It's 1040 time, and the farm client slides a new Schedule K-1 across the desk, explaining, "I invested in my brother-in-law's used car dealership in California." My inner voice of experience is thinking: I've just heard three facts and they're all trouble. But that's the business side. The tax side is also fraught with peril.
Continuing our story, let's really go fictional and assume the K-1 reports positive net income. If the business is an S corporation, there's no Social Security tax on the investor's allocated income. The fact that there were or were not any cash distributions is moot. If the taxpayer has a 20% ownership interest, 20% of the net income is taxable. But if the entity is a partnership, there may be an expensive 15.3% self-employed Social Security tax (SE tax) in addition to the income tax. General partners and limited partners that have management authority are generally subject to the SE tax on partnership allocations from an actively-conducted business. However, under complicated IRS regulations, a limited partner with no management rights under the governing documents may not be subject to the SE tax.
LOSSES: BASIS LIMIT
Getting more realistic, if that K-1 has a loss, the first issue will be whether the investor has sufficient tax basis. If it is an S corporation, deductible losses are limited to investment in S corporation stock and direct loans to the entity. In other words, if the entity has borrowed from third parties and allocable losses exceed the investment, the loss will be limited. Losses in excess of tax basis suspend and carry forward. But with a partnership, it's again more complicated. A partner can receive basis for an allocable share of entity debt and therefore generally has sufficient tax basis to use allocable losses.
LOSSES: PASSIVE LIMIT
A second hurdle is the Section 469 passive loss restrictions. In general, if an investor doesn't materially participate by attaining at least 500 hours of annual involvement in the activity, losses are suspended until either the activity generates income or the investor completely disposes of the investment. This rule only restricts losses; income from the activity remains taxable. This is the anti-tax shelter rule from the mid-1980s, generally holding that losses from a business activity are not deductible unless the individual personally participates at least 500 hours per year.
LOSS ON DISPOSITION
These WBIL (worthless brother-in-law) investments often end badly with a loss. Here the tax law is particularly harsh: It's a capital loss that's restricted to offsetting capital gains, with the excess only allowable at the rate of $3,000 per year against ordinary income. Absent capital gains, it can take a very long time to fully deduct the loss. The same holds true for loans in these situations. A personal or investment bad debt is a capital loss in the tax system.
Editor's Note: Andy Biebl is a CPA and tax principal with the firm of CliftonLarsonAllen LLP in Minneapolis with more than 40 years experience in ag taxation, including 30 years as a trainer for the American Institute of CPAs and other technical seminars. He writes a monthly column for our sister magazine, The Progressive Farmer. To pose questions for future tax columns, e-mail AskAndy@dtn.com.
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