Taxpayers generally think of a business loss as an immediate tax deduction, but the tax code is not quite so simple. Individual circumstances—such as how much is at risk in an activity, whether it is passive, and whether it entered into with a profit motive—can limit the deduction available. The authors examine various scenarios where deductions for business losses can be curtailed, delayed, or even disallowed.
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Publicly traded partnerships (PTP) in the oil and gas industry are now hemorrhaging cash and generating large tax losses for their limited partners, while managers wait for market prices and economic conditions to make production feasible. Individuals who have invested in such ventures often have limited knowledge of the proper handling of these losses for tax purposes, and are often disappointed when facing taxes due rather than immediate deductions. In some cases, the form of the business could have been rearranged to change the tax impact of these tax losses. CPAs should counsel their individual clients regarding whether the losses are deductible, the timing and the amount of the losses, and what events must occur to unlock deductible losses if the losses are suspended. This article will allow taxpayers and CPAs to gauge the economic impact of such tax losses.
Internal Revenue Code (IRC) section 465 limits the deductible loss from an activity to the amount an individual taxpayer has at risk with respect to such activity. A loss is defined in section 465(d) as the excess of the deductions attributable to the activity for the year over the income received or accrued from that activity for the year. Under section 465(c)(3), these restrictions apply to each “activity engaged in by the taxpayer in carrying on a trade or business or for the production of income,” in addition to certain enumerated activities. The at-risk rules allow only for the offset of income from one activity by losses from the same activity, not other, separate activities.
Congress intended that the amount a taxpayer has at risk in an activity be increased to the extent that his basis in the activity is increased by the activity’s income [Committee Reports on P.L. 94-955 (Tax Reform Act of 1976)]. Similarly, the amount at risk should be decreased by the amount of loss attributed to the taxpayer [IRC section 465(b)(5)]. Furthermore, section 465(b)(2)(A) generally provides that a taxpayer is considered at risk with respect to amounts borrowed to the extent that the taxpayer is personally liable for repayment.
The passive activity loss limitation rules provide that losses from a passive activity can be deducted only to the extent of the taxpayer’s income from passive activities for the year.
In some circumstances, however, debt may not be recognized as such for income tax purposes if the risk of non-payment is sufficiently great. This type of loan would not increase a taxpayer’s amount at risk [Waddell v. Comm’r, 86 T.C. 848 (1986)]. Instead, the borrowed amount would likely be treated as equity rather than debt for federal income tax purposes, and the lender would not be considered at risk because the borrower’s obligation to repay the debt generally constitutes protection against loss within the meaning of IRC section 465(b)(4). The borrower would not be at risk either, because she has not put up any money. Indeed, no one would be at risk until the borrower either defaults or pays the loan.
In addition, amounts borrowed will not be considered at risk with respect to an activity 1) if such amounts are borrowed from any person who has an interest in the activity or from a related person to anyone (other than the taxpayer) having such an interest or 2) the borrowed amount is protected against loss through nonrecourse financing, guarantees, stop-loss agreements, or other similar arrangements [IRC sections 465(b)(3)(A) and 465(b)(4)]. An individual would not be affected if he and the bank are unrelated parties, if the bank does not have an interest in the activity aside from being a creditor and a service provider, and if there is no protection against loss according to the loan documentation.
Passive Activity Loss Limitation
The passive activity loss limitation rules under IRC section 469 provide that losses from a passive activity can be deducted only to the extent of the taxpayer’s income from passive activities for the year. Under section 469(c)(1), a passive activity is any activity involving the conduct of a trade or business in which the taxpayer does not materially participate. The Treasury Regulations define a passive activity in part as any trade or business activity in which the taxpayer does not materially participate for such taxable year [Treasury Regulations section 1.469-1T(e)(2)].
Under Treasury Regulations section 1.469-1T(e)(6), the activity of trading personal property, such as various option positions, for the account of owners of interests in the activity is not a passive activity. Personal property includes all personal property that is actively traded. Specific rules limit the definition of personal property to exclude certain equity positions, such as S&P 500 equity options.
IRC section 1092 limits losses in connection to certain tax straddles. It disallows realized losses on straddles that are not otherwise subject to the mark-to-market rules of section 1092 to the extent that the gains on the offsetting positions are unrecognized; that is, the amount of gain that would be taken into account if any position were sold on the last day of the tax year at its fair market value and the amount of gain that has been realized but not recognized at the close of the taxable year. Disallowed losses are deferred and treated as sustained in the following year [section 1092(a)(3)(a), 1092(a)(1)(B)].
