In order to deduct losses associated with an S corporation, partnership, LLC, or even a sole proprietorship, there are a number of tests to pass. In one U.S. Tax Court case, the taxpayers ran into the two most frequently encountered issues: basis and material participation.

Facts of the Case

Patrick and Patricia Montgomery were involved in two businesses. The first, Utility Design, Inc. (Design) performed engineering work on telephone-related infrastructure. Because of conflict-of-interest rules, Design could not perform construction work on the projects for which it performed engineering work, so Patrick Montgomery formed UDI Underground LLC (UDI) to perform construction work.

On Form 1065, the taxpayers claimed Patricia Montgomery was an LLC member and Patrick was not. As a 40% member, that portion of the losses of UDI was passed through to Patricia. The IRS argued that some or all of her losses should be disallowed because she did not materially participate in the business. (Losses from passive activities are generally only allowed to the extent of passive income.)

According to the court, the couple credibly testified that Patricia handled all of the office functions, managed payroll, prepared documents, met with members of the company, and attended business meetings. She worked on company matters daily and discussed the company’s business with her husband. Patrick started the company, secured a contract with AT&T, and handled various operational aspects of the business, including buying equipment, hiring employees, etc.

Spousal Participation

The court found the couple had no other interests other than Design and UDI, spent the bulk of their time working for UDI, and that Patricia met the first (500 hours during the year) and seventh test (regular, continuous, and substantial basis) for material participation. The court noted that participation by a spouse counts as participation by the member, partner, or shareholder.

The IRS argued that the taxpayers maintained no log, diary, etc. to support their claim of participation. The court noted that such records are not required if participation can be established by other reasonable means. That could include identification of services performed over a period of time and the approximate number of hours spent, based on appointment books, calendars, or narrative summaries. In this case, the testimony of the taxpayers was sufficient.

The second issue in the case involved the taxpayers’ basis in Utility Design, an S corporation. You can claim pass-through losses from an S corporation up to the amount of your basis. Basis includes both stock and loan basis (in other words, your initial investment adjusted for income, losses, and distributions).

For an S corporation, your loan basis includes only amounts loaned directly by you to the corporation. It does not include any guarantee of loans from a third party, such as a bank. (The rules are different for a partnership.)

Design ran into financial difficulties. During the year at issue, Patrick Montgomery made substantial loans to Design, and the IRS gave him credit for these amounts in adjusting his basis. In addition, Design defaulted on a $1 million bank loan, which the couple personally guaranteed. The taxpayers argued that their basis should be increased by the amount of a judgment imposed on the taxpayers as a result of their guarantee of the bank loan.

The court noted that when an S corporation shareholder guarantees a loan by a bank to the corporation, no debt has been created between the S corporation and the shareholder. However, once the S corporation shareholder pays the bank pursuant to the guarantee, the S corporation becomes indebted to the shareholder. It is the payment by the guarantor that gives rise to indebtedness and basis. The mere fact that the debtor defaults and makes the guarantor liable is not sufficient. The court did not allow any increase in basis over that allowed by the IRS.(Montgomery, T.C. Memo. 2013-151).

Lessons from the Case

In order to deduct losses from a partnership, LLC, S corporation, or sole proprietorship, you must materially participate in the business. (Losses you can’t deduct aren’t lost but suspended.) If you’ve only got one source of income — your business — it’s unlikely the IRS will challenge your participation. However, your situation may not be as straightforward.

For example, let’s say you have a regular job and run a machine shop as a sideline. You should be prepared to substantiate your hours worked in the sideline business. The closer you are to the material participation requirement thresholds, the more cautious you should be. If you’re concerned, check with your tax adviser.

Poor planning can result in the worst of both worlds. It’s not unusual for a parent to advance most, if not all, the funds for a venture but not participate in the activity. The son or daughter does all the work. The parent or other investor can’t currently deduct the losses because he or she doesn’t materially participate, and the son or daughter can’t deduct them because he or she has no basis.

Material participation has now become important with respect to profitable activities as a result of the new 3.8% net investment income tax on interest, dividends, and passive activities. If you materially participate in the business, the tax doesn’t apply.

Your equity basis in an S corporation, partnership, LLC, or even a sole proprietorship is usually uncomplicated. However, the rules with respect to debt basis are more subtle. For S corporations, you need to make a true economic outlay in order to generate basis. A direct loan to the corporation is required. One option is for the shareholder to borrow from a bank or other party and loan the funds to the corporation. But funds you borrow from another shareholder don’t count.

There are some steps you can take if you’re approaching the end of the year and you have insufficient basis to take the losses. You can reduce items that you would pay to yourself, such as your salary, but be aware of the compensation rules. Not taking distributions can also help. Utilizing these losses, or deciding not to, should be an important part of your year-end planning.

 

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