Please reply to the below discussion in 2 paragraphs. In the first, clearly state with which parts of the other student’s thread you agree or disagree. You must provide an explanation for why you agree or disagree with the other student’s thread. In the second, add some additional comments of your own that add to the discussion. the reply must be at least 250 words.
Question 3: Shareholders are required to have a basis before losses are deducted. Describe why this would be important, and how losses are handled.
Before discussing the importance of basis on business losses, we must define basis and understand how it is calculated. The most basic definition of basis is, “a measure of your investment in your business” (Fox, 2013, p. 236). This concept applies to partners in entities with more than one owner and to shareholders in S-corps. In addition, there are two types of basis: inside basis (aka. capital accounts) and outside basis. Both are calculated by adding contributions, subtracting distributions, and adding (subtracting) the distributive share of profits (losses). However, the outside basis is also affected by liabilities distributed to the individual partner/shareholder. These liabilities can cause an increase or a decrease in the outside basis balance (Partner Capital Account vs. Outside Basis, n.d.). It is the outside basis that must be used to determine limitations on losses.
Another important comparison of the capital account versus the outside basis is that the capital account can be a negative amount, such as when distributions and/or losses are greater than contributions and/or gains. In contrast, according to Spilker (2021), “the owner of an entity taxed as a partnership or an S corporation shareholder may deduct losses from the entity only to the extent of the owner’s basis in her ownership interest in the flow-through entity” (p. 15-17).
In addition, the IRS (2021) makes provision for the treatment of excess losses:
Loss and deduction items not allowable in the current year are suspended due to basis limitations and are carried over to the subsequent year. Suspended losses and deductions due to basis limitations retain their character in subsequent years. Any suspended loss or deduction items in excess of stock and/or debt basis are carried forward indefinitely. (para. 36)
In other words, the outside basis used for tax purposes cannot be a negative amount, but it can reduce the taxable basis balance to zero. Then, the amount of loss that exceeds the basis can be used to reduce the basis of future years for as long as it takes to recoup the losses. After this stock/debt basis limitation, there are three more limitations which may apply: at-risk limitations, passive activity loss limitations, and excess business loss limitations (S Corporation Stock and Debt Basis, 2021).
The differences between capital accounts and the basis used for tax purposes gives the necessary clues to discern the importance of having a basis before losses are deducted. Without basis (and the limitations mentioned), the losses would all have to be applied in the year they occurred. If the taxpayer had other taxable income, this could seem like a positive arrangement. However, if the taxpayer had no other taxable income, or income insufficient to cover the full amount of the loss, then the tax advantage that the loss provides would be forfeited. By having a basis that cannot drop below zero, the IRS is ensuring that the full tax benefit of a business loss will be realized.
A few other points that are also worth noting: it is the responsibility of the owner/partner to keep track of outside basis balances, not the responsibility of the entity. If a loss is being reported, the basis calculation will have to be included with the tax return. Therefore, most accountants complete an adjusted basis worksheet as part of their regular tax preparation services. Additionally, it is the capital account balance that is reported on the K-1, which should not be used as basis when calculating losses. Finally, the Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020, Section 2304(a), has temporarily suspended the threshold limits for excess business losses (Ray, 2020). This is applicable to losses incurred in 2018, 2019, and 2020 only. After December 31, 2020, the threshold limits will be reinstated until they are set to expire in 2026 (Ray, 2020).
References
Fox, R. (2013). Tax strategies for the small business owner reduce your taxes and fatten your profits. Apress. https://doi.org/10.1007/978-1-4302-4843-9
Partner Capital Account vs. Outside Basis. (n.d.). TaxAct. https://columbiacollege-ca.libguides.com/apa/websites
Ray, R. (2020, November 1). Deducting losses in the CARES Act’s window. Journal of Accountancy. https://www.journalofaccountancy.com/issues/2020/nov/deducting-losses-cares-act-coronavirus-relief.html
S Corporation Stock and Debt Basis. (2021, January 13). IRS. https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-stock-and-debt-basis
Spilker, B. (2021). Taxation of individuals and business entities. McGraw-Hill Education