A tax straddle includes offsetting positions for personal property [section 1092(c)(1)]. A position is an interest (including a futures or forward contract or option) in personal property [IRC section 1092 (d)(2)]. Two or more positions are presumed to be offsetting if—
- they are in the same personal property;
- they are in the same personal property, even in a substantially altered form;
- they are in debt instruments of a similar maturity or other debt instruments described in Treasury Regulations;
- they are sold or marketed as offsetting positions;
- the aggregate margin requirement is lower than the sum of each (if held separately); or
- there are such other factors (or satisfaction of subjective or objective tests) in the Treasury Regulations indicating such positions are offsetting.
The first, second, third, and sixth criteria above apply only if the value of one or more of the positions ordinarily varies inversely with the value of one or more other positions [IRC section 1092(c)(3)].
A taxpayer holds offsetting positions if there is a substantial diminution of the taxpayer’s risk of loss by holding at least one other position with respect to personal property, whether or not of the same kind [IRC section 1092(c)(2)(A)]. As seen above, offsetting positions need not be for the same kind of property; it is enough that the price movement on the positions correlates in a manner that substantially diminishes the risk of loss. The legislative history of section 1092, however, states that “risk reduction through mere diversification usually would not be considered to substantially reduce risk … if the positions are not balanced” [Staff, Joint Committee on Taxation, General Explanation of the Economic Recovery Tax Act of 1981, at 288 (1981)].
Personal property must be of a type that is actively traded and for which there is an established financial market, as defined by Treasury Regulations section 1.1092(d)-1(a)–1(b). Foreign currency for which there is an active interbank market is presumed to be actively traded [IRC section 1092(d)(7)(B)], and foreign currency options are therefore considered personal property.
If part or all of the gain or loss for a position is held by a partnership, trust, or other entity, it is treated as held by the appropriate taxpayer according to her proportionate interest. The holder of a call option should be treated as holding the underlying foreign currency options themselves. For example, each member of a limited liability company is treated as holding its proportionate share of that entity’s option positions for income tax purposes, and therefore a person holding an option to become a member of a limited liability company should be treated as holding that entity’s option positions: “The IRS believes that the term ‘actively traded’ under section 1092 was intended to cover financial instruments that are liquid or easily offset, even when these instruments are not traded on an exchange or in a recognized secondary market” [Preamble to T.D. 8491 (Oct. 14, 1993), publishing section 1092 regulations].
Profit Motive Requirement
IRC section 165(a) allows as a deduction any loss sustained during the year and not compensated by insurance or otherwise. Such losses are, however, limited by section 165(c) to 1) losses incurred in a trade or business and 2) losses incurred in any transaction entered into for profit, though not connected with a trade or business. Section 165(c)(2) limits an individual’s deduction of losses not arising from a business, casualty, or theft to those “incurred in any transaction entered into for profit.” The transaction must be completed and closed, fixed by an identifiable event, and actually sustained during the taxable year [Treasury Regulations section 1.165-1(b)]. The critical factor under IRC section 165(c)(2) is the taxpayer’s motive for entering into the transaction, as indicated by the facts and circumstances. The presence of reasonable expectation of profit is not sufficient; in the case of a partnership, profit motive is determined at the partnership level. [See Fox v. Comm’r, 80 T.C. 972, 1006 (1983); Andros v. Comm’r, 71 T.C.M. (CCH) 2472 (1996).] In Ewing v. Comm’r, 91 T.C. 396 (T.C. 1988), the Tax Court derived the following guidelines from Fox:
- The ultimate issue is profit motive and not profit potential. Profit potential is, however, a relevant factor in determining profit motive.
- Profit motive refers to economic profit, independent of tax savings.
- The overall scheme determines the deductibility or nondeductibility of the loss.
- If there are two or more motives, it must be determined which is primary. The determination is essentially factual, and greater weight is to be given to objective facts than statements characterizing intent.
- Because the statute speaks of motive in “entering” into a transaction, the main focus must be at the time the transactions were initiated. All circumstances surrounding the transactions are, however, material to the question of intent.
