At-Risk Limitation Rules
The at-risk rules are tax laws that prevent taxpayers from deducting losses on an activity that exceeds their actual investment. How do at-risk rules work? What are the types of at-risk rules? Read on to learn more.
An at-risk rule is a limitation on the amount of a loss that can be deducted from a business activity. This limitation is designed to prevent taxpayers from manipulating taxable income by using tax shelters. The at-risk rule only allows a deduction for losses at risk of being incurred. The amount at risk is determined by adding cash and adjusted basis in property contributed to a business activity and amounts borrowed for use in the activity for which the taxpayer is personally liable or has pledged property other than that used in the activity as security.
To determine their at-risk basis, the at-risk rules require taxpayers to use their actual investment in an activity, plus amounts borrowed, to the extent they are personally liable for. This is their tax basis in the activity and must be reported on Form 6198. The at-risk rules are outlined in Section 465 of the Internal Revenue Code and apply to individuals and closely held C corporations. A closely held C corporation is defined as one that meets the stock ownership test of a personal holding company and whose stock is owned by five or fewer individuals. The at-risk rules also limit the losses allowed to certain activities of a qualified C corporation, but these limitations are subject to special exceptions.
How is At-risk Basis Calculated?
The at-risk rules prevent taxpayers from claiming losses on their tax returns that are greater than what they have invested in a business. A partner’s at-risk basis is the sum of their cash and property investment in a business plus any amount that they have borrowed and are personally liable for with respect to the activity (Sec. 465(b) and Prop. Regs. Sec. 1.465-22(c)).
A taxpayer’s at-risk basis is measured annually at the end of each year. It increases when the taxpayer shares in the income of an activity and decreases when they withdraw from the business. The at-risk limit also changes each year as the amount of debt is increased or decreased and as the status of the debt is changed from recourse to nonrecourse.
If a taxpayer has an expected loss for a particular tax year, they should check their stock and loan basis prior to the end of the year. This will help ensure they have enough at-risk basis to absorb the loss. Any losses limited by the at-risk rules may be suspended and deducted in future years. They can also be used to offset any gain recognized upon disposition of the investment activity.
