Chapter 6 Losses and Loss Limitations Taxation of

Chapter 6 Losses and Loss Limitations Taxation of Business Entities Copyright © 2010 Cengage Learning Taxation of Business Entities 1

Bad Debts • If an account receivable arising from credit sale of goods or services becomes worthless – A bad debt deduction is permitted only if income arising from creation of the receivable was previously included in income – No deduction is allowed if taxpayer is on the cash basis since no income is reported until the cash has been collected Taxation of Business Entities 2

Business Bad Debts (slide 1 of 4) • Specific charge-off method must be used – Exception: Reserve method is allowed for some financial institutions • Deduct as ordinary loss in the year when debt is partially or wholly worthless – Cash basis taxpayer does not have bad debt deduction for unpaid receivables Taxation of Business Entities 3

Business Bad Debts (slide 2 of 4) • If a business debt previously deducted as partially worthless becomes totally worthless in a future year – Only the remainder not previously deducted can be deducted in the future year Taxation of Business Entities 4

Business Bad Debts (slide 3 of 4) • In the case of total worthlessness, deduction is allowed for entire amount in the year the debt becomes worthless • Deductible amount depends on basis in bad debt – If debt arose from sale of services or products and the face amount was previously included in income • That amount is deductible – If the taxpayer purchased the debt • Deduction is equal to amount taxpayer paid for debt instrument Taxation of Business Entities 5

Business Bad Debts (slide 4 of 4) • If a receivable has been written off – The collection of the receivable in a later tax year may result in income being recognized – Income will result if the deduction yielded a tax benefit in the year it was taken Taxation of Business Entities 6

Nonbusiness Bad Debts (slide 1 of 2) • Nonbusiness bad debt – Debt unrelated to the taxpayer’s trade or business • Deduct as short-term capital loss in year amount of worthlessness is known with certainty – No deduction is allowed for partial worthlessness of a nonbusiness bad debt Taxation of Business Entities 7

Nonbusiness Bad Debts (slide 2 of 2) • Related party (individuals) bad debts are generally suspect and may be treated as gifts – Regulations state that a bona fide debt arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money – Thus, individual circumstances must be examined to determine whether advances between related parties are gifts or loans Taxation of Business Entities 8

Classification of Bad Debts • Individuals will generally have nonbusiness bad debts unless: – In the business of loaning money, or – Bad debt is associated with the individual’s trade or business • Determination is made either at the time the debt was created or when it became worthless Taxation of Business Entities 9

Worthless Securities (slide 1 of 2) • Loss on worthless securities is deductible in the year they become completely worthless – These losses are capital losses deemed to have occurred on the last day of the year in which the securities became worthless Taxation of Business Entities 10

Worthless Securities (slide 2 of 2) • Example of worthless securities – On December 1, 2008, Falcon Company purchased stock for $10, 000. The stock became worthless on June 1, 2009. Falcon Company’s loss is treated as having occurred on December 31, 2009. The result is a long-term capital loss. Taxation of Business Entities 11

Section 1244 Stock (slide 1 of 3) • Sale or worthlessness of § 1244 stock results in ordinary loss rather than capital loss for individuals – Ordinary loss treatment (per year) is limited to $50, 000 ($100, 000 for MFJ taxpayers) • Loss in excess of per year limit is treated as capital loss Taxation of Business Entities 12

Section 1244 Stock (slide 2 of 3) • Section 1244 loss treatment is limited to stock owned by original purchaser • Corporation must meet certain requirements for stock to qualify – Major requirement is limit of $1 million of capital contributions • Section 1244 does not apply to gains Taxation of Business Entities 13

Section 1244 Stock (slide 3 of 3) • Example of § 1244 loss – In 2004, Sam purchases from XYZ Corp. stock costing $150, 000. (Total XYZ stock outstanding is $800, 000. ) In 2009, Sam sells the stock for $65, 000. – Sam, a single taxpayer, has the following tax consequences: $50, 000 ordinary loss $35, 000 long-term capital loss Taxation of Business Entities 14

Definition of Casualty & Theft (C & T) • Losses or damages to the taxpayer’s property that arise from fire, storm, shipwreck, or other casualty or theft – Loss is from event that is identifiable, damaging to taxpayer’s property, and sudden, unexpected, and unusual in nature – Events not treated as casualties include losses from disease and insect damage Taxation of Business Entities 15

Definition of Theft • Theft includes robbery, burglary, embezzlement, etc. – Does not include misplaced items Taxation of Business Entities 16

When Casualty & Theft Is Deductible • Casualties: year in which loss is sustained – Exception: If declared “disaster area” by President, can elect to deduct loss in year prior to year of occurrence • Thefts: year in which loss is discovered Taxation of Business Entities 17

