Taxation of Business Entities

1
Taxation of Business Entities

• Losses and Loss Limitations
• Text Chapter 6

2
Outline

• Bad Debts
• Worthless Securities
• Casualty Losses
• NOL Deductions
• At-risk and Passive Loss Rules

3
Bad Debts-In General

• Bad Debt Deduction is allowed for
• Bona-fide debts that are not repaid
• Unpaid accounts receivable for accrual-basis
  taxpayers
• Cash-basis taxpayers have not recognized income
  from the creation of an A/R, thus can not deduct
  a bad debt expense

4
Specific Charge-Off Method

• Must be used by most taxpayers
• Under the specific charge-off method, a deduction
  is allowed when
• A business bad debt becomes wholly or partially
  worthless
• A non-business bad debt becomes wholly worthless
• Collection of a receivable previously written off
  bad debt requires recognition of income to the
  extent of the tax benefit from the previous
  write-off

5
Business vs. Nonbusiness Debt

• Business bad debt
• Debt related to taxpayers trade or business
• Deductible as an ordinary loss
• Nonbusiness bad debt
• Debt not related to the taxpayers trade or
  business
• Deductible as a short-term capital loss

6
Business vs. Nonbusiness Debt

• Example t/p (an individual) has ordinary income
  of 40,000, and a bad debt write-off of 10,000.
• What is t/ps AGI if bad debt is business bad
  debt?
• What is t/ps AGI if bad debt is non-business bad
  debt?
• What if t/p was a Corporation instead of
  individual?

7
Loans Between Related Parties

• Primary issue is whether the transaction was a
  bona fide loan or a gift
• Factors determining loan vs. gift status
• Was a note properly executed?
• Was there a reasonable rate of interest?
• Was collateral provided?
• What collection efforts were made?
• What was the intent of the parties?

8
Worthless Securities

• Securities include stocks, bonds, and registered
  notes
• Loss is allowed in tax year that securities
  become completely worthless
• Losses are treated as capital losses deemed to
  have occurred on the last day of the tax year
  (regardless of the actual date of worthlessness)

9
Small Business Stock ( 1244)

• 1244 exception
• Ordinary loss treatment on sale (or
  worthlessness) of small business stock by
  individuals
• Applies to first 1,000,000 of stock issued by
  corporation
• Up to 50,000 per year (100,000 for MFJ) can be
  treated as ordinary loss
• Only individuals who acquired the stock from the
  issuing corporation qualify
• Example Single t/p sells 1244 stock in December
  2008, with a basis of 110,000 for 40,000.
• What is the amount and character of loss
  recognized in 2008?
• Any tax planning suggestions?

10
Casualty Loss Definition

• Casualty losses include those caused by
• Fire, storm, shipwreck, theft
• Other casualty (e.g. plane crash, car crash
  etc.)
• The event that causes the casualty must be
• Identifiable
• Damaging to property
• Sudden, unexpected, and unusual in nature
• Theft includes, but is not limited to
• Larceny
• Embezzlement
• Robbery

11
Casualty Loss Definition

• Events that are not casualties
• Damage resulting from progressive deterioration
  (e.g., erosion, wind, rain)
• Insect damage (unless sudden, unexpected, and
  unusual in nature)
• An event that causes a decline in value rather
  than an actual loss (e.g., a flood that reduces
  value of property because of its location)
• Theft does NOT include misplaced property

12
When to Deduct Casualty and Theft Losses

• Generally, a casualty loss is deducted in the
  year incurred
• Disaster area losses may be deducted in the tax
  year prior to the year the loss occurred (at the
  election of the taxpayer)
• Theft losses are deducted in the year of
  discovery (not the year of the theft, if earlier)

13
Amount of Casualty Theft Deductions
14
Casualty and Theft Losses Business Property

• Example 1Complete Destruction
• Corporations warehouse was destroyed by fire
  basis was 100,000 FMV was 90,000
• How much is deductible casualty loss?
• Example 2Partial Destruction
• Corporations warehouse was damaged by fire
  adjusted basis was 100,000 FMV was 150,000
  before, 80,000 after fire
• How much is deductible casualty loss?
• What is corporations adj. basis in warehouse
  after deducting casualty loss?

15
Casualty and Theft Losses Personal Use Property

• Example 1Complete Destruction
• Individuals residence was destroyed by flood
  basis was 100,000 FMV was 90,000
• How much is deductible casualty loss (before AGI
  limitations)?
• Example 2Partial Destruction
• Individuals residence was damaged by flood
  basis was 100,000 FMV was 150,000 before,
  80,000 after flood
• How much is deductible casualty loss (before AGI
  limitations)?