Similarly, IRC section 183(a) generally disallows deductions attributable to an activity “not engaged in for profit.” “Although a reasonable expectation of profit is not required, the facts and circumstances must indicate that the taxpayer entered into the activity … with the objective of making a profit” [Treasury Regulations section 1.183-2(a)]. In the case of a commercial transaction, the profit objective need not be the primary objective; a taxpayer need only have a good-faith expectation of earning a reasonable pretax profit from the activities undertaken. [See Levy v. Comm’r, 91 T.C. 838, 871 (1988); Johnson v. U.S., 11 Cl. Ct. 32 (1986).]
Despite the literal language of IRC section 165(c)(2) and the apparent parallel language in section 183(a), courts have required that the taxpayer’s profit motive be primary. This is derived from footnote 5 in Helvering v. National Grocery Co. [304 U.S. 282 (1938)], where the Supreme Court stated that under section 23(e), the predecessor of section 165(a)(2), the deductibility of losses may depend upon whether the taxpayer’s motive in entering the transaction was “primarily” for profit. This statement is merely dictum, because the Court’s point would have been equally made by asserting that what matters is the taxpayer’s motive to make a profit.
Over the next 45 years, courts applied this standard to disallow loss deductions, but only in a noncommercial setting such as a hobby, the purchase of a personal residence, or another transaction entered into for personal purposes. In Austin v. Comm’r [298 F.2d 583 (2d Cir. 1962)], the court explained that the standard is a consequence of the apparent conflict between section 165(c)(2) and section 262, which bars a deduction for “personal, living, or family expenses.” In a transaction with multiple motives, one must determine which provision applies.
In a transaction with multiple motives, one must determine which provision applies.
By contrast, a loss from a partially tax-motivated transaction is not a personal expense, being wholly unlike any of the examples of “personal, living, and family expenses” set out in Treasury Regulations section 1.262-1(b). The Third Circuit in Weir v. Comm’r [109 F.2d 996 (3d Cir. 1940)] made this very point, rejecting the IRS’s attempt to disallow the deduction of a loss on a sale of housing cooperative stock. While the taxpayer testified that he had bought the stock to have a voice in management and because he intended to live in the building, the court inferred that the purchase of corporate stock indicated an intention to receive profits “unless the purchaser knows at the time of purchase that such profits are an impossibility,” which was not the case. The court also pointed out that the taxpayer’s intention to influence the corporation through his stock ownership did not conflict with a profit motive. The court then concluded that “the public coffers are weighted with same amount from taxes on [the stock] dividends, whether the stock is held with the motive of voting or with the motive of profit” and allowed the deduction.
A commercial transaction resulting in a tax benefit is no more a personal, living, or family expense than the purchase of co-op stock in Weir; as Justice Harlan said in Comm’r v. Brown [380 U.S. 563, 580 (1965)], “a tax dollar is just as real as one derived from another source.” As late as 1982, the Tax Court in Smith v. Comm’r [78 T.C. 350, 391 (1982)] suggested that in a tax-motivated transaction, any bona fide non-tax motive would suffice, although it failed to find any.
Nonetheless, later courts recited the primary standard in opinions on wholly or partially tax-motivated transactions without explaining why it should apply. The first case to do so was Fox v. Comm’r [82 T.C. 1001 (1984)], involving the deductibility of losses from so-called “vertical option spreads” on U.S. Treasury bills traded on a promoter-sponsored market. In concluding that the taxpayer “was motivated primarily by tax considerations, and not primarily by the desire for economic profit,” the court noted the following factors:
- The taxpayer had learned of the market from a tax attorney;
- The only written material received from the promoter was a letter explaining the tax treatment of the transactions;
- He sustained losses after paying annual commissions for three years;
- He did not “appear to make profit-maximizing decisions,” switching at year-end into positions offering a lower potential profit and higher potential loss;
- The bulk of the trading in the market occurred in November, December, and January;
- Customers commonly engaged in identical trades;
- An National Association of Securities Dealers (NASD) investigator had concluded that the promoter’s market was suitable for investors interested only in tax advantages;
- The market itself closed after the enactment of anti–tax straddling rules in 1981; and
- Strike prices for the options were set much higher than the prevailing market price of the particular Treasury bill.
The court then proceeded to “relax” its holding to “allow for those essentially tax-motivated transactions which are unmistakably within the contemplation of congressional intent.”
