Module 15

Business Losses and Limitations

Business Losses & Related Restrictions

Key Learning Objectives How losses fit into the statutory framework

that authorizes deductions How the laws limit taxpayers' abilities to

deduct losses realized in certain types of transactions.

Definition of Loss

Excess of current period deductions over current period gross income

A realized decline in the value of a taxpayer's assets used for Trade or businessTrade or business Production of incomeProduction of income Personal use if casualty or theft Personal use if casualty or theft

Net Operating Loss Deduction(NOL)

Key Learning Objectives

Compute an NOL Decide when and how to take the NOL

NOL Calculation Limited to losses from a trade or businessLimited to losses from a trade or business

Includes employee business expenses Includes employee business expenses Add back to negative taxable income:Add back to negative taxable income:

NOLs from other yearsNOLs from other years Personal and dependency exemptionsPersonal and dependency exemptions Capital lossesCapital losses Excess of nonbusiness deduction over nonbusiness Excess of nonbusiness deduction over nonbusiness

incomeincome AMT NOL is a different calculationAMT NOL is a different calculation

NOL Elections Made on Timely Filed ReturnFor tax years beginning For tax years beginning afterafter 8-5-97 8-5-97 First choiceFirst choice

2 years back, then 20 forward2 years back, then 20 forward Other choiceOther choice

Forward only for 20 yearsForward only for 20 years Default is 2 back/20 forwardDefault is 2 back/20 forward Irrevocable electionIrrevocable election

NOL Elections Made on Timely Filed ReturnFor tax years beginning For tax years beginning beforebefore 8-5-97 8-5-97 First choiceFirst choice

3 years back, then 15 forward3 years back, then 15 forward Other choiceOther choice

Forward only for 15 yearsForward only for 15 years Default is 3 back/15 forwardDefault is 3 back/15 forward Irrevocable electionIrrevocable election

Compliance Query

T reported the following this year:T reported the following this year: Loss from sole proprietorship: <$15,100>Loss from sole proprietorship: <$15,100> Wages from part-time job: $2,300Wages from part-time job: $2,300 Interest income from savings: $400Interest income from savings: $400 Mortgage interest and real estate taxes: $8,000Mortgage interest and real estate taxes: $8,000 Personal exemption: $2,700Personal exemption: $2,700 Taxable income: <$23,100>Taxable income: <$23,100>

What is T’s NOL?What is T’s NOL?

Solution--Compliance Query

Start with taxable income of <$23,100>Start with taxable income of <$23,100> Add back $2,700 personal exemptionAdd back $2,700 personal exemption Add back excess of nonbusiness deductions Add back excess of nonbusiness deductions

over nonbusiness income ($8,000 - $400 = over nonbusiness income ($8,000 - $400 = $7,600)$7,600)

NOL = <$12,800>NOL = <$12,800>

Research Query

T claimed the following losses on her T claimed the following losses on her current year tax return:current year tax return: $22,000 loss on sale of Section 1244 stock$22,000 loss on sale of Section 1244 stock $13,000 deductible personal casualty loss$13,000 deductible personal casualty loss

Are either of these losses allowable in Are either of these losses allowable in determining T’s NOL? determining T’s NOL?

Solution--Research Query

The loss on the sale of the Section 1244 The loss on the sale of the Section 1244 stock is allowable.stock is allowable. Code Sec. 1244(d)(3); Reg § 1.1244(d)-4(a).Code Sec. 1244(d)(3); Reg § 1.1244(d)-4(a).

Personal casualty losses are “business” Personal casualty losses are “business” deductions for net operating loss purposes.deductions for net operating loss purposes. Code Sec. 172(d)(4)(C).Code Sec. 172(d)(4)(C).

The Bad Debt Deduction

Key Learning Objectives

Identify eligible bad debts Amount of the deduction Timing of the deduction Classification of the deduction

Eligible Bad Debt Good Loan in Past

Bona fide debt Promise to pay fixed & determinable Sum enforceable under state law Related party loans--suspected giftsRelated party loans--suspected gifts

Written note?Written note? Adequate security?Adequate security? Interest reasonable & reported annuallyInterest reasonable & reported annually

Amount of the DeductionA Question of Basis

Cash basisCash basis Unrecoverable out-of-pocket costsUnrecoverable out-of-pocket costs

Accrual basisAccrual basis Accounts ReceivableAccounts Receivable Other amount previously included in Other amount previously included in

incomeincome

Timing of the DeductionA Question of Values

Based on Based on facts/circumstances facts/circumstances

Legal action not Legal action not required if cost required if cost prohibitiveprohibitive

Documentation is Documentation is crucialcrucial

No money in your future

Classification of the DeductionBusiness Bad Debt

Ordinary loss for full/partial worthlessness Arises in connection with T/B Must be closely related to business activity

Uncollected A/RUncollected A/R To secure source of materialTo secure source of material Loans/advances to employeesLoans/advances to employees Loans by Employee to protect employmentLoans by Employee to protect employment T/B of making loansT/B of making loans

Classification of the DeductionNon-Business Bad Debt

Short term capital loss Short term capital loss Deduction only when totally worthlessness Deduction only when totally worthlessness Personal loansPersonal loans Investment loans Investment loans

Not in T/B of loaning moneyNot in T/B of loaning money Shareholder loan to keep business goingShareholder loan to keep business going

Research Query:

T’s former spouse was $5,000 in arrears in T’s former spouse was $5,000 in arrears in child support payments. Because of this, T child support payments. Because of this, T had to spend $5,000 of her own funds to had to spend $5,000 of her own funds to support her children.support her children.

