Risk And Reward: Schedule C Investments

Schedule C is used to report income or loss from a business operated as a sole proprietor. If you have a loss on Schedule C, you must indicate whether all investment is at risk or some investment is not at risk. This means that you must identify whether you are using your own money for the business. At-risk means that you are using your own money, or borrowed funds for which you are personally liable, for the business. A loss may only be deducted up to the amount you personally have at risk. If you have money not at risk, you cannot take a loss on Schedule C. If you have a business loss and amounts invested in the business for which you are not at risk, you must complete Form 6198 to apply a limitation that may reduce your loss. The at-risk rules generally limit the amount of loss you can claim to the amount you could actually lose in the business.

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. A closely held corporation is defined by the IRS as a corporation that has more than 50% of its outstanding stock owned by five (or fewer) individuals at any time during the last half of the tax year.

The at-risk rules limit your losses from most activities to your amount at risk in the activity. You treat any loss that’s disallowed because of the at-risk limits as a deduction from the same activity in the next tax year. If your losses from an at-risk activity are allowed, they’re subject to recapture in later years if your amount at risk is reduced below zero.

You must apply the at-risk rules before the passive activity rules. A loss is the excess of allowable deductions from the activity for the year (including depreciation or amortization allowed or allowable and disregarding the at-risk limits) over income received or accrued from the activity during the year. Income doesn’t include income from the recapture of previous losses.

You’re at risk in any activity for:

• The money and adjusted basis of property you contribute to the activity, and
• Amounts you borrow for use in the activity if:
• You’re personally liable for repayment, or
• You pledge property (other than property used in the activity) as security for the loan.

You’re at risk for amounts borrowed to use in the activity if you’re personally liable for repayment. You’re also at risk if the amounts borrowed are secured by property other than property used in the activity. In this case, the amount considered at risk is the net fair market value of your interest in the pledged property. The net fair market value of property is its fair market value (determined on the date the property is pledged) less any prior (or superior) claims to which it is subject. However, no property will be considered as security if it is directly or indirectly financed by debt that is secured by property you contributed to the activity.

If you borrow money to finance a contribution to an activity, you can’t increase your amount at risk by the contribution and the amount borrowed to finance the contribution. You may increase your at-risk amount only once.

The at-risk rules apply to individuals (including partners and S corporation shareholders), estates, trusts, and certain closely held C corporations.

At-risk basis

The at-risk basis is a concept that deals with the amount of your investment in a business that you are personally liable to lose if the business fails. It is important to understand that the at-risk rule is not concerned with whether the business itself is at risk but rather with the amount you, as an individual, stand to lose.

The purpose of the at-risk rule is to prevent you from claiming a loss that exceeds what you actually stand to lose. 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 is also referred to as your at-risk basis or tax basis.

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, which 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 to the company is called your debt or loan basis.

If you invest in an S corporation or partnership, the amount of 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. In other words, a loss may only be deducted up to the amount you personally have at risk. If a loss exceeds your at-risk investment, the excess amount is referred to as a suspended loss, which may be deducted in future years indefinitely, until you have sufficient at-risk basis to absorb the loss.

It is worth noting that there are certain situations where you might not be considered at risk even if you have invested money. For example, if you have borrowed money for an investment but are not personally responsible for repaying it (non-recourse loan), that portion of the investment may not be considered "at-risk" for tax purposes.

Tax basis

The basis of an asset is a very important concept for tax purposes because it is used to calculate deductions for depreciation and casualties, as well as gains or losses on the disposition of that asset. It is important to note that the basis is not always equal to the original purchase cost. It is determined in different ways for purchases, gifts, and inheritances.

There are two types of basis:

• Cost Basis: This is the amount originally paid for an item before any improvements, as well as before any credits, business depreciation, expensing, or adjustments as a result of a casualty loss.
• Adjusted Basis: This starts with the original cost basis (or gift or inherited basis) and then incorporates adjustments such as increases for any improvements and reductions for tax credits claimed, business depreciation or expensing deductions, and any claimed personal or business casualty-loss deductions.

Some activities will change the basis of property for a variety of reasons, such as increased costs or property depreciation. This change in tax basis more accurately reflects what the owner should be taxed on after a sale.

Examples of expenses that increase basis include rehabilitation expenses, the cost of extending utility service lines to a property, and legal fees for defending and perfecting title. Examples of expenses that decrease basis include deductions for clean-fuel vehicles and refueling property, deductions for amortization, depreciation, and depletion, postponed gain from the sale of a home, casualty and theft losses, and insurance reimbursements.

Non-recourse loans

In the context of Schedule C, "all investment at risk" refers to the money and adjusted basis of property contributed to an activity, as well as any amounts borrowed for that activity if the borrower is personally liable for repayment. If a non-recourse loan is used to fund a business, it means that the borrower is not personally liable for repayment. In this case, the investment would not be considered "at risk" because the lender cannot pursue the borrower's personal assets if the business fails to pay back the loan.

However, it is important to note that non-recourse loans may have stricter terms, higher interest rates, and other conditions compared to recourse loans. While they offer more protection for the borrower, non-recourse loans are generally reserved for individuals and businesses with stellar credit histories.

Amounts invested in the business

Amounts invested in a business refer to the money and adjusted basis of property contributed to the activity, as well as any amounts borrowed for use in the activity. If you are personally liable for repayment or have pledged property as security for the loan, you are considered "at-risk" for these amounts.

If you are not at-risk for all your investments, you will need to fill out Form 6198 to determine if your deduction is limited. If you are at-risk for all your investments, you can take the full write-off.

• If you are at-risk for all your investments, check box 32a on Schedule C.
• If you are not at-risk for all your investments, check box 32b on Schedule C and attach Form 6198 to your return.
• The at-risk rules generally limit the amount of loss (including loss on the disposition of assets) you can claim to the amount you could actually lose in the business.
• If you are at-risk for all your investments, your loss will not be reduced by the at-risk rules or the passive activity loss rules.
• If you are not at-risk for all your investments and answered "No" on line G, you may need to complete Form 8582 to figure your loss.

Frequently asked questions