Business losses have become all-too common during COVID-19. Though new tax benefits have been introduced, understanding whether these will benefit a specific business can be a complicated process. One common COVID-era benefit is the Paycheck Protection Program (PPP) loan. Businesses celebrated the news that PPP funds are tax exempt, so they wouldn’t have to pay tax or reduce payroll deductions for expenses used to qualify for loan forgiveness. Yet this same benefit can cause tax basis problems.
Tax basis refers to the amount that a taxpayer has invested in business assets, calculated by taking the purchase price and subtracting any accumulated depreciation. For a shareholder of an S corporation to claim a loss, the deduction cannot exceed the tax basis—the sum of their stock and debt in that corporation. If the taxpayer does not have sufficient basis, the loss will be carried over to a future tax year. So it’s important to note that not every business loss results in tax benefits.
Since an S corporation passes income and losses through to their shareholders, shareholders are impacted by loans made to the company. Let’s say that an S corp received a PPP loan in the year 2020 but did not receive loan forgiveness until 2021. Once PPP loans are forgiven, they’re treated like any other tax-exempt income, making the tax basis increase. The problem arises when we have an unforgiven PPP loan and a loss. In the case above, there would be a span of time when the PPP loan does not create sufficient basis, and the shareholder would be limited in the losses they can deduct.
Shareholders in an S corporation must pass four limitation tests, applied in order, before they qualify for a deduction:
- Stock and Debt Basis Limitations: A shareholder is not allowed to claim loss and deduction items that exceed their stock and/or debt basis.
- At-Risk Limitations: A shareholder cannot deduct more than their actual stake in a business, e.g. the money they are personally liable for.
- Passive Activity Loss Limitations: For investments where the investor is not materially involved, a shareholder must have enough passive income to deduct that loss.
- Excess Business Loss and Taxable Income Limitations: If a shareholder has a loss on an S corporation and there’s no other income from the shareholder, that loss will just be carried over and will not benefit them in this tax year.
To see how to apply these rules, let’s say a taxpayer has a $100,000 reported loss (as shown on their K-1 tax form) and the following circumstances are true:
- The business has a stock and direct loan basis of $80,000 → $20,000 will be carried over because of insufficient basis.
- The business is at-risk to an extent of $60,000 → another $20,000 will be carried over, since a taxpayer can only deduct amounts up to the at-risk limitations.
- We have one passive income activity, resulting in $40,000 against the $60,000 loss → another $20,000 is suspended, since passive losses can only be deducted to the extent that there is passive income.
- The new excess business loss and taxable income limitations tell us that to the extent that we have a loss, we can only offset 80% of our taxable income → this results in another $20,000 carried over.
After applying the limitation rules, we end up with a $20,000 benefit this year and a total of $80,000 in carryover losses. Ouch! As you can see, understanding tax basis is crucial to accurately anticipating tax consequences.
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