Can T claim a nonbusiness bad debt of Can T claim a nonbusiness bad debt of $5,000?$5,000?

Solution--Research Query

A spouse's failure to make required alimony A spouse's failure to make required alimony or child support payments does not give rise or child support payments does not give rise to a bad debt deduction.to a bad debt deduction. Rev Rul 93-27; Swenson, Dale, (1965) 43 TC Rev Rul 93-27; Swenson, Dale, (1965) 43 TC

897.897.

Casualty and Theft Loss Deductions

Key Learning Objectives

Which losses qualify Amount of the deduction Timing of the deduction

Which Losses Qualify? Personal Use Property

Losses from personal use property Losses from personal use property not deductible w/o §165(c)not deductible w/o §165(c)

Sudden, unusual, unexpected event Sudden, unusual, unexpected event Not normal wear and tearNot normal wear and tear Not everyday accidentsNot everyday accidents Not erosion/termitesNot erosion/termites OK if at fault if not willfulOK if at fault if not willful

Amount of the Deduction Personal Use Property

Decline in FMV, limited to adjusted Decline in FMV, limited to adjusted basisbasis

Decline in FMV measured byDecline in FMV measured by Appraisal value before & afterAppraisal value before & after Repairs to return to original conditionRepairs to return to original condition Not amounts that increase FMVNot amounts that increase FMV

Amount of the Deduction Personal Use Property

Each personal loss is reduced by Each personal loss is reduced by $100 floor$100 floor Each occurrence = one $100 floorEach occurrence = one $100 floor

Total for year is reduced by 10% Total for year is reduced by 10% AGIAGI

Net personal casualty loss Net personal casualty loss From AGIFrom AGI Not 2% or 3% limitedNot 2% or 3% limited

Amount of the Deduction Business Use Property

Decline in FMV, limited to adjusted Decline in FMV, limited to adjusted basis basis

If completely destroyed ,get If completely destroyed ,get adjusted basisadjusted basis

Not subject to 100 floor Not subject to 100 floor Not subject to 10% AGI offsetNot subject to 10% AGI offset

Compliance Query

T’s auto (basis = $12,000) completely T’s auto (basis = $12,000) completely destroyeddestroyed

Blue book value right before the accident Blue book value right before the accident $6,000$6,000

No other casualty events during yearNo other casualty events during year What is T’s loss deduction if auto is personal? What is T’s loss deduction if auto is personal?

business?business?

Solution--Compliance Query

PERSONAL USEPERSONAL USE Loss base is $6,000Loss base is $6,000 Reduce by Reduce by

insurance proceedsinsurance proceeds Reduce by $100Reduce by $100 Reduce by 10% of Reduce by 10% of

AGIAGI Deduct from AGIDeduct from AGI

BUSINESS USEBUSINESS USE Loss base is Loss base is

$12,000$12,000 Reduce by Reduce by

insurance proceedsinsurance proceeds N/AN/A N/AN/A

Deduct for AGIDeduct for AGI

Business & Personal Property Must apply for insurance Must apply for insurance

reimbursement reimbursement Insurance may cause realized gainInsurance may cause realized gain

Treated as an involuntary conversionTreated as an involuntary conversion

Timing of the Deduction Casualty deductible in Casualty deductible in

year of lossyear of loss If National Disaster If National Disaster

Area can use preceding Area can use preceding yearyear

Theft deductible in Theft deductible in year discoveredyear discovered

Special Restrictions on Business Loss Deductions

Key Learning Objective

Identify transactions and deductions subject to special limitations

Amount of the deduction Timing of the deduction.

Hobby Loss--Work or Fun? Is activity inherently Is activity inherently

personal or profit personal or profit motivatedmotivated

Facts and Facts and circumstances controlcircumstances control

If Hobby, Deductions May Be Limited

Deductions from AGI "Otherwise allowable" deductions allowed

in full Other deductions limited to remaining gross

income from activity Income reduced by "otherwise allowables" firstIncome reduced by "otherwise allowables" first

If Hobby, Deductions May Be Limited

All deductions except "otherwise allowable" treated as miscellaneous 2% deductions

Excess deductions do not carryover

§267(a) Disallows Losses on Related Party Sales

Includes immediate familyIncludes immediate family AncestorsAncestors Lineal descendants Lineal descendants Brothers & sistersBrothers & sisters > 50% Owned corporations/partnerships> 50% Owned corporations/partnerships Special attribution rules also applySpecial attribution rules also apply

§267(a) Disallows Losses on Related Party Sales

Disallowed loss can be used by related party if subsequent gain on sale of same property

If property not sold for gain, disallowed loss is never utilized

§267(a) applies even if sale is at FMV

Passive Activity Losses (PAL)

Current law makes several income Current law makes several income classificationsclassifications

Active--T/B w/material participationActive--T/B w/material participation Portfolio--§212 except rentalsPortfolio--§212 except rentals Passive activitiesPassive activities

Passive Activity Defined

AllAll rental activities unless material services rental activities unless material services providedprovided

All T/B in which taxpayer does not All T/B in which taxpayer does not materially participatematerially participate

Material participation only if regular, Material participation only if regular, continuous, substantialcontinuous, substantial

PAL Netting Procedures

Record income/loss for each passive Record income/loss for each passive activity activity

Net all passive activitiesNet all passive activities If overall net passive income--report in fullIf overall net passive income--report in full If overall loss--report zeroIf overall loss--report zero

PAL--Suspended Losses

$25,000 rental real estate loss exception may apply

Use an activity's carryover in full if disposition

Suspended losses carry over to future years by activity