#13 Reporting of Items from Pass through Entities Flashcards
(14 cards)
What rules do you need to know to calculate AGI when salary, capital gain dividends, and a partnership loss are involved?
1) Salary – Fully included in gross income.
2) Capital gain dividends – Included in gross income.
3) Partnership loss – Only deductible up to the partner’s basis. Excess loss is carried forward.
4) AGI = Salary + Capital gain dividends – Deductible partnership loss (limited to basis)
How do you determine net self-employment income for a cash-basis sole proprietor?
1) Start with gross business receipts (total income earned from self-employment).
2) Subtract only ordinary and necessary business expenses allowed on Schedule C (e.g., parts, advertising, utilities).
3) Exclude personal expenses like:
- Charitable contributions (deducted separately on Schedule A)
- Estimated income taxes (never deductible)
4) Formula:
Net SE income = Gross receipts - Allowable business expenses
When can passive activity losses (PALs) be deducted, and what type of income can they offset?
1) PALs can only be deducted against passive income.
- Passive income includes rental income and income from businesses in which the taxpayer does not materially participate.
- Example: Income from the rental of a residence (even if the taxpayer is involved) is classified as passive.
2) PALs cannot offset:
- Active income (e.g., wages, salaries, guaranteed payments, self-employment income).
- Portfolio income (e.g., interest, dividends, capital gains, annuities).
3) Key categories:
- Active income = Wages, self-employment, guaranteed payments.
- Portfolio income = Interest, dividends, royalties, capital gains.
- Passive income = Rental income, non-participation business interests (like limited partnerships).
4) Exception: Real estate professionals may treat rental income as non-passive if they meet both material participation and time requirements.
Bottom line: Passive losses can reduce passive gains — not wages, interest, or dividends.
What tax applies to income earned by a sole proprietor, and how does it differ from FICA tax?
1) Sole proprietors pay self-employment (SE) tax, not FICA tax.
- SE tax = Social Security + Medicare tax on net earnings from self-employment.
- The owner is treated as both employer and employee for tax purposes.
2) SE tax applies to:
- Net earnings from a trade or business (Schedule C).
- Partnership guaranteed payments.
- General partner’s share of ordinary income (K-1).
3) SE tax vs. FICA:
- FICA = Tax on employee wages (shared by employee and employer).
- SE tax = Paid entirely by the self-employed individual.
4) Exemption rule:
- No SE tax owed if SE income is less than $400 for the year.
Key point: A sole proprietor reports and pays SE tax on business income after subtracting ordinary and necessary business expenses.
What business expenses are NOT deductible when calculating net profit on Schedule C
1) Illegal expenses (e.g. referral fees that violate state law) are NOT deductible.
2) Government penalties (e.g. parking fines) are NOT deductible.
3) Only ordinary and necessary expenses that are legal and related to the business (e.g. auto rentals, legal referral fees) are deductible.
In the real estate broker case:
- Commission income = $100,000
- Deductible expenses = $2,000 (auto) + $20,000 (legal referral fees)
- Nondeductible = $8,000 (illegal referral fees) + $200 (parking fine)
Net profit = $100,000 - $2,000 - $20,000 = $78,000
Key Rules:
- Ordinary and necessary = deductible
- Illegal or penalty-related = NOT deductible
When can an individual deduct a loss on a personal-use transaction?
1) Losses from personal-use assets (like cars, furniture, or a home) are generally not deductible — they’re considered personal consumption losses.
2) Exception: A personal loss may be deducted only if it qualifies as a casualty or theft loss from a federally declared disaster.
3) