When a Business Loss Can’t Be Deducted


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As you’re doing your year-end tax planning, here’s a trap you want to avoid.

Excerpt from “Taxmageddon 2018: How to Brace for the Trump Tax Plan”. Pick up your copy today at www.Taxmageddon2018.com.

I like to do a lot of preparation before consultations with new clients. When you have a consultation with me you’ll get asked a lot of questions about the businesses you have now, what businesses you plan to start, what your income currently is and what you project it will be. I’ll ask you to tell me about your dreams and your goals. And about your challenges with those businesses and investments. I’ll answer your questions and then finally I’ll ask you how I can best help you.

A new client was concerned that he had a lot of carry forward NOL that wasn’t being used. His main questions all revolved about how to use those losses. He’d read what I, and others, had said about NOL and he wanted to know why he wasn’t getting the deduction.

“That seems strange,” I thought. NOLs are deductible against income.

As I looked at his last tax return, I spotted a few things that I wanted to investigate. Before we even had our consultation, I asked for more information and in this case, it meant more years’ worth of tax returns.

The answer was in the past tax returns.

My new client actually had several carry forward losses on his return. He also had some suspended real estate losses. That likely wasn’t going to change, but we wanted to stop the bleeding, so I recommended he stop taking depreciation. Depreciation is a strange type of deduction. You can take it, or not. You can catch it up. You can accelerate it with a cost segregation study. And you can just stop it, after you’ve already started it.

Since depreciation has to be recaptured when you sell and he received no benefit from the additional loss it created, he, in effect, was exchanging capital gains tax (maximum of 20%) for depreciation recapture tax (25%). Not a smart strategy.

He also had capital loss carry forward. In case of this type of carry forward, your deduction is limited to the amount of capital gains in that year plus $3,000. Sometimes I see clients with losses of $100,000 or more. Recently, a new client showed a loss of $300,000. It would take 100 years to get the full tax benefit of that loss. He needed a whole different strategy.

In the case of my consulting client, he needed to turn ordinary income into capital gains income. Not hard, if you have enough time to plan and are willing to do things a little differently. (For more details on this strategy, please go to Chapter 16 to register your book and refer to Insider Tax Strategies, a free bonus as a thank you for your purchase of Taxmageddon 2018.)

And then we got to the net operating loss. He was absolutely right. He had net operating losses that were carried forward and he was not using those losses to offset his other income.

In this case, the issue was that he did not have sufficient basis. There are actually two requirements that must be met before net operating losses can even be considered to offset other income. These are:

  1. You need to have active participation in the business, and
  2. You need to have basis.

Active participation is a pretty low standard, as tax rules go. It means you have to be active in the business. For example, if you go over the financials with the CFO and talk to the manager a few times a week as a way to stay in touch and help focus on what the company can do better, you have active participation!

Basis, though, is a little trickier. There are two types of basis that qualify. One is equity basis. Equity is comprised of the money you put in the company that isn’t just a loan. If you make a loan, it’s not equity, it’s a liability for the company. The loan will increase your debt basis, but not your equity basis.

If you fund your company with $10,000, you have $10,000 in equity. Over time, there is income the company will make. Your share of the income increases your basis. If there is a loss in the company, your share of the loss decreases your basis. If you take out a distribution, it decreases your basis as well.

If the business has a flow-through loss to you, you need to tally up the equity basis you have. If you don’t have enough equity basis, you may not be able to take a deduction for the loss.

You do have one more shot, though. You may have enough debt basis. If you have loaned your business money, that can add to the debt basis. In the case of a partnership, or an LLC that has elected to be taxed as a partnership, if you have personally guaranteed partnership debt then it will count as well.

However, in the case of an S Corporation or an LLC that elects to be taxed as an S Corporation, if you personally guarantee the debt, that will not count toward the debt basis.

That’s an important difference to keep in mind.

In this case, my new client didn’t have enough basis. He had a lot of debt, but he had not personally contributed the money and because it was an S Corporation, the fact that he had personally guaranteed the debt didn’t count.

Over the next year, the company paid off that debt and he personally loaned money to the corporation so that he had the needed debt basis.

The corporation didn’t have enough cash to pay off the debt without getting a loan. This time, though, they got the loan through the owner so he could get basis. That meant he could take advantage of the net operating losses he had carried over.

The lesson to take away from this real-life story is to first understand what kind of carry forward loss you have and then figure out what needs to change in order for you to use that loss to offset other income. And, make sure you have a strategy BEFORE year-end to maximize your tax benefits.

Do you have your copy of “Taxmageddon 2018?” Don’t let the new tax plan catch you unaware! Go to www.Taxmageddon2018.com.



3 Comments

  1. Diane Kennedy says:

    Diana,

    The section that I think you’re referencing says that there has to be a recapture of depreciation that was allowed or allowable. That had puzzled tax professionals for years.

    The IRS set that all straight in 2004, over 14 years ago, with Rev Proc 2004-11.

    “Taxmageddon 2018: How to Brace for the Trump Tax Plan” has a chapter on clearing up “myths” regarding real estate tax. These are things have changed in the past 15 years but bad, outdated advice is still being given.

    The depreciation question still lingers, as do misconceptions on how the “2 out of 5 year” rule for Section 121 works (big change in 2009, that some people conveniently forget until the IRS snags you) and carving away at Section 1031 deferrals, (like kind exchange exclusions.)

  2. Diana says:

    You state that he can stop taking depreciation completely. I thought the IRS mandates recapture on the depreciation you have taken or SHOULD have taken, if you have not done so? I am specifIcally interested in depreciation of rental real estate as I have a property for which taking the depreciation would generate a loss?

  3. Mir Shuttari says:

    Very useful and timely information.

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