A loss from a 1120-S Schedule K-1 is not always deductible. Passive losses can only be used to offset passive gains, and generally losses from passive activities that exceed the income from passive activities are disallowed for the current year.
If there is no passive income entered in the return, the loss will not be deducted from the total income. Instead, the loss will carry forward 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.
- 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:
- Rents, Royalties, Entities (Sch E, K-1, 4835, 8582)
- K-1 Input - Select the K-1 from the entries listed.
- Ordinary Income/Loss from Trade or Bus. Activities
The Schedule K-1 won't indicate if the loss (or income) should be considered passive or nonpassive. It's up to the taxpayer to determine this based on their level of participation.
Consult IRS Publication 925, Passive Activity and At-Risk Rules if there are any questions regarding how to treat the losses and/or income on a taxpayer's Schedule K-1.