New IRS Audit Effort Focuses on Partnership Loss Limitation Rules
By: John Conner
The IRS Large Business and International (LB&I) Division recently announced that it has added a new “compliance campaign“ which addresses the tax basis limitations that apply to the amount of partnership losses (or, deductions such as Sec. 179 immediate expensing) that can be claimed by its partners. The Code §704(d) limitations which “are the main focus of this campaign” state that a partner’s distributive share of partnership loss will be allowed only to the extent of the partner’s adjusted basis in his partnership interest at the end of the partnership year in which the loss occurred. If the partner’s share of losses exceeds this amount, the excess amount is suspended and may be carried over for use in another tax year in which the partner has basis available. The IRS has said that “partnership compliance is a priority and that the agency is stepping up enforcement.” (Code §704; K-1 Losses)
Comment: Starting with the 2022 tax year, there are basically four distinct barriers to taking a flowthrough loss from a partnership return. They are applied in the following order: (1) Adjusted basis of the partner’s interest; (2) How much of that adjusted basis is considered to be at-risk (i.e., pursuant to Code §465 as shown on Form 6198); (3) Is the loss (or, deduction such as Sec. 179 immediate expensing) subject to the passive loss (PAL) rules under Code §469, and (4) Does the loss represent an “excess business deduction under Code §461 (l) $250,000/500,000 limits. If a capital loss is being passed through on the K-1, then it might also be subject to the overall cap of $3,000 annually.
Comment: The S corporation equivalent of this increased focus by the IRS on properly claiming K-1 losses or deductions flowing through from a partnership, is the current requirement on page two of Schedule E, Part I] where a separate “basis statement” (i.e., on Form 7203) needs to be provided if (1) a K-1 loss is being claimed; (2) the shareholder is receiving a distribution; (3) the shareholder is disposing of their stock; or (4) the shareholder is receiving a loan repayment from the S corporation. (Code §704; Partnership Losses)