Understanding basis limitations for K-1 losses

For more Schedule K-1 resources, check out our Tax topics page for Schedule K-1 where you'll find answers to the most commonly asked questions.

Definition

The basis limitation is a limitation on the amount of losses and deductions that a partner of a partnership or a shareholder of a S-Corporation can deduct. The basis limits are the first of three limitations that are applied to Schedule K-1 losses and deductions. After the basis limits are applied, the At-risk limits (Form 6198) are applied. If losses are allowed by the basis and at-risk limits, the passive limits (Form 8582) are applied, if applicable.

Per Schedule E (1040), shareholders of S Corporations are required to attach a basis calculation to their tax return each year. There is no form for the basis limitation, but a worksheet, and some instructions have been provided in the partner and shareholder instructions for Schedule K-1.

It is important to note that the capital account shown on the Partner's K-1 is not the same as basis. According to the Partner's Instructions for Schedule K-1, the basis schedule represents outside basis while the capital account represents inside basis. These can differ, even when the partnership maintains its books and records on a tax basis. One way this difference can occur is when a partner buys his partnership interest from another partner, since the purchase price becomes the starting point for his outside basis.

Computation

The starting point for the basis limitation is adjusted basis at the beginning of year. The adjusted basis at the beginning of the year is the ending adjusted basis from last year reduced by loss allowed in the previous year. In the initial year, basis is equal to the adjusted basis of property contributed to the partnership, plus any gain recognized on the contribution of property.

The following adjustments are made to arrive at the beginning adjusted basis used in applying the basis limitation:

• Increases:

  Adjusted basis is increased by current income from the activity, additional amounts invested in the activity, and depletion in excess of the oil and gas property basis.

  
  

  Additionally, the adjusted basis of a partner's interest in a partnership includes the partner's share of the partnership's liabilities. This is not the case for shareholders in an S-Corporation. Because the S-Corporation is a corporation, it is a distinct legal entity separate from the shareholder, so the shareholder does not increase his or her basis by their share of liabilities. The shareholder only increases their basis by the loans they make directly to the corporation.

• Increases to Shareholders' Debt Basis:

  Once losses have reduced a shareholder's stock basis to zero, basis in loans that the shareholder has made to the S-corp is used to allow losses. In future years, any net increases increase debt basis before stock basis. It is important to note "Net Increases" is determined by netting together current year income, losses, prior year losses and distributions. If prior year losses are in excess of current year income, there is no "net increase" and therefore no restoration of debt basis. For more information, please see IRC. 1367(b)(2)(B)).

• Decreases:

  Distributions, decreases in a partner's share of partnership debt, and repayments on loans the shareholder made to the S corporation are all reductions to a partner's or a shareholder's basis.

  
  

  If the current year plus prior year disallowed losses exceed basis, some of the loss is disallowed. Any disallowed loss is carried to the following year return and is treated as incurred in the following tax year.

  
  

  For partners, the allowed loss is allocated pro-rata to each category of loss or deduction (Ordinary, 1231, capital gains/losses, 179 expense, etc). For shareholders, there are ordering rules. Nondeductible expenses and depletion are allowed in full first, unless the shareholder has filed an election to do otherwise. (Regulation 1.1367-1(f))