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READING YOUR K-1: IS YOUR BASIS 'AT-RISK'?

March 29, 2008

If you have losses on your K-1 from an S corporation or partnership, there are three hurdles to clear before you can deduct them. Yesterday we discussed how to use K-1 information in when seeing if you clear the first hurdle: having enough tax basis to deduct the loss. Today we'll look at the second hurdle: is your basis "at-risk"?

The at-risk rules apply to almost all business activities. Originally enacted to deal with the first wave of marketed tax shelters in the 1970s, these rules were largely superseded by the "passive loss" rules of 1986, but they were never repealed. In fact, your losses don't even get to the "passive loss" rules unless they are "at-risk." Losses that aren't at-risk are disallowed until they can offset future income from the activity, or until the taxpayer gets other "at-risk" basis.

What "at-risk" means

The at-risk rules arise from Code Section 465. In very simplified terms, they only let you deduct losses attributable to borrowed funds if you are on the hook for them. For example, should you borrow money to buy some cattle, and the bank can come after you personally for the funds if the loan isn't paid, you are likely "at-risk." If the bank's only recourse if you skip out on the loans is to repossess the animals, you aren't at-risk. The rules are quite complex; the tax law can treat loans from a related party, a promoter or your business partner as not at-risk, even if they can take everything you own if you default. Loans for which you are at-risk are typically called "recourse" loans; if you aren't at risk, the debt is "non-recourse."

So what does this have to do with your K-1? If your K-1 comes from an S corporation, not a lot. If you borrow money on a non-recourse basis to buy S corporation stock, you may have an at-risk rule problem, but nothing on your K-1 will tell you that.

Partnerships are different. For historical reasons most people don't care about, a partner's basis includes his share of borrowings by the partnership. In contrast, corporate shareholders get no basis for borrowings incurred by the corporation with third parties, not even when shareholders guarantee the debt.

Your partnership K-1 has a section to show you your share of partnership debt, and whether it is at-risk: Part II, Line K.

You can see that there is space for the "recourse" and "nonrecourse" liabilities of the partnership that we've mentioned. You'll also see a space for "qualified non-recourse filing." This is a tribute to the real-estate lobby of the 1970s, who won special treatment for non-recourse debt incurred in real estate activities. Nonrecourse debt that meets certain conditions - mostly debt from commercial lenders or government agencies - is "qualified nonrecourse financing" and is deemed to be "at-risk" under the tax law, even if it isn't in real life.

So when you are looking to see whether you have enough basis to deduct your partnership losses, you start with your "outside" basis, which we discussed yesterday -- your investment, adjusted for income, losses, and distributions. You add your share of your line K liabilities in determining your total basis, but only the "recourse" and "qualified nonrecourse financing" lines to see whether you have enough "at-risk" basis to deduct your losses.

Tomorrow we continue our thrilling series on reading K-1s by by tying this together with an example.

This is another installment in our daily series of 2008 filing season tips running through April 15. Don't miss any!

Tags: at-risk rules.basis.Partnerships.reading K-1s.s corporations.

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