Effect of Claim for Reimbursement • If reasonable prospect of full recovery: – No casualty loss is permitted – Deduct in year of settlement any amount not reimbursed • If only partial recovery is expected, deduct in year of loss any amount not covered – Remainder is deducted in year claim is settled Taxation of Business Entities 18

Amount of C&T Deduction • Amount of loss and its deductibility depends on whether: – Loss is from nonpersonal (business or production of income) or personal property – Loss is partial or complete Taxation of Business Entities 19

Amount of Nonpersonal C&T Losses • Theft or complete casualty (FMV after = 0) – Adjusted basis in property less insurance proceeds • Partial casualty – Lesser of decline in value or adjusted basis in property, less insurance proceeds Taxation of Business Entities 20

C&T Examples • Business and production of income losses (no insurance proceeds received) Adjusted Item Basis A 6, 000 B 6, 000 C 6, 000 Taxation of Business Entities FMV Before 8, 000 4, 000 FMV After 5, 000 1, 000 0 Loss 3, 000 6, 000 21

Nonpersonal C&T Losses • Losses on business, rental, and royalty properties – Deduction will be for AGI – Not subject to the $100 ($500 for 2009) per event and the 10% of AGI limitation • Losses not connected with business, rental, and royalty properties – Deduction will be from AGI – Example - theft of a security • Theft losses of investment property are not subject to the 2% of AGI floor on certain miscellaneous itemized deductions Taxation of Business Entities 22

Nonpersonal C&T Gains • Depending on the property, gain can be ordinary or capital • Amount of nonpersonal gains – Insurance proceeds less adjusted basis in property Taxation of Business Entities 23

Personal C&T Gains and Losses (slide 1 of 4) • Casualty and theft losses attributable to personal use property are subject to the $100 ($500 for 2009) per event and the 10% of AGI limitations – These losses are itemized deductions, but they are not subject to the 2% of AGI floor • Amount of personal C&T losses – Lesser of decline in value or adjusted basis in property, less insurance proceeds • Insurance proceeds may result in gain recognition on certain casualty and thefts Taxation of Business Entities 24

Personal C&T Gains and Losses (slide 2 of 4) • If a taxpayer has both personal casualty and theft gains as well as losses, a special set of rules applies – A personal casualty gain is the recognized gain from a casualty or theft of personal use property – A personal casualty loss for this purpose is a casualty or theft loss of personal use property after the application of the $100 ($500) floor • Taxpayer must first net (offset) the personal casualty gains and personal casualty losses – Tax treatment depends on the results of this netting process Taxation of Business Entities 25

Personal C&T Gains and Losses (slide 3 of 4) • If netting personal casualty gains and losses results in a net gain – Treat as gains and losses from the sale of capital assets • Short term or long term, depending on holding period • Personal casualty and theft gains and losses are not netted with the gains and losses on business and income-producing property Taxation of Business Entities 26

Personal C&T Gains and Losses (slide 4 of 4) • If netting personal casualty gains and losses results in a net loss – All gains and losses are treated as ordinary items • The gains—and the losses to the extent of gains— are treated as ordinary income and ordinary loss in computing AGI • Losses in excess of gains are deducted as itemized deductions to the extent the losses exceed 10% of AGI Taxation of Business Entities 27

Example of C&T Limitation (slide 1 of 2) • Karen (AGI = $40, 000) has the following C&T in 2009 (amounts are lesser of decline in value or adjusted basis): 1. Car stolen ($6, 000) with camera inside ($500) 2. Earthquake damage: house ($2, 000), furniture ($1, 000) Taxation of Business Entities 28

Example of C&T Limitation (slide 2 of 2) • Example of C&T limitation (cont’d) Karen has no insurance coverage for either loss: 1. $6, 000 + $500 = $6, 500 – $500 = $6, 000 2. $2, 000 + $1, 000 = $3, 000 – $500 = $2, 500 Karen’s deductible C&T loss is $4, 500 [$6, 000 + $2, 500 – (10% $40, 000)] Taxation of Business Entities 29

Net Operating Losses (slide 1 of 4) • NOLs from any one year can be offset against taxable income of other years – The NOL provision is intended as a form of relief for business income and losses – Only losses from trade or business operations, casualty and theft losses, or losses from foreign government confiscations can create a NOL Taxation of Business Entities 30

Net Operating Losses (slide 2 of 4) • No nonbusiness (personal) losses or deductions may be used in computing NOL • Exception: personal casualty and theft losses Taxation of Business Entities 31

Net Operating Losses (slide 3 of 4) • Carryover period – Must carryback to 2 prior years, then carryforward to 20 future years • May make an irrevocable election to just carryforward • When there are NOLs from two or more years, use on a FIFO basis Taxation of Business Entities 32

