Your Corporate Investments: Are They Truly Safe?

All investments carry some degree of risk. The at-risk rule deals with the amount of your investment in a business that you stand to lose if the business fails. This rule is about what you, as an individual, are at risk of losing. 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 example, if you own an S corporation and invest $10,000 in stock and lend the company $5,000, your tax basis would be $15,000, which is the amount you have at risk. 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 that can result in financial losses.

Understanding 'at-risk' rules

Understanding at-risk rules:

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 are detailed in Section 465 of the Internal Revenue Code (IRC) and were enacted to ensure that losses claimed on returns are valid and that taxpayers do not manipulate their taxable income using tax shelters.

The amount that a taxpayer has at risk is measured annually at the end of the tax year. 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 regarding that investment. This basis may be increased annually if the investor makes additional contributions or receives income from the investment. It is decreased by the amount that deductions exceed income and distributions.

At-risk rules are intended to prevent investors from writing off more than the amount they invested in a business, generally a flow-through entity such as S corporations, partnerships, trusts, and estates. A taxpayer cannot deduct more than the amount of money they had at risk at the end of the tax year for any activity in which they were not a material participant. Any unused portion of losses can be carried forward until there is sufficient at-risk income to allow the deduction.

In the context of real estate investing, "at-risk" has a specific meaning related to tax regulations when it comes to deducting losses. When investing in real estate, the "at-risk" amount is generally the money personally invested in the property, including cash and any loans for which the investor is personally liable. Being "at-risk" means being personally responsible for covering any losses associated with the investment. If the investment generates a loss, this can typically be deducted from taxable income, but only up to the amount considered "at-risk."

There are exceptions to the at-risk rules. For example, if an investor has borrowed money for an investment but is not personally responsible for repaying the loan (non-recourse loan), that portion of the investment may not be considered "at-risk" for tax purposes. Additionally, if the amount invested is protected against loss by a guarantee, stop-loss agreement, or similar arrangement, it is not considered at risk.

Tax shelter laws

At-risk rules originated with the enactment of the Tax Reform Act of 1976. They are detailed in Section 465 of the Internal Revenue Code (IRC) and are intended to guarantee that losses claimed on returns are valid and that taxpayers do not attempt to manipulate their taxable income using tax shelters.

The amount that a taxpayer has at risk is measured annually at the end of the tax year. An investor's at-risk basis is calculated by combining the amount of the investor's investment in the activity with any amount that the investor has borrowed or is liable for with respect to that particular investment.

There are various types of tax shelters, including:

• Retirement accounts
• Workplace benefits
• Medical savings accounts
• Business ownership
• Tax-deductible charitable donations
• Municipal bonds
• Real estate investments
• Insurance products
• Partnerships

Investments with no or limited risk

Money Market Accounts:

Money market accounts are similar to savings accounts but offer more flexibility, allowing you to spend directly from the account. They are currently offering competitive interest rates of 5% or more and are FDIC-insured for up to $250,000 per depositor, making them a safe investment option.

High-Yield Savings Accounts:

Online high-yield savings accounts are similar to traditional savings accounts but offer higher interest rates as they operate solely online, cutting down on overhead expenses. They are FDIC-insured and currently offer interest rates of 5% or more, making them a safe and attractive investment option.

Cash Management Accounts:

Cash management accounts are offered by non-bank financial institutions and are often found at online brokerages and robo-advisors. They function similarly to online savings accounts and offer competitive interest rates of around 5% or more. These accounts are FDIC-insured through partnerships with banks, ensuring the safety of your investment.

Certificates of Deposit (CDs):

CDs are FDIC-insured investments where you deposit a lump sum of money for a fixed period, typically ranging from six months to five years. They offer fixed interest rates, guaranteeing returns, and are ideal if you don't need immediate access to your funds. Early withdrawal may result in penalties, so it's important to consider your investment horizon.

Treasury Securities:

Treasury securities are backed by the full faith and credit of the US government, making them extremely low-risk. They come in the form of bills, notes, and bonds, with varying maturity periods. Treasury Inflation-Protected Securities (TIPS) are a type of treasury security that adjusts with inflation, providing a hedge against inflation.

Bond Mutual Funds and Exchange-Traded Funds (ETFs):

These investment options pool different bonds together, offering diversification and reducing credit risk. They provide liquidity, and you can sell them at any time before maturity. However, they may have management fees and additional charges, and their value can fluctuate based on market conditions.

Deferred Fixed Annuity:

Issued by insurance companies, deferred fixed annuities provide a guaranteed rate of return over a set period, typically ranging from three to ten years. Your investment grows tax-deferred, and there are no IRS contribution limits. Annuity guarantees are subject to the claims-paying ability of the issuing insurance company. Early withdrawal may result in penalties, so it's important to consider your investment timeline.

At-risk basis

The "at-risk basis" is a term used in tax rules to describe 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 is concerned with what you stand to lose personally, rather than the business itself.

The "at-risk basis" is calculated by combining the amount of the investor's initial investment with any additional amounts they have borrowed or are liable for with respect to that particular investment. This includes any loans the investor has made to the business. For example, if you own an S corporation and invest $10,000 in the stock and also lend the S corporation $5,000, your at-risk basis would be $15,000.

The purpose of the at-risk rule is to prevent investors from claiming losses on their tax returns that exceed the amount they actually stand to lose. Investors are only allowed to deduct losses up to the amount they are personally at risk of losing, which is their at-risk basis. If an investment has no risk or limited risk, the investor may be disallowed from claiming any losses on their tax return.

In the context of real estate investing, the "at-risk" rule also applies to determining the amount of loss a taxpayer can claim for tax purposes. The "at-risk" amount generally includes the money personally invested in the property, including cash and any loans for which the investor is personally liable.

It's important to note that there are exceptions to the "at-risk" rule. For example, if an investor has borrowed money for an investment but is not personally responsible for repaying the loan (non-recourse loan), that portion of the investment may not be considered "at-risk" for tax purposes.

Managing investment risk

All investments carry some degree of risk. Stocks, bonds, mutual funds, and exchange-traded funds can lose value—even their entire value—if market conditions turn unfavourable. Even conservative, insured investments, such as certificates of deposit (CDs) issued by a bank or credit union, come with inflation risk. That is, they may not earn enough over time to keep pace with the increasing cost of living.

The level of risk associated with a particular investment or asset class typically correlates with the level of return the investment might achieve. Investors willing to take on risky investments and potentially lose money should be rewarded for their risk.

• Asset Allocation: This refers to the way you weigh the investments in your portfolio to meet your financial goals. It involves investing in different asset classes, such as stocks, bonds, alternative investments, and cash, while considering your risk tolerance, tax situation, and time horizon.
• Portfolio Diversification: Diversification is the process of selecting a variety of investments within each asset class. By investing in multiple companies across different industries, you can reduce the potential for a substantial loss. If the return on one investment falls, another may be rising, offsetting the poor performer.
• Dollar-Cost Averaging: This strategy involves investing a fixed amount of money into the same investment vehicle(s) on a regular basis, regardless of market performance. With dollar-cost averaging, you buy fewer shares when the market is high and more when it is low, helping to build wealth over time.

Additionally, "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 due to financial losses. These rules are intended to prevent investors from claiming losses in excess of what they actually stand to lose and from manipulating their taxable income using tax shelters.

Frequently asked questions