The application of the primary standard in Fox has been criticized as inconsistent with the principle that a tax motive will not invalidate an otherwise proper transaction. It is also technically dictum since the court merely assumed that the taxpayer had any profit motive. Moreover, the opinion cited no justification for applying the standard to a commercial transaction, and none of the six cases it cited as authority for doing so is, in fact, such authority. Three of the cases, Austin, Weir, and Helvering, are cited above; another, Ewing v. Comm’r [20 T.C. 216 (1953)], involved noncommercial transactions, as in Austin. In the other two cases, Knetsch v. U.S. [348 F.2d 932 (Ct. Cl. 1965)] and King v. U.S. [545 F.2d 700 (10th Cir. 1976)], the courts set out a standard in direct contradiction with the primary standard.
In Knetsch, the appellate Court of Claims, while again reciting that “the determinative question is whether the taxpayer’s purpose in entering into the transaction was primarily for profit,” indicated that it thought the test required much less: “There are two crucial words contained in this test: purpose and profit. … Thus, you can have a profit intention side-by-side with a nonprofit motive. However, the statutory requirement ‘for profit’ can be satisfied by either. … By the same token, you can have a prohibited profit motive or intent side-by-side with a legitimate profit motive or intent and meet the statutory requirement.” The court then noted that two possible motives or intentions could be ascribed to the taxpayers: a “dominant intent or motive” to deduct the purported interest, and a “secondary purpose” of the production of retirement income. The court held that although the first purpose would produce a “profit” of sorts, it was not the profit intended to be covered by IRC section 165(c)(2): “the statutory word ‘profit’ cannot embrace profit seeking activity in which the only economic gain derived there-from results from a tax reduction.” Note that Knetsch is read by Johnson in dictum as suggesting that “some, arguably even a slight, profit motive, in addition to tax motives will sustain tax deductions” under IRC section 165(c)(2).
King dealt with the deduction of losses from an investment in oil and gas net operating interests (NOPI). In King, the court first stated, “We agree with the IRS that in order to deduct a loss under Section 165(c)(2) the taxpayer must show that profit was the primary motivation.” The court then added that profit motivation (not “a primary profit motivation”) was required because the ordinary loss deduction was not intended to extend to a transaction lacking economic substance. It is not necessary, however, that the venture actually result in a profit; it is sufficient that “these transactions were entered in good faith for the purpose of making a profit.”
While numerous later cases recite the “primarily profit” standard in commercial transactions with tax motives, in nearly all of the cases, the recitation is dictum. For the most part, this is because the taxpayer lacked any intent to make a profit (even if a possibility of profit existed) or because the court held that the “for profit” requirement in section 108 of the Deficit Reduction Act of 1984 meant an objective possibility of profit as opposed to a subjective intent to profit, which the court phrased as “primarily for profit.” For example, in Laureys v. Comm’r [92 T.C. 101 (1989)], the court held that the taxpayer entered into a straddle on a public market for the “primary” purpose of realizing a profit; the taxpayer denied any tax motive for the transaction, and the IRS’s only proffered evidence was that the tax benefits were disproportionate to the potential economic gain.
Other cases juxtapose a recitation of the standard with either a recitation of cases that do not support its application in commercial transactions or a statement that the taxpayer need merely enter the venture “in good faith, for the purpose of making a profit,” bringing into question whether the court intended this be taken literally. For example, in Miller v. Comm’r [836 F.2d 1274, 1279 (10th Cir. 1988)], the court, in denying the deduction of losses from a straddle transaction, cited Helvering, Austin, Knetsch and King in support and then stated, “Losses from a transaction entered into in part for tax-avoidance may still be allowable under section 165(c)(2), provided the required nontax profit motive predominate,” further quoting King that “What need be shown is that the taxpayer entered into the venture in good faith, for the purpose of making a profit.” In Yosha v. Comm’r [861 F.2d 494, 499 (7th Cir. 1988)], the court stated that it need not decide whether the standard was “for profit” or “primarily for profit” because “by either standard … this is an easy case. There was no nontax profit motive and the transactions did not impinge on the world. … The effort here to turn paper losses into tax benefits was contrary to the original, unembellished purpose of section 165(c)(2).”