Net Operating Losses (slide 4 of 4) • Example of NOL carryovers – Wren Corp. has a NOL for 2009 – Wren must carryover its NOL in the following order: • Carryback to 2007 and 2008, then carryforward to 20010, 2011, . . . , 2029 – Wren can elect to just carryforward the NOL • Carryover would be to 2010, 2011, . . . , 2029 Taxation of Business Entities 33

Passive Losses Rules (slide 1 of 2) • Require income and losses to be separated into three categories: – Active – Portfolio – Passive • Generally, disallow the deduction of passive losses against active or portfolio income Taxation of Business Entities 34

Passive Losses Rules (slide 2 of 2) • In general, passive losses can only offset passive income • Passive losses are also subject to the at-risk rules – Designed to prevent taxpayers from deducting losses in excess of their economic investment in an activity Taxation of Business Entities 35

At-Risk Limits (slide 1 of 4) • At-risk defined – The amount of a taxpayer’s economic investment in an activity • Amount of cash and adjusted basis of property contributed to the activity plus amounts borrowed for which taxpayer is personally liable (recourse debt) Taxation of Business Entities 36

At-Risk Limits (slide 2 of 4) • At-risk defined – At-risk amount does not include nonrecourse debt unless the activity involves real estate • For real estate activities, qualified nonrecourse debt is included in determining at-risk limitation Taxation of Business Entities 37

At-Risk Limits (slide 3 of 4) • At-risk limitation – Can deduct losses from activity only to extent taxpayer is at-risk – Any losses disallowed due to at-risk limitation are carried forward until at-risk amount is increased – Previously allowed losses must be recaptured to the extent the at-risk amount is reduced below zero – At-risk limitations must be computed for each activity of the taxpayer separately Taxation of Business Entities 38

At-Risk Limits (slide 4 of 4) • Interaction of at-risk rules with passive loss rules – At-risk limitation is applied FIRST to each activity to determine maximum amount of loss allowed for year – THEN, passive loss limitation applied to ALL losses from ALL passive activities to determine actual amount of loss deductible for year Taxation of Business Entities 39

Calculation of At-Risk Amount • Increases to a taxpayer’s at-risk amount: • Decreases to a taxpayer’s at-risk amount: – Cash and the adjusted basis of property contributed to the activity – Amounts borrowed for use in the activity for which the taxpayer is personally liable or has pledged as security property not used in the activity – Taxpayer’s share of amounts borrowed for use in the activity that are qualified nonrecourse financing – Taxpayer’s share of the activity’s income – Withdrawals from the activity – Taxpayer’s share of the activity’s loss – Taxpayer’s share of any reductions of debt for which recourse against the taxpayer exists or reductions of qualified nonrecourse debt Taxation of Business Entities 40

Passive Loss Limits (slide 1 of 7) • Active income – Wages, salary, and other payments for services rendered – Profit from trade or business activity in which taxpayer materially participates – Gain from sale or disposition of assets used in an active trade or business – Income from intangible property created by taxpayer Taxation of Business Entities 41

Passive Loss Limits (slide 2 of 7) • Portfolio income – Interest, dividends, annuities, and certain royalties not derived in the ordinary course of business – Gains/losses from disposition of assets that produce portfolio income or held for investment Taxation of Business Entities 42

Passive Loss Limits (slide 3 of 7) • Passive losses defined – Losses from trade or business activities in which taxpayer does not materially participate, and – Certain rental activities Taxation of Business Entities 43

Passive Loss Limits (slide 4 of 7) • Limitations on passive losses – Generally, passive losses can only offset passive income, i. e. , they cannot reduce active or portfolio income – Disallowed losses are suspended and carried forward • Suspended losses must be allocated to specific activities Taxation of Business Entities 44

Passive Loss Limits (slide 5 of 7) • Suspended losses are deductible in year related activity is disposed of in a fully taxable transaction Taxation of Business Entities 45

Passive Loss Limits (slide 6 of 7) • Passive credits – Credits from passive activities are subject to loss limitation – Utilize passive credits to the extent of tax attributable to passive income – Credits disallowed are suspended and carried forward similar to losses • Suspended credits can be used to offset tax from disposition of activity but any credits left after activity is disposed of are lost forever Taxation of Business Entities 46

Passive Loss Limits (slide 7 of 7) • Taxpayers subject to rules – Individuals, estates, trusts, personal service corporations – Closely-held corporations • Can deduct passive losses against active income – S Corp and partnership passive losses flow through to owners and limits applied at the owner level Taxation of Business Entities 47

Passive Loss Issues • Passive losses are losses from trade or business activities in which taxpayer does not materially participate and certain rental activities • What constitutes an activity? • What is “material participation"? • When is an activity a rental activity? Taxation of Business Entities 48

