So, if the K-1 has a loss from the company, can YOU deduct those losses on your personal tax return? The answer is not an immediate “yes” or “no”.
A Schedule K-1 is an IRS form that is produced when a Partnership or S-Corporation Tax Return is filed.
Each Equity Owner (Partner or Shareholder) receives a personalized K-1 that reflects their’ portion of the company’s current year Profits (Losses) as well as any non-deductible, owner responsible expenses incurred by the company (such as Charitable Donations or Distributions).
The K-1 is then passed through to the respective Owner’s (Partner’s or Shareholder’s) and is reported on the individual’s income tax return (1040, Schedule E).
Losses are only deductible if (all three must be present):
ONE: The reported loss on the Individual Owner’s K-1 is less than the Individual Owner’s tax basis FOR THAT YEAR.
Refer to above explanation on how the Tax Basis fluctuates each year.
TWO: The basis is considered “at risk”: You’re at risk in any activity for the:
- Money and adjusted basis of property you contribute to the activity
- Any amounts borrowed IF:
- You’re personally liable for repayment, or
- You pledge property (other than property used in the activity) as security for the loan
THREE: The losses are not passive. In other words, the owner must be actively participating in business operations. (IRS Pub 925 (rev 2016) emphasis added).
All three conditions above must be met for the loss rules to be applied.
Bottom line is, both you and your CPA, or Tax Accountant, needs to know your basis because:
- Your tax basis will determine (to an extent, as explained above) how much of the business’ losses are deductible.
If you don’t know how much basis you have in the business, you won’t know how much you are able to deduct.
- Your basis will determine the amount of gain or loss on sale of the business, partner share, or stock.
- Your annual Schedule K-1 often looks incorrect or inconsistent due to the changes made annually.
If you have changed accountants over time, they may not have been calculating your basis correctly and applying the correct balances.
Your CPA or Tax Accountant should be involved throughout your ownership of every investment company to properly advice you on tax and accounting changes and how they will impact you on an individual level.
Corporations, Partnerships, Estates and Trusts 2017 Edition. Authors: Hoffman, William; Raabe, WIlliam; Maloney, David; Young, James. Publisher: South-Western Cengage Pages: 14-4 to 14-8.
IRS.gov (2016). Publication 925. Retrieved July 24, 2017 from: https://www.irs.gov/publications/p925/ar02.html#en_US_2016_publink1000104595
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