to offset passive income in subsequent years or can be fully deducted when the shareholder sells their entire interest in the S corporation. An excess business loss is treated as a net operating loss (NOL) carryforward to the following tax year. This NOL can then be used to offset future income under NOL rules.