05 Sep AT RISK LIMITATIONS (IRC § 465) PART 1
I am knee deep in another interesting file under dispute with our esteemed taxing authorities involving At Risk Limitations. This is intended as the first of many posts on the topic as I navigate the shoals of a relatively complicated file that involves equipment leasing by a closely held C Corporation.
Complimentary references for this post originate from:
- IRS Form 6198 At-Risk Limitations
- IRS Form 6198 At-Risk Limitations – Instruction Set
- 26 U.S. Code § 465 – Deductions limited to amount at risk
- IRS Publication 925 – Passive Activity and At-Risk Rules
- IRS Audit Technique Guide – Passive Activity Loss
What are the At-Risk Rules?
The at-risk rules limit your losses from most activities to your amount at risk in the activity, seems straight forward. Any loss that is disallowed because of the at-risk limits is carried forward as a deduction from the same activity in the next tax year. Still relatively straight forward.
Here is where matters start to get complicated. If your losses from an at-risk activity is allowed in a current tax year, these losses may be subject to recapture in later years if your amount at risk in the activity is reduced below zero.
What Activities Are Covered by the At Risk Rules?
If you’re involved in one of the following activities as a trade or business or for the production of income, you’re subject to the at-risk rules.
- Holding, producing, or distributing motion picture films or video tapes.
- Leasing section Section 1245 property, including personal property and certain other tangible property that’s depreciable or amortizable.
- Exploring for, or exploiting, oil and gas.
- Exploring for, or exploiting, geothermal deposits (for wells started after September 1978).
- Any other activity not included in (1) through (5) that’s carried on as a trade or business or for the production of income. So pretty much everything with a profit motive it seems.
Section 1245 property includes any property that is or has been subject to depreciation or amortization and is:
- Personal property,
- Other tangible property (other than a building or its structural components) that is:Used in manufacturing, production, extraction or furnishing transportation, communications, electrical energy, gas, water, or sewage disposal services,
- A research facility used for the activities in (a), or
- A facility used in any of the activities in (a) for the bulk storage of fungible commodities,
- Real property (other than property described in (2)) with an adjusted basis that was reduced by certain amortization deductions listed in section 1245(a)(3)(C) of the Internal Revenue Code,
- A single purpose agricultural or horticultural structure, or
- A storage facility (other than a building or its structural components) used for the distribution of petroleum.
The at-risk rules don’t apply to the holding of real property placed in service before 1987. They also don’t apply to the holding of an interest acquired before 1987 in a pass-through entity engaged in holding real property placed in service before 1987. This exception however doesn’t apply to holding mineral property.
Personal property and services that are incidental to making real property available as living accommodations are included in the activity of holding real property.
For example, making personal property, such as furniture, and services available when renting a hotel or motel room or a furnished apartment is considered incidental to making real property available as living accommodations.
What is a loss?
- A loss is the excess of allowable deductions from the activity for the year over income received or accrued from the activity during the year.
- Income does NOT include income from the recapture of previous losses. I will be discussing the Recapture Rules in a future post.
- Allowable deductions include depreciation or amortization allowed or allowable
- Allowable deductions do not include at-risk limits from other tax periods carried into the current tax period.
How is the loss reported?
IRS Form 6198 is used to calculate how much loss from an activity can deducted in the current tax year.
You must file Form 6198 with your tax return if:
- You have a loss from any part of an activity that’s covered by the at-risk rules, and
- You aren’t at risk for some of your investment in the activity.
You must also file Form 6198 if you’re engaged in an activity included under Activities Covered by the At-Risk Rules, and you have borrowed amounts described in Certain borrowed amounts excluded under At-Risk Amounts.
What are the loss limits for partners and S corporation shareholders?
Four separate limits may apply to a partner’s or shareholder’s distributive share of an item of deduction or loss from a partnership or S corporation. The limits determine the amount each partner or shareholder can deduct on his or her own individual income tax return. These limits and the order in which they apply are:
- The adjusted basis of:The partner’s partnership interest, or
- The shareholder’s stock plus any loans the shareholder DIRECTLY makes to the corporation,
- The excess farm loss rules,
- The at-risk rules, and
- The passive activity rules.
The at-risk limits apply to individuals (including partners and S corporation shareholders), estates, trusts, and certain closely held C corporations.
The case file I am currently wrestling with involves the loss limits for a closely held C Corporation.
For the at-risk rules, a C corporation is a closely held corporation if at any time during the last half of the tax year, more than 50% in value of its outstanding stock is owned directly or indirectly by or for five or fewer individuals.
To figure if more than 50% in value of the stock is owned by five or fewer individuals, apply the following rules.
- Stock owned directly or indirectly by or for a corporation, partnership, estate, or trust is considered owned proportionately by its shareholders, partners, or beneficiaries.
- An individual is considered to own the stock owned directly or indirectly by or for his or her family. Family includes only brothers and sisters (including half-brothers and half-sisters), a spouse, ancestors, and lineal descendants.
- If a person holds an option to buy stock, he or she is considered to be the owner of that stock.
- When applying rule (1) or (2), stock considered owned by a person under rule (1) or (3) is treated as actually owned by that person. Stock considered owned by an individual under rule (2) isn’t treated as owned by the individual for again applying rule (2) to consider another the owner of that stock.
- Stock that may be considered owned by an individual under either rule (2) or (3) is considered owned by the individual under rule (3).
What exceptions apply (or do not apply) for equipment leasing by a closely held corporation?
- If a closely held C corporation is actively engaged in equipment leasing, the equipment leasing is treated as a separate activity not covered by the at-risk rules.
- A closely held corporation is actively engaged in equipment leasing if 50% or more of its gross receipts for the tax year are from equipment leasing.
- Equipment leasing means the leasing, purchasing, servicing, and selling of equipment that is defined as section 1245 property.
- However, equipment leasing doesn’t include the leasing of master sound recordings and similar contractual arrangements for tangible or intangible assets associated with literary, artistic, or musical properties, such as books, lithographs of artwork, or musical tapes.
- A closely held corporation cannot exclude these leasing activities from the at-risk rules nor count them as equipment leasing for the gross receipts test.
- The equipment leasing exclusion also isn’t available for leasing activities related to other at-risk activities, such as motion picture films and video tapes, farming, oil and gas properties, and geothermal deposits.
For example, if a closely held corporation leases a video tape, it can’t exclude this leasing activity from the at-risk rules under the equipment leasing exclusion. It appears I am going to loose this case file and the practitioner preparing, signing and filing the tax return is going to get thrown under the bus.