Deducting Losses, Trapped Cash

By Jason Watson, CPA
Posted Sunday, December 29, 2024

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 Expensing Limits

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 expensing 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 expensing was $100,000). Here is the catch. Section 179 is limited to the business income of the S Corp, so it cannot create a loss. Your K-1 would show $60,000 of net business income and only $60,000 of Section 179 deduction. The two wash out, and your taxable income from the business is zero. $60k minus $60k = 0, even in Canada. Sorry Canada… just too easy to pick on.

The $40,000 remainder of the Section 179 deduction that was not used would be carried forward to future years. Yuck! Sorry, the once-benevolent IRS king is now asking you to be patient and wait. On the bright side, your shareholder basis stays at $10,000 since the income and the deduction offset each other.

Here is a table to demonstrate the depreciation conundrum more clearly. We love tables.

Bonus Depreciation Losses

Here is another example that shows a small but important difference between Section 179 and bonus depreciation. It uses the same facts as above, except this time you used bonus depreciation. Unlike Section 179, bonus depreciation can create a loss, but you can only deduct that loss up to your shareholder basis.

Bonus depreciation is 100% for qualifying property acquired after January 19, 2025 under the One Big Beautiful Bill Act (OBBBA). The table above uses the full 100%.

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 $40,000 loss. $10,000 of this $40,000 was allowed and the remaining $30,000 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, which is taxed as a capital gain.

A quick note on partnerships. These examples are S Corp examples. In a partnership or multi-member LLC, your share of the $100,000 equipment loan would generally add to your basis, so most or all of the bonus depreciation loss would be allowed. Same equipment, same loan, different result.

We will expand on this some more in a bit. The big takeaway is that business losses created by depreciation on a financed equipment purchase can be painfully and unknowingly limited. This is why WCG CPAs & Advisors tracks shareholder basis on Form 7203 every year for our S Corp clients, rather than reconstructing it when a loss or a large distribution shows up.

Wait! Looks like we talk about shareholder distributions and basis next. Yay!