A passive loss reported on Schedule K-1 (Form 1120-S) is not always deductible. Passive losses can only be used to offset passive gains, and generally losses from passive activities that exceed income from passive activities are disallowed for the current year.
If there is no passive income entered in the tax return, the loss will not be deducted from the total income. Instead, the loss will carry forward to future years until it can be used to offset passive income. Form 8582 is used to calculate the loss carryforward.
There are essentially two kinds of passive activities:
- Trade or business activities in which the taxpayer doesn't materially participate during the year.
- Rental activities, regardless of participation level, with the exception of being a real estate professional.
S corporations are required to report income or loss and credits separately for each of the following activities:
- Trade or business activities.
- Rental real estate activities.
- Rental activities other than rental real estate.
- Portfolio income.
It's up to the taxpayer to determine their level of participation in an activity to determine if it is passive or nonpassive.
There are two ways to diagnose why a loss isn't being allowed:
- Examine Form 8582. Look for the loss in an unallowed column in one of the sections.
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Examine the Schedule K-1 entry to see if it's being treated as passive. From the Main Menu of the tax return (Form 1040) select:
- Income
- Rents, Royalties, Entities (Sch E, K-1, 4835, 8582)
- K-1 Input - Select the K-1 from the entries listed.
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Ordinary Income/Loss from Trade or Bus. Activities - In this example, the loss in the amount of $1,000 has been entered as passive:
In the above example, if the $1,000 loss should be treated as nonpassive rather than passive, you will fix it by first zeroing out the Passive Income/Loss field and clicking Ok, then entering it in the Nonpassive Income/Loss field.
The Schedule K-1 that the taxpayer receives from the S corporation won't indicate if their participation in the corporation should be considered passive or nonpassive. This determination isn't made at the entity level. It's up to the taxpayer to make this determination in their individual tax return.
Consult IRS Publication 925, Passive Activity and At-Risk Rules if there are any questions regarding how to treat the passive losses and/or passive income on a taxpayer's Schedule K-1.
Additional Information: