What Is the LBD Tax? A Rule Limiting Loss Deductions
Unpack the tax framework that restricts loss deductions to your capital at risk. Understand its purpose and how disallowed amounts are handled.
The Limited Basis Deduction (LBD) is not a direct tax but a rule within U.S. tax law that restricts the amount of losses a taxpayer can claim from specific investments. This rule prevents individuals from deducting losses that exceed their actual economic investment in an entity. Its purpose is to align deductible losses with the true financial risk undertaken by the investor.
Entities Affected by Basis Limitations
Basis limitations primarily affect owners of pass-through entities, specifically S corporations and partnerships. These business structures are relevant because their income and losses are not taxed at the entity level but “pass through” directly to the owners’ individual tax returns, impacting their personal tax liabilities. An owner’s “basis” in these entities is a foundational concept for understanding how these limitations operate.
Calculating Your Investment Basis
Understanding your investment “basis” is foundational for pass-through entities like S corporations and partnerships. Basis represents your capital investment in the entity for tax purposes. For S corporation shareholders, initial basis is established by the cash contributed or the cost of purchased stock. For partners, initial basis includes cash contributed plus the adjusted basis of any property contributed to the partnership.
Basis is not static; it undergoes continuous adjustments throughout the life of the investment. For S corporation shareholders, basis increases with their share of corporate income, including both taxable and tax-exempt income, and by additional capital contributions. Basis decreases by their share of corporate losses and deductions, non-deductible expenses, and any non-dividend distributions received from the S corporation.
For partners in a partnership, basis increases with additional cash contributions, their distributive share of both taxable and tax-exempt partnership income, and increases in their share of partnership liabilities. Conversely, a partner’s basis decreases by distributions of money or property (but not below zero), their share of partnership losses and deductions, and any decrease in their share of partnership liabilities. For tax years 2021 and beyond, S corporation shareholders may need to attach Form 7203, S Corporation Shareholder Stock and Debt Basis Limitations, to their Form 1040 if certain conditions are met, such as reporting a loss or claiming a deduction.
How the Limited Basis Deduction Works
The core principle of the Limited Basis Deduction dictates that an owner’s deductible share of losses from an S corporation or partnership cannot exceed their adjusted basis in the entity. For example, if an S corporation shareholder has an adjusted basis of $10,000 but the corporation reports a $30,000 loss, the shareholder can only deduct $10,000 of that loss in the current tax year. The remaining $20,000 of the loss is not permanently lost.
These disallowed losses are suspended and carried forward indefinitely to future tax years. They can be deducted in a subsequent year when the owner’s basis increases sufficiently to cover the carried-forward loss. This increase in basis could occur through future contributions of capital, additional loans to the entity, or the allocation of future entity income.