Pass-Through Entity Loss Limits: At-Risk vs. Passive Activity Rules
Understanding the allocation of losses in a pass-through entity is critical for CPA exam takers and tax professionals. In this post, we break down the key limitations under the at-risk rules and the passive activity loss (PAL) rules, and explain how to allocate losses correctly based on basis schedules and IRS forms.
🔍 What Is a Pass-Through Entity?
A pass-through entity is a business structure (e.g., S corporation or partnership) that does not pay corporate income tax. Instead, income, losses, deductions, and credits are passed through to the owners.
📉 Key Limitations on Losses
- At-Risk Limitation: Limits the amount of loss you can deduct to the amount you have "at risk" in the activity. See IRS Form 6198.
- Passive Activity Loss (PAL): Prevents deducting losses from activities in which you don’t materially participate. Use IRS Form 8582 for reporting.
🧾 Basis Schedule & Documentation
To verify the allowable loss, review the shareholder’s or partner’s basis schedule. Pay close attention to:
- Initial capital contributions and additional investments
- Distributions received
- Allocated income/losses
- Loans affecting at-risk amounts
✅ Allocation Example
Let’s say a partner receives a $30,000 K-1 loss. If they only have $10,000 at risk, only that portion is eligible for deduction. If their passive income is $5,000, only that portion is currently deductible, with the rest carried forward.
📌 CPA Exam Tip
This topic falls under Representative Task REG-ARE-525. Be ready to analyze source documents and apply correct tax treatment under both at-risk and PAL rules.
🎧 Listen to the Podcast
If you want to go deeper with examples and walkthroughs, check out our podcast episode on this topic:
