Module 15 Business Losses and Limitations

Business Losses & Related Restrictions Key Learning Objectives n n How losses fit into the statutory framework that authorizes deductions n n How the laws limit taxpayers' abilities to deduct losses realized in certain types of transactions.

Definition of Loss n n Excess of current period deductions over current period gross income n n A realized decline in the value of a taxpayer's assets used for u Trade or business u Production of income u Personal use if casualty or theft

Net Operating Loss Deduction (NOL) Key Learning Objectives n n Compute an NOL n n Decide when and how to take the NOL

NOL Calculation n Limited to losses from a trade or business u Includes employee business expenses n Add back to negative taxable income: u NOLs from other years u Personal and dependency exemptions u Capital losses u Excess of nonbusiness deduction over nonbusiness income n AMT NOL is a different calculation

NOL Elections Made on Timely Filed Return For tax years beginning after n First choice u 2 years back, then 20 forward n Other choice u Forward only for 20 years n Default is 2 back/20 forward n Irrevocable election

NOL Elections Made on Timely Filed Return For tax years beginning before n First choice u 3 years back, then 15 forward n Other choice u Forward only for 15 years n Default is 3 back/15 forward n Irrevocable election

Compliance Query n T reported the following this year: u Loss from sole proprietorship: u Loss from sole proprietorship: u Wages from part-time job: $2,300 u Interest income from savings: $400 u Mortgage interest and real estate taxes: $8,000 u Personal exemption: $2,700 u Taxable income: u Taxable income: n What is T’s NOL?

Solution--Compliance Query n Start with taxable income of n Start with taxable income of n Add back $2,700 personal exemption n Add back excess of nonbusiness deductions over nonbusiness income ($8,000 - $400 = $7,600) n NOL = n NOL =

Research Query n T claimed the following losses on her current year tax return: u $22,000 loss on sale of Section 1244 stock u $13,000 deductible personal casualty loss n Are either of these losses allowable in determining T’s NOL?

Solution--Research Query n The loss on the sale of the Section 1244 stock is allowable. u Code Sec. 1244(d)(3); Reg § (d)-4(a). n Personal casualty losses are “business” deductions for net operating loss purposes. u Code Sec. 172(d)(4)(C).

The Bad Debt Deduction Key Learning Objectives n n Identify eligible bad debts n n Amount of the deduction n n Timing of the deduction n n Classification of the deduction

Eligible Bad Debt Good Loan in Past n n Bona fide debt n n Promise to pay fixed & determinable n n Sum enforceable under state law n Related party loans--suspected gifts u Written note? u Adequate security? u Interest reasonable & reported annually

Amount of the Deduction A Question of Basis n Cash basis u Unrecoverable out-of-pocket costs n Accrual basis u Accounts Receivable u Other amount previously included in income

Timing of the Deduction A Question of Values n Based on facts/circumstances n Legal action not required if cost prohibitive n Documentation is crucial No money in your future

Classification of the Deduction Business Bad Debt n n Ordinary loss for full/partial worthlessness n n Arises in connection with T/B n n Must be closely related to business activity u Uncollected A/R u To secure source of material u Loans/advances to employees u Loans by Employee to protect employment u T/B of making loans

Classification of the Deduction Non-Business Bad Debt n Short term capital loss n Deduction only when totally worthlessness n Personal loans n Investment loans u Not in T/B of loaning money n Shareholder loan to keep business going

Research Query: n T’s former spouse was $5,000 in arrears in child support payments. Because of this, T had to spend $5,000 of her own funds to support her children. n Can T claim a nonbusiness bad debt of $5,000?

Solution--Research Query n A spouse's failure to make required alimony or child support payments does not give rise to a bad debt deduction. u Rev Rul 93-27; Swenson, Dale, (1965) 43 TC 897.

Casualty and Theft Loss Deductions Key Learning Objectives n n Which losses qualify n n Amount of the deduction n n Timing of the deduction

Which Losses Qualify? Personal Use Property Losses from personal use property not deductible w/o §165(c) Losses from personal use property not deductible w/o §165(c) Sudden, unusual, unexpected event Sudden, unusual, unexpected event Not normal wear and tear Not normal wear and tear Not everyday accidents Not everyday accidents Not erosion/termites Not erosion/termites OK if at fault if not willful OK if at fault if not willful

Amount of the Deduction Personal Use Property Decline in FMV, limited to adjusted basis Decline in FMV, limited to adjusted basis Decline in FMV measured by Decline in FMV measured by u Appraisal value before & after u Repairs to return to original condition u Not amounts that increase FMV

Amount of the Deduction Personal Use Property Each personal loss is reduced by $100 floor Each personal loss is reduced by $100 floor u Each occurrence = one $100 floor Total for year is reduced by 10% AGI Total for year is reduced by 10% AGI Net personal casualty loss Net personal casualty loss u From AGI u Not 2% or 3% limited

Amount of the Deduction Business Use Property Decline in FMV, limited to adjusted basis Decline in FMV, limited to adjusted basis If completely destroyed,get adjusted basis If completely destroyed,get adjusted basis Not subject to 100 floor Not subject to 100 floor Not subject to 10% AGI offset Not subject to 10% AGI offset

Compliance Query n T’s auto (basis = $12,000) completely destroyed n Blue book value right before the accident $6,000 n No other casualty events during year n What is T’s loss deduction if auto is personal? business?

Solution--Compliance Query PERSONAL USE  Loss base is $6,000  Reduce by insurance proceeds  Reduce by $100  Reduce by 10% of AGI  Deduct from AGI BUSINESS USE  Loss base is $12,000  Reduce by insurance proceeds  N/A  Deduct for AGI

Business & Personal Property Must apply for insurance reimbursement Must apply for insurance reimbursement Insurance may cause realized gain Insurance may cause realized gain u Treated as an involuntary conversion

Timing of the Deduction n Casualty deductible in year of loss u If National Disaster Area can use preceding year n Theft deductible in year discovered

Special Restrictions on Business Loss Deductions Key Learning Objective n n Identify transactions and deductions subject to special limitations n n Amount of the deduction n n Timing of the deduction.

Hobby Loss--Work or Fun? n Is activity inherently personal or profit motivated n Facts and circumstances control

If Hobby, Deductions May Be Limited n n Deductions from AGI n n "Otherwise allowable" deductions allowed in full n n Other deductions limited to remaining gross income from activity u Income reduced by "otherwise allowables" first

If Hobby, Deductions May Be Limited n n All deductions except "otherwise allowable" treated as miscellaneous 2% deductions n n Excess deductions do not carryover

§267(a) Disallows Losses on Related Party Sales n Includes immediate family n Ancestors n Lineal descendants n Brothers & sisters n > 50% Owned corporations/partnerships n Special attribution rules also apply

§267(a) Disallows Losses on Related Party Sales n n Disallowed loss can be used by related party if subsequent gain on sale of same property n n If property not sold for gain, disallowed loss is never utilized n n §267(a) applies even if sale is at FMV

Passive Activity Losses (PAL) n Current law makes several income classifications n Active--T/B w/material participation n Portfolio--§212 except rentals n Passive activities

Passive Activity Defined n All rental activities unless material services provided n All T/B in which taxpayer does not materially participate Material participation only if regular, continuous, substantial Material participation only if regular, continuous, substantial

PAL Netting Procedures n Record income/loss for each passive activity n Net all passive activities n If overall net passive income--report in full n If overall loss--report zero

PAL--Suspended Losses n n $25,000 rental real estate loss exception may apply n n Use an activity's carryover in full if disposition Suspended losses carry over to future years by activity