Protecting Your S Corp Investments: Strategies For Mitigating Risk

S corporations are attractive to investors due to their ability to avoid double taxation on distributions and allow corporate losses to pass through to their owners. However, shareholders of S corporations must navigate a complex set of loss limitations, including stock and debt basis limitations, passive activity loss limitations, and at-risk loss limitations. At-risk rules, as outlined in Section 465 of the Internal Revenue Code, are tax shelter laws designed to limit the amount of allowable deductions that an individual or closely held corporation can claim for tax purposes when engaging in activities that may result in financial losses. This rule is intended to prevent investors from claiming losses in excess of what they stand to lose and ensures that the amount they can deduct is limited to their at-risk basis, which is calculated by combining their investment in the activity with any borrowed or liable amounts. For S corporation shareholders, understanding and effectively managing their at-risk basis is crucial to optimizing their tax position and ensuring compliance with tax regulations.

Understanding the at-risk rules

The at-risk rules are tax shelter laws that limit the amount of allowable deductions that an individual or closely held corporation can claim for tax purposes as a result of engaging in specific activities referred to as "at-risk activities" that can result in financial losses. These rules were introduced with the enactment of the Tax Reform Act of 1976 to ensure that claimed losses on returns are valid and that taxpayers do not manipulate their taxable income using tax shelters.

The at-risk rules apply to all trade or business activities and activities for the production of income. They apply to individuals, partners, S-corporation shareholders, estates, trusts, and certain closely held corporations. The rules generally do not apply to widely held C-corporations.

A taxpayer's at-risk amount is calculated by combining their investment in the activity with any borrowed amounts or liabilities with respect to that investment. This amount is typically adjusted annually at the end of the tax year.

For S-corporations, the amount of loss that a shareholder can deduct is limited to their amount at risk in the corporation. This amount is calculated separately from the shareholder's basis in the corporation and can be increased by contributions to the corporation's capital, unencumbered funds lent by the shareholder, or loans secured by real property used in the activity. It is important to note that loans made by a shareholder to an S-corporation may not increase their at-risk amount if the shareholder is not personally liable for repayment.

The at-risk rules also apply when an S-corporation shareholder borrows money from a bank or a related party and lends it to the corporation. In this case, the shareholder's liability and the source of the funds loaned will determine their at-risk amount. Additionally, a shareholder is not considered at risk for amounts borrowed from any person who has an interest in the activity or from a person related to someone with such an interest.

To increase their at-risk amount, a shareholder can invest additional funds in the S-corporation or lend the corporation funds for which they are personally liable to repay. This ensures that they do not claim a loss in excess of what they stand to lose.

Calculating your at-risk basis

The at-risk rule is a tax shelter law that limits the amount of allowable deductions that an individual or closely held corporation can claim for tax purposes as a result of engaging in specific activities that can result in financial losses. It is important to note that the at-risk rule deals with the amount of your investment in a business that you are personally at risk of losing if the business fails. In other words, this rule focuses on what you, personally, stand to lose rather than the business itself.

Your initial tax basis in an S corporation is equal to your investment in the business plus any loans you make to the business. For instance, if you own an S corporation and invest $10,000 in the stock and also lend the S corporation $5,000, your tax basis would be $15,000 and this is the amount you have at risk. The amount you invest in the capital stock is called your stock basis, and the amount you lend the company is called your debt or loan basis.

If you invest in an S corporation or partnership, the amount of a loss incurred by these entities that you may deduct on your individual income tax return is limited to the amount of your investment or at-risk basis. It is important to note that you can only deduct amounts up to the at-risk limitations in any given tax year, and any unused portion of losses can be carried forward until you have enough positive at-risk income to allow the deduction.

An investor's at-risk basis is calculated by combining the amount of their investment in the activity with any amount they have borrowed or are liable for concerning that particular investment. An investor's at-risk basis may be increased annually by additional contributions to the investment or by the amount of income they receive from the investment (in excess of deductions). Conversely, an investor's at-risk basis is decreased annually by the amount by which deductions exceed income and distributions.

In the context of real estate investing, "at-risk" has a specific meaning related to tax regulations, particularly when it comes to deducting losses. When you invest in real estate, your "at-risk" amount typically refers to the cash you've personally invested in the property, including any loans for which you are personally liable. When you withdraw cash from the project, you are reducing your “at-risk” basis. Being "at-risk" means that you are personally responsible for covering any losses associated with the investment. If the investment generates a loss, you can usually deduct that loss from your taxable income, but only up to the amount you are considered "at-risk."