Identification of Activities (slide 1 of 2) • Taxpayers with complex business operations must determine if segments of their business are separate activities or entire business is treated as a single activity Taxation of Business Entities 49

Identification of Activities (slide 2 of 2) • Regs allow grouping multiple trade or businesses if they form an appropriate economic unit for measuring gain or loss – Once activities are grouped, can’t regroup unless: • Original groups were clearly inappropriate, or • Material change in circumstances Taxation of Business Entities 50

Material Participation Tests (slide 1 of 8) • An activity is treated as active rather than passive (thus, not subject to the passive loss limits) if taxpayer meets one of 7 material participation tests • Participation is generally defined as work performed by an owner Taxation of Business Entities 51

Material Participation Tests (slide 2 of 8) • Test 1 – Taxpayer participates in the activity more than 500 hours during the year Taxation of Business Entities 52

Material Participation Tests (slide 3 of 8) • Test 2 – Taxpayer’s participation in the activity is substantially all of the participation in the activity of all individuals for the year Taxation of Business Entities 53

Material Participation Tests (slide 4 of 8) • Test 3 – Taxpayer participates in the activity more than 100 hours during the year and not less than the participation of any other individual in the activity Taxation of Business Entities 54

Material Participation Tests (slide 5 of 8) • Test 4 – Taxpayer’s participation in the activity is significant and taxpayer’s aggregate participation in all significant participation activities during the year exceeds 500 hours – Significant participation is more than 100 hours Taxation of Business Entities 55

Material Participation Tests (slide 6 of 8) • Test 5 – Taxpayer materially participated in the activity for any 5 years during the last 10 year period Taxation of Business Entities 56

Material Participation Tests (slide 7 of 8) • Test 6 – The activity is a personal service activity in which the taxpayer materially participated for any 3 preceding years Taxation of Business Entities 57

Material Participation Tests (slide 8 of 8) • Test 7 – Based on the facts and circumstances, taxpayer participated in the activity on a regular, continuous, and substantial basis • Regular, continuous, and substantial are not specifically defined in the Regulations Taxation of Business Entities 58

Participation Defined • Participation generally includes any work done by an individual in an activity that he or she owns – Does not include work if of a type not customarily done by owners and if one of its principal purposes is to avoid the disallowance of passive losses or credits – Work done in an individual’s capacity as an investor is not counted in applying the material participation tests – Participation by an owner’s spouse counts as participation by the owner Taxation of Business Entities 59

Rental Activities • Rental of tangible (real or personal) property is automatically passive activity unless it meets one of the 6 exceptions (Regs) • If exception applies, activity is subject to the material participation tests Taxation of Business Entities 60

Interaction of At-Risk and Passive Loss Limits • Passive loss rules are applied after the atrisk rules – Losses not allowed under the at-risk rules are suspended under the at-risk rules, not the passive loss rules – Basis is reduced by deductions even if not currently usable due to passive loss rules Taxation of Business Entities 61

Real Estate Passive Loss Limits (slide 1 of 4) • Generally, losses from rental real estate are treated like other passive losses • There are two significant exceptions to the general rule Taxation of Business Entities 62

Real Estate Passive Loss Limits (slide 2 of 4) • Exception 1: Real estate professionals – Rental real estate losses are not treated as passive if the following requirements are met: • Taxpayer performs more than half of his/her personal services in real property businesses in which the taxpayer materially participates, and • Taxpayer performs more than 750 hours of services in these real property businesses as a material participant Taxation of Business Entities 63

Real Estate Passive Loss Limits (slide 3 of 4) • Exception 2: Rental real estate activities – Taxpayer can deduct up to $25, 000 of losses on real estate rental activities against active or portfolio income – Benefit is reduced by 50% of taxpayer’s AGI in excess of $100, 000 Taxation of Business Entities 64

Real Estate Passive Loss Limits (slide 4 of 4) • Exception 2: Rental real estate activities – To qualify for this exception the taxpayer must: • Actively participate in rental activity, and • Own at least 10% of all interests in activity – Active participation defined: • Requires only participation in making management decisions in a significant and bona fide sense Taxation of Business Entities 65

Suspended Losses • Losses can be suspended due to the passive loss limits or the at-risk limits • Losses suspended due to at-risk limitations are investment specific, thus no allocation of suspended losses is necessary • Suspended at-risk and passive losses can be carried forward indefinitely Taxation of Business Entities 66

Disposition of Passive Interests • Disposition at death: suspended loss deductible on decedent’s final tax return to extent of excess over any step-up in basis • Disposition by gift: suspended loss increases donee’s basis in property Taxation of Business Entities 67

If you have any comments or suggestions concerning this Power. Point Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta. edu SUNY Oneonta Taxation of Business Entities 68