Even some of the cases that appear to apply the primary standard—and even then without specifically finding that the taxpayer had a profit motive at all—do so in circumstances where, for the most part, the taxpayer’s conduct is inconsistent with a profit motive. For example, in Keeler v. Comm’r [243 F.3d 1212 (10th Cir. 2001)], the court looked to such factors as 1) the taxpayer’s continued trading even while he and every other non-insider were losing money on the bulk of their transactions, 2) the taxpayer’s losses offsetting almost all of his income over a three-year period, 3) the taxpayer leaving a large balance in his margin account “making net profit on his [trading] activities all but impossible,” 4) the taxpayer’s continued trading even though it was clear that prices and participation in the market were fixed, and 5) his exiting the program only when Congress eliminated its tax benefits in 1984. Moreover, the Tenth Circuit distinguished cases such as Laureys where “the trading at issue occurred on established markets and was part of the taxpayers’ overall profit-motivated strategy to hedge their investments.” In Leslie v. Comm’r [146 F.3d 643, 647 (9th Cir. 1998)], the court noted that the trades were closed out in a noncommercial manner, were designed to maximize tax benefits, and required a higher commission.
The word “primary” does not appear in IRC section 165(c)(2). As the Seventh Circuit observed, “we find no basis therein for our understanding to put words into the statute that, whatever the reasons may have been, Congress did not put there. Our task is to construe and apply, not to write, legislation” [International Trading Co. v. Comm’r, 484 F.2d 707, 711 (7th Cir. 1973)]. Inserting the word “primary” to govern a commercial transaction is not required by a construction of the statute, is inconsistent with its justification in noncommercial transactions, is inconsistent with the longstanding principle that a tax avoidance motive will not void an otherwise proper transaction, and is unsupported by precedent appearing before 1984.
Net Operating Losses
When an individual taxpayer with business activity has negative taxable income, this is generally considered a net operating loss (NOL) that may be deducted against other years’ taxable income. The economic value is only known after it is converted to an NOL by removing nonbusiness/personal deductions in excess of nonbusiness income. Nonbusiness deductions include all itemized deductions (less personal casualty and theft losses and unreimbursed employee business expenses) plus self-employed retirement plan contributions. Nonbusiness income is all income not derived from a trade or business, such as dividends, interest, and nonbusiness capital gains. This conversion may result in a much smaller NOL, or possibly none at all.
Once the NOL is determined for the tax year, it may be carried back two years. If the carryback year has insufficient taxable income to absorb the NOL, adjustments to the tax loss shown in the carryback year must be made to determine the amount of NOL deduction that can be carried forward to the next year. These adjustments may require a recomputation of adjusted gross income.
Individual taxpayers often have sales or exchanges of capital assets (IRC section 1221) that result in a net capital loss for the tax year after subtracting the tax basis from the amount realized. The net capital loss amount may offset up to $3,000 of ordinary income in the year incurred. The remaining capital loss must be carried forward into the netting process for capital gains/losses in future years until it is used up. A large net capital loss (e.g., $50,000) may take many years to be offset against ordinary income unless significant capital gains are generated.
Related Party Property Sales
If property is sold to a family member, any loss on the sale is disallowed. No loss is recognized on a sale of property between a person and a partnership when the person owns, directly or indirectly, more than 50% of partnership capital or profits. In both cases, the loss may not vanish entirely. If the family member eventually sells the property at a gain, the previously disallowed loss may be used to offset the gain that would otherwise be recognized.
Partner Loss Limitations
Three different loss limitation tests must be applied to partnership loss pass-throughs before a deduction is allowed. The overall limitation in IRC section 704(d) allows a loss deduction only to the extent of the partner’s adjusted basis. Losses deductible under the overall limitation may then be subject to the at-risk limitation of section 465, as discussed above, under which losses are deductible only to the extent the partner is at risk for the partnership interest. Losses that pass both tests may be subject to the passive loss rules of section 469, also discussed above. Only losses that pass all three tests may be deducted on the partner’s tax return.
Wash Sale Rules
If a shareholder has a realized loss in a stock and wants to recognize the tax loss but is bullish on the future prospects for the stock and wants to maintain ownership, she must be aware of the “wash sale” rules. A wash sale occurs when an investor sells or trades stock or securities at a loss and, within 30 days either before or after the day of sale, buys substantially identical stocks or securities, including contracts or options (IRC section 1091). Under the wash sale provisions, realized losses are not recognized; instead, the amount of the unrecognized loss is added to the basis of the newly acquired stock. The 61-day window ensures that taxpayers cannot deduct losses from stock sales without exposing themselves to the risk that the stock they sold will subsequently increase in value.
A Complicated Endeavor
Individual taxpayers equate an economic loss with a deductible tax loss, but the reality is not so clear-cut. CPAs must have a working knowledge of tax loss limitation rules and make their clients aware of them so that they can strategize without overlooking the tax factors in their economic decision-making.