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Deducting Losses, Trapped Cash
By Jason Watson, CPA
Posted Sunday, October 29, 2023
With an S corporation or partnership you need sufficient shareholder / partnership basis in your business to deduct losses. For example, if you invested $10,000 into your business but the business lost $30,000, as an S Corp shareholder you can only deduct losses up to the amount of your shareholder basis (in this example, $10,000).
Think of Google. You invested $10,000 into Google stock and they go out of business, you only lose $10,000. Remember that with an S corporation you wear two hats- one as an employee, and one as an investor (shareholder).
Section 179 Depreciation Losses
How does a loss in a small S corporation happen? A lot of small businesses are cash based and don’t have a lot of equipment (dentists are a common exception). However, for the sake of argument we will assume you bought a piece of equipment for $100,000 and borrowed $100,000 to pay for it. The equipment also qualified for Section 179 depreciation deduction allowing you to deduct (or attempt to deduct) the full amount against business income. Great! The benevolent IRS king is alive and well.
Let’s assume that the business income prior to depreciation was $60,000 (and Section 179 depreciation was $100,000). The S corporation tax return would still show a $60,000 net business income amount, but your K-1 would show a $70,000 amount for Section 179 deduction. Why $70,000? You had $10,000 in basis (using the example above) plus the $60,000 net business income. 10k + 60k = 70k, even in Canada. Sorry Canada… just too easy to pick on.
You would be able to deduct $70,000 as a loss. The $30,000 remainder of the Section 179 deduction that was not taken or used would be carried forward to future years. Yuck! Sorry, the once-benevolent IRS king is now asking you to be patient and wait.
Here is a table to demonstrate the depreciation conundrum more clearly. We love tables.
|Taxable Income Prior to Depreciation||60,000|
|Section 179 Depreciation||100,000|
|Beginning Shareholder Basis||10,000|
|Net Biz Income (profit) on K-1||60,000|
|Section 179 Depreciation on K-1||70,000|
|Loss Taken on 1040 Tax Return||-70,000|
|Section 179 Depreciation Carryforward||30,000|
Bonus Depreciation Losses
Here is another example, that is just slightly different and shows a small difference between Section 179 and bonus depreciation. Similar example to above, but you used bonus depreciation.
|Starting Shareholder Basis||10,000|
|Net Income Before Depreciation||60,000|
|Bonus Depreciation (80%, 2023)||80,000|
|Net Income (loss) on K-1||-20,000|
|Available Cash in Business||60,000|
|Ending Shareholder Basis||0|
|Disallowed Losses Carried Forward||10,000|
What we are showing here are two things- first, your losses created by the bonus depreciation will be limited because of your shareholder basis. You started with $10,000 but didn’t have any net business income (profits). Rather, you had a $20,000 loss. $10,000 of this $20,000 was allowed and the remainder will be carried forward to future years.
The second thing we are showing is how your cash is trapped. You had profits before bonus depreciation of $60,000 and for the sake of argument this also is your ending cash balance in your checking account. This cash is trapped since you cannot distribute it without creating a distribution in excess of basis.
We will expand on this some more in a bit. The big takeaway is that business losses created by depreciation created by a financed equipment purchase can be painfully and unknowingly limited.
Wait! Looks like we talk about shareholder distributions and basis next. Yay!
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