You just got off the phone with your CPA and he tells you that your S corporation business has a loss of $20,000. You say, "great, that should reduce my personal taxes. Hey, do you think I'll get a big refund?" Then your CPA lays the bomb on you. "Nope. These losses are not deductible on your personal return." He goes on to tell you something about "basis" and "at-risk limitation" and you hang up the phone and scratch your head because you still haven't the faintest idea what your CPA just said and why the losses are disallowed.

This scenario is played out over and over again in businesses across the country. The reason you don't understand what your CPA was trying to tell you about the losses is not your fault. Listen to me, it's not your fault, its not your fault. Sorry, I got lost in Good Will Hunting for a moment there. The fact is, the rules regarding S corporation business losses are intentionally made too complicated. The reason? Simple. The IRS and our federal government do not want you to be able to deduct S corporation losses.  So they throw numerous obstacles (three, which I will get into soon) at you and hope you won't be able to hurdle them.  Because CPAs are considered by many to be the most trusted adviser and understand that following the tax rules actually keeps our clients out of trouble, we are the ones that must force our clients to follow the rules and we are the ones that have to lay this bomb on S corporation clients periodically and incur their wrath.

While the rules are complicated I believe I have it in me to translate this needlessly complicated IRS-tax speak into words that may actually make sense to human beings.  So here we go.

IRS Obstacle #1 - What the heck is "Basis"?
When you own start a business you usually invest some of your money into the business. In an S corporation this is called basis. If you later run into financial problems and need money to keep the business going, you may go to a bank and personally borrow money, which you lend to the S corporation. This is called basis. Now imagine that you invested $10,000 initially and then ran into problems later on, got a loan for $30,000 from your bank, and gave that money to the S corporation, just to keep it running until things turned around. Those two numbers add up to $40,000. right?  Your basis is $40,000.  Why does basis matter?  Basis is important because without it you would not be able to deduct your S corporation losses on your personal tax return (form 1040). You want to deduct these losses on your form 1040 because that means you pay less tax or get a big refund come April 15th.  So not being able to deduct your S corporation losses means you owe more taxes or don't get your big refund. It means less money to you. It means no vacation this year.  So, you see, basis matters because no basis means no money.

IRS Obstacle #2 - What the heck does "At-Risk Rules" mean?
It wasn't enough. The IRS failed to stop you from getting your refund using the dreaded "basis" obstacle. But they're not done just yet. Whamo, out from their holster they pull another obstacle.  This one they call  "at-risk rules".  Think of  "at-risk rules" as "basis" but with a disability. Ok, you have basis, the IRS tells you, but now they want to know if your basis is disabled. Because if it is then, guess what, you can't deduct the losses once again. How does your basis become disabled? This happens a number of ways. When the IRS finds out you have more than one business activity going on inside your S corporation your basis becomes disabled. When this happens,  the IRS wants you to calculate your basis for each activity. They're hoping that one of the activities that is generating the loss, turns out not to have basis, thus no loss deduction allowed. Another trick they use to disable your basis is to take away basis if the IRS finds out that the money your borrowed and gave to the S corporation is money you are not personally on the hook for or that is not secured by some S corporation asset.  Let me give you one more disability. Let's say the IRS determines that you aren't actively involved in your S corporation. Disabled! To be actively involved you have to be involved at the operational or management level. If you aren't, you lose!  Way too complicated folks. That's why you need a CPA, I guess.

IRS Obstacle #3 - Now What?  My loss is "Passive"?  What the heck does that mean?
Great job, you have slayed the mighty IRS and hurdled Obstacles # 1 and #2. But the IRS is persistent. They whip out another obstacle. This one they call the "passive activity" obstacle. The passive activity obstacle says that if you are not actively involved in the S corporation you can't deduct the losses. "But", you say, "didn't I just hurdle this test in Obstacle #2 above?" Nope. Why? Because, guess what? The IRS has a different definition for  "actively involved" for this obstacle (passive obstacle) than it did for the "at-risk" obstacle.  "Actively involved" for this obstacle is far more stringent than for Obstacle #2 and it has its own separate tests which involve hours worked in the activity etc.. If this obstacle applies, your loss will be limited. I can't get into the passive activity rules here as I have to go to work and make some money, but suffice it to say, they, too are way too complicated.