It is important to understand the different types of debt that qualify as "at-risk". Recourse debt is considered "at-risk" when the investor is personally liable for the repayment of that debt. If the investor has loaned money to the company for a real estate investment or has personally guaranteed the bank debt, the total amount loaned or guaranteed is considered part of the investor's at-risk basis.

On the other hand, non-recourse debt refers to a situation where the investor is not personally responsible for repaying the loan, and this portion of the investment is generally not considered "at-risk" for tax purposes. An exception to this is qualified non-recourse debt, which specifically pertains to non-recourse debt secured by real property used in the activity (excluding mineral property). Even though this is non-recourse debt, it is considered “at-risk”. The debt must be borrowed from a “qualified person” or a government entity, and no person is considered personally liable. A “qualified person” is someone actively and regularly engaged in the business of lending money, with no relation to the taxpayer, and who does not receive a fee regarding the taxpayer’s investment in the property.

How to increase your at-risk basis

Tracking at-risk investments in an S-corporation is important for shareholders to understand their tax liability. The at-risk rule deals with the amount of your investment in a business that you are personally at risk of losing if the business fails.

• Invest More Capital: If you have a suspended loss from previous years, you can increase your at-risk basis by investing more capital in the S-corporation. This will allow you to deduct a larger portion of the losses in the current year.
• Make Loans to the S-Corporation: You can lend money to the S-corporation and be personally liable for repayment. This will increase your loan basis, which is part of your overall at-risk basis.
• Increase Income and Reduce Deductions: At-risk basis is increased by any amount of income in excess of deductions. Focus on generating more revenue and reducing expenses to increase your at-risk basis.
• Make Additional Contributions: Any additional contributions you make to the S-corporation will increase your at-risk basis. This could include contributing cash or property to the business.
• Qualified Nonrecourse Financing: In the context of holding real property, borrowing funds from a qualified person without being personally liable for repayment can increase your at-risk basis.
• Recapture of Prior-Year Losses: If you had previously recognized losses and the circumstances change, you may be able to recapture those losses and increase your at-risk basis. This could happen if there is a change in the character of partnership debt or a reduction in the amount of debt.

Tracking cash payments

To avoid attracting unwanted attention, it is advisable to limit cash payments and invest in tools like a Square Card Reader. If transitioning away from cash payments is not possible, ensure robust tracking methods are in place to help demonstrate the legitimacy of those payments to the IRS in the event of an audit. Additionally, if you receive cash payments over $10,000, you must file IRS Form 8300.

It is also important to understand the difference between shareholder salaries and shareholder distributions. Shareholder salaries are paid to S-Corp owners who are involved in the company's day-to-day operations and are reported on a W-2 form. In contrast, shareholder distributions are payments of business earnings to shareholders who are not involved in the company's operations and are reported on Form 1120S. Distributions are not taxed until they exceed the shareholder's stock basis, which is the amount of money initially invested in the business.

Understanding the Discriminant Function (DIF) Score

The Discriminant Function (DIF) Score is an algorithm used by the IRS to determine whether a tax return should be audited. The specifics of the algorithm are kept secret by the IRS, but it is known that the DIF score is calculated based on a comparison of the taxpayer's return with others in their income bracket, with a focus on deviations in deductions. The algorithm also considers factors such as income, family size, residence, and how money is earned. A higher DIF score indicates a higher probability of an audit, which is why certain red flags can increase the score. For example, claiming large charitable deductions while having a low total income and living in an exclusive residential area may result in a higher DIF score.

While it is challenging to counter an algorithm that is not fully transparent, understanding the DIF score can help S Corporations operate in a way that minimizes audit risks. This includes being aware of other common audit triggers, such as low or non-existent shareholder salaries, excessive expenses and deductions, and issues with tracking cash payments.

To track at-risk investments in an S Corporation, it is important to understand the at-risk rules, which deal with the amount of your investment that you are personally at risk of losing if the business fails. The at-risk rule prevents you from claiming losses that exceed your actual risk. Your initial tax basis in an S Corporation is equal to your investment in the business plus any loans you make to the business. This includes your stock basis (investment in the capital stock) and your debt or loan basis (amount lent to the company). If you incur a loss, you can only deduct up to the amount of your at-risk basis. Any excess loss can be carried forward indefinitely or until there is sufficient basis to absorb it.

To increase your tax basis and potentially deduct more losses, you can invest more in the stock of the S Corporation or lend the company additional funds for which you are personally liable to repay. It is important to review your stock basis and loan basis before the end of the year to ensure you have enough basis to cover anticipated losses.

Frequently asked questions