What hurdles must partners overcome before they can ultimately deduct partnership losses on their tax returns?

What hurdles must partners overcome before they can ultimately deduct partnership losses on their tax returns?

Partners must overcome the four loss limitations are (1) the tax basis limitation, (2) the at-risk loss limitation, (3) the passive activity loss limitation, and (4) the excess business loss limitation. While a partnership can create an ordinary business loss, the individual partners potentially will not be able to deduct the entire amount in the year of the loss. The partner must potentially overcome four loss limitation rules before the deduction is available. If the loss does not pass any of the limitations, then the loss is suspended indefinitely under that specific hurdle.

How do partners determine whether they are passive participants in partnerships when applying the passive loss limitation rules

partners are passive participants if their involvement not ‘regular, continuous and substantial.’ Here are the 7 tests to determine material participation:

The individual participates in the activity more than 500 hours during the year.

The individual’s activity constitutes substantially all the participation in such activity by individuals.

The individual participates more than 100 hours during the year and the individual’s participation is not less than any other individual’s participation in the activity.

The activity qualifies as a “significant participation activity” and the aggregate of all other “significant participation activities” is greater than 500 hours for the year.

The individual materially participated in the activity for any 5 of the proceeding 10 taxable years.

The activity involves personal services in health, law, accounting, architecture, and so on, and the individual materially participated for any three preceding years.

Taking into account all the facts and circumstances, the individual participants on a regular, continuous, and substantial basis during the year.

 

 

 

2) Partners must overcome 4 loss limitation rules before they can ultimately deduct partnership losses on their tax returns. The 4 hurdles are (1) tax basis (2) at-risk amount (3) passive activity loss limitation (4) excess business loss limitation. The tax basis limitation is the amount a partner has invested in a partnership to satisfy their debt obligations (Spilker, 2020). Losses in excess of their tax basis must be carried forward. The at-risk limitation is more restrictive as it is meant to limit the partner’s usage of nonrecourse debt to create a tax basis. Passive activity loss limitation is created as a backstop for the at-risk limitations. They are applied after-tax basis and at-risk hurdles (Spilker, 2020). While it is mainly applied to individuals, it is also used on estates, trusts, some c corporations, and personal service corporations. Lastly, the excess business loss limitation is applied after the first 3 limitations to losses that aren’t passive. The purpose of this limitation is that business losses from partnerships are limited to business income from other sources plus a threshold amount (Spilker, 2020). All 4 of these hurdles should be overcome or checked before completely deducting partnership losses.

 

A passive activity is defined as “activity that involves the conduct of a trade or business and in which the taxpayer does not “materially participate” (Spilker, 2020). In order to determine material participation, there are seven tests.  (1) the individual participates in the activity for more than 500 hours each year, (2) the individual’s activity constitutes substantially all the participation, (3) the individual participates more than 100 hours during the year and is not less than anyone else’s participation, (4) the activity qualifies as a significant participation activity which means the individual participates for more than 100 hours during the year, (5) you materially participated in the activity for any 5 of the preceding 10 taxable years, (6) the activity involves personal services and materially participated for any of 3 preceding years, (7) the individual participates on a regular, substantial basis during the tax year (Spilker, 2020).