16
Casualty Theft Losses Insurance Recoveries

• Losses on property are reduced by insurance or
  other type of recovery (e.g. FEMA payment)
• An insurance recovery will result in a casualty
  gain if the proceeds exceed the adjusted basis of
  the property (see Chapter 8 for treatment of gain)

17
Casualty Theft Losses Personal Use Property
Floors

• Casualty losses on personal use property are
  further reduced by
• 100 per casualty
• 10 of adjusted gross income (applies to
  aggregate losses of the individual)
• Occasionally this limitation is lifted for
  presidentially declared disaster areas
• Whatever amount remains (if any) is then deducted
  as an itemized deduction

18
Casualty Theft Losses Additional Examples

• t/ps property (Basis 50,000 FMV 60,000)
  is completely destroyed by fire. Insurance
  reimbursement 30,000. b4 consideration of this
  loss, t/ps AGI 100,000.
• How much can t/p deduct if property is business
  property? Where is it deducted?
• How much can t/p deduct if property is
  personal-use property? Where is it deducted?

19
Net Operating Loss (NOL)

• An NOL occurs when business expenses exceed
  business income
• Length of carryback and carryforward periods
• 2-year carryback
• 20-year carryforward
• 3-year carryback is available in limited cases
• May elect to forgo carryback

20
Effect of NOL Deductions

• The NOL is offset against taxable income
• Carry-back
• NOL generates a refund if tax was paid in
  carryback years
• Carry-forward
• NOL reduces taxable income in carry forward years
• Only C corporations and individuals are allowed
  to deduct NOLs
• WHY???

21
Computation of NOL for Individual

• NOL Taxable Income Net Capital Loss
  Personal and Dependency Exemptions (Non
  Business Deductions in excess of Non Business
  Income)
• Allowed Business Deductions include
• Moving expenses
• Loss on rental property
• 1244 losses
• ½ self employment tax
• Losses from Sole Proprietorships, partnerships
  and S Corps
• Personal (and Business) Casualty Losses

22
At-Risk and Passive Loss Rules

• At-risk and passive loss rules were designed to
  solve the tax shelter problem that was
  prevalent in the 1970s and early 1980s
• Tax shelters were attractive to investors for the
  following reasons
• Large (ordinary) loss deductions (through use of
  nonrecourse debt, accelerated depreciation, etc.)
  in the early years of the tax shelter allowed for
  the deferral of taxes
• Tax-favored treatment applied to long-term
  capital gain upon the eventual sale of the tax
  shelter investment

23
At-risk and Passive Loss Rules

• Tax provisions aimed at tax shelters
• At-risk limitation
• Limits taxpayers deductions to amount taxpayer
  could actually lose from the investment (the
  amount at-risk)
• Passive loss rules
• Limit an investors ability to deduct losses from
  so-called passive activities against income
  from non-passive sources (e.g. active
  trade/business income and portfolio income)

24
The At-Risk Limitation

• A t/ps deductible loss from an activity for any
  taxable year is limited to the amount the t/p has
  at-risk at the end of the taxable year
• A t/ps at-risk amount fluctuates over time
• Losses suspended under the at-risk rules can be
  deducted in later years when the t/p has a
  positive at-risk amount in the activity
• Initial amount at-risk includes
• Cash and property contributed to the
  investment/activity
• Amounts borrowed for use in the activity for
  which the taxpayer is personally liable
• Adjusted basis of property not used in the
  activity that is pledged as security for debts of
  the activity

25
The At-Risk Limitation

• At Risk amount is adjusted each year by
• Income recognized by t/p
• Losses deducted by t/p
• Distributions received by t/p
• (sometimes) t/ps share of debt incurred by
  entity

26
The At-Risk Limitation Ex.

• 1/1/2007 Rich contributes 10,000 to be 1/3
  owner in 3R Partnership (no debt). He actively
  participates in the partnerships business.
• 12/31/2007 3R Partnership reports 90,000
  Ordinary Income for the year. Rich reports
  30,000 on HIS tax return, he receives NO
  distributions from partnership.
• How much is Richs at-risk basis at 12/31/07?
• During 2008, 3R Partnership takes out a recourse
  loan with bank of 30,000 (partners guarantee
  loan.)
• 12/31/2008 3R reports 60,000 ordinary for the
  year. Each partner receives a distribution of
  5,000. Rich dutifully reports his 20,000 share
  of partnership income on his tax return.
• How much is Richs at-risk basis at 12/31/08?
• 12/31/2009 3R Partnership reports a loss of
  240,000. There is no change in liabilities and
  the partners received no distributions during the
  year.
• How much is Richs at-risk basis at 12/31/09?
  How much of 3Rs loss can he deduct on his 2009
  tax return?

