A Schedule K-1 is an IRS form that is produced when a Partnership or S-Corporation Tax Return is filed. Each Equity Owner (Partner or Shareholder) receives a personalized K-1 that reflects their’ PORTION of the company’s current year Profits (Losses) as well as any non-deductible, owner responsible expenses incurred by the company (such as Charitable Donations or Distributions).
The K-1 is then PASSED THROUGH to the respective Owner’s (Partner’s or Shareholder’s) and is reported on the individual’s income tax return (1040, Schedule E).
(q) How does a Company’s Losses affect the Individual’s tax return?
So, if the K-1 has a loss from the company, can YOU deduct those losses on your personal tax return? The answer is not an immediate “yes” or “no”.
Losses are only deductible if (all three must be present):
ONE: The reported loss on the Individual Owner’s K-1 is less than the Individual Owner’s tax basis FOR THAT YEAR. Refer to above explanation on how the Tax Basis fluctuates each year.
TWO: The basis is considered “at risk”: You’re at risk in any activity for the:
- Money and adjusted basis of property you contribute to the activity
- Any amounts borrowed IF:
- You’re personally liable for repayment, or
- You pledge property (other than property used in the activity) as security for the loan
THREE: The losses are not passive. In other words, the owner must be actively participating in business operations. (IRS Pub 925 (rev 2016) emphasis added).
All three conditions above must be met for the loss rules to be applied.
Peter and Paul form a partnership: P&P Plumbing, LLC. Peter contributed (gave) $80,000 to P&P Plumbing, and Paul gave $20,000. This means that P&P Plumbing now has $100,000 in the Bank as an asset and $100,000 in Owner’s Contribution in Equity.
This also means that Peter OWNS 80% and Paul OWNS 20% of P&P Plumbing,LLC. These percentages and amounts are what will be used to apply both financial and tax accounting rules when the LLC conducts business that impacts the Equity of the company.
In year one, instead of $100,000 Net Income, P&P Plumbing has a ($90,000) Net Loss, and Paul gets a K-1 showing 20% of the Net Loss.
The question is, can Paul take the $18,000 as a loss on his personal income tax return to offset other forms of Income, like the $82,162 he earned in the brokerage account at Edward Jones?
Using the above criteria:
Is the $18,000 less than the $20,000 tax basis that Paul has? YES
Is Paul have “at risk” for the activity? He personally gave the $20,000 originally to P&P Plumbing to create his basis in the company, so yes he is “at risk”.
The losses are not passive. Did Paul work in the company actively throughout the year or is he just collecting dividend payments for his initial investments (like a silent partner)?
*This final step is the biggest hurdle to cross. Even though the K-1 reports a Loss, if this loss is passive to the individual, the loss is not allowed for that year (few exceptions apply and assuming no other passive activity for Paul).
Though this may seem like an easy “YES, Paul can take the $18,000 as a long on his personal income tax”, It isn’t that easy. Unfortunately, this question seems simple but is actually quite technical. In order to properly assess the question correctly a CPA or Tax Accountant should be consulted to look at all other factors that have an affect on “Paul’s” or an individual’s taxes.
Bottom line is, both you and your CPA, or Tax Accountant, needs to know your basis because:
- Your tax basis will determine (to an extent, as explained above) how much of the business’ losses are deductible. If you don’t know how much basis you have in the business, you won’t know how much you are able to deduct.
- Your basis will determine the amount of gain or loss on sale of the business, partner share, or stock.
- Your annual Schedule K-1 often looks incorrect or inconsistent due to the changes made annually. If you have changed accountants over time, they may not have been calculating your basis correctly and applying the correct balances.
Your CPA or Tax Accountant should be involved throughout your ownership of every investment company to properly advice you on tax and accounting changes and how they will impact you on an individual level.
Corporations, Partnerships, Estates and Trusts 2017 Edition. Authors: Hoffman, William; Raabe, WIlliam; Maloney, David; Young, James. Publisher: South-Western Cengage Pages: 14-4 to 14-8.
IRS.gov (2016). Publication 925. Retrieved July 24, 2017 from: https://www.irs.gov/publications/p925/ar02.html#en_US_2016_publink1000104595
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