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YEAR-END PLANNING: COVER YOUR BASIS

December 21, 2005

When a business has a bad year and loses money, sometimes the tax return is the silver lining to a dark cloud. When the business is run through a pass-through entity, like an S corporation or partnership, losses can pass through to the owners returns, reducing the owners taxes.

In theory, anyway.

BASIS: WHAT IT IS, WHY IT MATTERS

The tax law only allows owners of pass-through entities to deduct pass-through losses to the extent of their basis in a pass-through entity. Basis starts with what you pay for the entity. It is increased by your share of earnings and capital contributions, and reduced by losses and distributions to owners. S corporation shareholders can get basis for losses by loaning money to their corporations, but NOT by guaranteeing S corporation debt. Partners get basis to the extent of their share of debt inside the partnership.

If you don't have basis in excess of your losses, you can only deduct the losses up to your basis; the excess losses carry forward to years in which you have income from the pass-through or make additional capital contributions.

BASIS MUST BE REAL AND "AT-RISK"

Taxpayers have learned to their sorrow that you have to be careful when you make year-end loans or capital contributions to enable you to use losses. This is especially a problem when taxpayers use loans to obtain basis. If the loans contributions lack "substance" or are funded by borrowings that are not "at-risk," the deductions will be denied.

THE OREN PROBLEM.

The Oren case illustrates this problem. An owner of multiple S corporations found that it needed to get basis in a loss corporation by year-end. One corporation then loaned money to the owner, who loaned it to the loss corporation, which then loaned it back to the corporation that made the first loan - the money all ending where it started.

While the taxpayer did all of the paperwork correctly, the courts ruled that there was no substance to the loans, because everyone ended up pretty much where they started. They also ruled the loan was not "at-risk" because it was borrowed from a related party.

YEAR-END BASIS DOS AND DON'TS

DON'TS:

- Don't borrow money from a related party (family member, another business you own, or a business owned by a family member, for example).

- Don't put money into the pass-through on December 31 and withdraw it on January 1. Leave the money in the business a decent lenght of time.

- Don't send the money right back where it came from.

DOS:

- If you must borrow to fund the capital contribution, borrow from an unrelated party, like your friendly community banker.

- If you must use funds from a related business, take them out as a distribution, rather than a loan.

- Leave the money in the loss business for a decent length of time.

- Work closely with your tax advisor to make sure you do things right.

OTHER RESTRICTIONS ON PASS-THROUGH LOSSES

There are other limits on pass-through losses besides basis. The "passive loss" rules, for example, disallow many losses even when there is plenty of basis. At-risk limits can apply even to unrelated-party loans in many instances. If you're talking real money at year-end, get your tax pro involved.

This is an installment in our series on 2005 year-end planning.

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