27
Passive Loss Limits

• The passive loss rules require income and loss to
  be classified into three categories
• Active
• Portfolio
• Passive
• General rule losses generated by passive
  activities can only be deducted to the extent of
  income from passive activities

28
Income Definition

• Active income or loss includes
• Wages, salary, commissions, bonuses
• Profit /(loss) from a trade or business in which
  the taxpayer is a material participant
• Portfolio income or loss includes
• Interest, dividends, annuities and royalties not
  derived in the ordinary course of a trade or
  business
• Gain or loss from the disposition of property
  that produces portfolio income or is held for
  investment purposes
• Passive income or loss arises from the following
  activities
• Any trade or business or income-producing
  activity in which the taxpayer does not
  materially participate
• Subject to certain exceptions, all rental
  activities, regardless of taxpayers level of
  participation are considered passive activities

29
Suspended Passive Losses

• Passive losses that are not deductible in the
  year incurred are suspended
• Suspended passive losses may be carried forward
  and used to offset
• Passive income in future years
• Passive income and other types of income in the
  year the passive activity is disposed of

30
Passive Loss Limits Examples

• Example 1 Joe has active income of 60,000 and
  a passive loss of 20,000 in 2008
• Can Joe deduct passive loss in 2008?
• Example 2 Joe has active income of 70,000 and
  passive income of 25,000 in 2009
• What is Joes 2009 AGI? (what happens to 2008
  suspended loss?)

31
Multiple Passive Activities

• When a taxpayer owns more than one passive
  activity with losses, the total suspended loss
  must be allocated among the activities
• The total disallowed loss for the year is
  allocated among the loss activities using the
  following fraction
• Loss from activity/Sum of losses from all
  activities having losses

32
Passive Loss Allocation Example

• Example T/P has wages of 100,000 and 3 passive
  activities, which produced income (losses) as
  follows
• Activity A (40,000)
• Activity B ( 10,000)
• Activity C 20,000
• Total (30,000)
• What is t/ps AGI and how much of the losses are
  suspended??
• How much of the suspended loss is allocated to
  each Activity? Why does it matter?

33
Taxpayers Subject to the Passive Loss Rules

• The passive loss rules apply to
• individuals,
• estates and trusts
• personal service corporations (PSCs)
• closely held C corporations
• Net passive losses can offset active income but
  not portfolio income
• Income/losses from partnership and S corps flow
  through to owners and passive loss rules apply to
  owners

34
Identifying Passive Activities

• Identification of what constitutes an activity
  is necessary to apply the passive loss rules
• If taxpayer is involved in more than one trade or
  business, grouping may be possible IF the
  activities form an appropriate economic unit
• A trade or business is treated as
• Active if the taxpayer is a material participant
• Passive if the taxpayer is not a material
  participant
• Material participation is defined as
  participation that is regular, continuous, and
  substantial. Regulations identify 7 tests for
  determining if t/p is a material participant (see
  pgs 6-23 thru 6-26).

35
Rental Activities Defined

• A rental activity is any activity where payments
  are received principally for the use of tangible
  (real or personal) property
• Regulations identify six exceptions where
  activities involving rentals are not to be
  treated as rental activities
• General rulerental activities are automatically
  treated as passive activities, even if the
  taxpayer would meet the material participation
  definition
• There are two special rules related to real
  estate rental activities
• Real estate professionals may qualify for
  non-passive treatment under material
  participation rules
• Small landlords may deduct up to 25,000 loss
  from rental activity against active or portfolio
  income

36
Real Estate Professional Exception

• To qualify as an active trade or business the
  taxpayer must satisfy both of the following
  requirements
• More than half of the personal services that the
  taxpayer performs are performed in real property
  businesses in which the taxpayer materially
  participates
• The taxpayer performs more than 750 hours of
  services in these real property trades or
  businesses as a material participant

37
Small Landlord Exception

• To qualify for the 25,000 exception, the
  taxpayer must
• Actively participate in the real estate rental
  activity
• Own 10 percent or more (in value) of all
  interests in the activity
• Active participation requires participation in
  making management decisions in a significant and
  bona fide sense
• The potential 25,000 deduction is reduced by 50
  of the amount by which the taxpayers AGI exceeds
  100,000 (so if AGI 150,000, no small
  landlord loss allowed).

38
Small Landlord Example

• In 2008, Ryan has income(losses) from the
  following sources
• Salary 90,000
• Passive Rental Income 20,000
• Loss from Rental Real Estate activity (50,000)
• How much is Ryans AGI for 2008?
• What if his salary was 110,000 instead?

39
Interaction of At-Risk and Passive Activity Limits

• The passive loss rules are applied after
  application of the at-risk rules
• A loss that is allowable under the at-risk rules
  may still be suspended under the passive loss
  rules
• Example
• Taxpayer has 10,000 at risk basis in an activity
  and the activity results in a 15,000 passive
  loss for the year. His only other income is
  100,000 salary.
• How much can be deducted against other income?
• How much is suspended and what future events have
  to occur to be able to deduct suspended loss?