Suspended Losses from the Disposition of an Interest in a Pass-Through Entity

Owners of pass-through entities — partnerships, limited liability companies, and S corporations — may be allocated business losses that they cannot deduct because of an insufficient tax basis in the entity, because the loss exceeds the taxpayer's at-risk amount, or because the loss is passive, which can only be deducted against passive income. The nondeductible portion of a pass-through loss is a suspended loss, which can usually be carried forward to be deducted against taxable income in the future.

The 1st and most important restriction in deducting losses allocated from a pass-through entity — and the only one that may never be deductible — is that the owner must have a sufficient tax basis in the entity, since the deduction of losses is limited to the extent of that basis — partners are limited to the outside basis of their partnership interest, while shareholders of an S corporation are limited to their stock basis + any allocated portion of a debt obligation of the S corporation.

However, stock basis is adjusted on the last day of the S-corporation year in the following order:

  1. increase
    • income
    • excess depletion
  2. decrease
    • distributions
    • nondeductible, non-capital expenses and depletion
    • losses and deductions

A suspended loss because of a basis limitation can only be deducted if basis is increased in later tax years. So if the owner disposes of his entire interest, then basis cannot be increased, so the suspended losses can never be used to offset future income. The loss becomes permanent.

Example: Permanent Nondeductible Loss because of Limited Tax Basis
You have 100 shares of stock in an S corporation.
Original Stock Basis $0
Suspended Ordinary Loss $6,000
Stock Sale $7,000
Pro rata share of income prior to sale $2,000
Increases to stock basis because of the income allocation $2,000
Suspended losses allocated to stock basis $2,000
Stock basis after allocation of income + loss $0 = Original Stock Basis + Stock Basis Increase from IncomeStock Basis Decrease from Allocated Loss
Recognized Capital Gain $7,000 = Stock SaleStock Basis After Allocating Loss
Permanent Suspended Loss $4,000 = Suspended Ordinary LossSuspended Loss Allocated to Increased Stock Basis

Suspended Losses from an At-Risk Limitation

Generally, an investor cannot deduct more than what she has at-risk in the investment. What often occurs is that the business entity has nonrecourse loans that are apportioned to each of the owners. Because the loans are nonrecourse, the owners have no personal liability for the debt since the creditor is restricted to claiming the collateral in case of default. However, the at-risk limitation is not really a limitation since, when the owner disposes of her interest, then she is also relieved of the liability, and the relieved amount is includable as income to the seller, allowing her to fully deduct the loss.

Example: Deducting a Suspended Loss because of an At-Risk Limitation
Outside Basis $10,000
LLC Allocation of Nonrecourse Liability $13,000
Suspended Ordinary Loss $3,000 = Allocation of Nonrecourse LiabilityOutside Basis
LLC Interest Sale $2,000
Amount Realized $15,000 = Sale Proceeds + Relief From Liability
Gain $5,000 = Amount RealizedOutside Basis

Thus the recognized gain allowed the full deduction of the loss that was suspended because of the at-risk limitation.

Suspended Passive Activity Losses

Losses may be suspended even if the owner has sufficient basis and a sufficient at-risk amount if the investment is also classified as a passive activity, since passive losses can only be deducted from passive income. Suspended passive losses can be carried forward to future tax years to be deducted from future passive income earned from whatever source. However, if the owner disposes of the entire interest in the business entity, then the entire suspended loss is fully deductible in the year of the transaction.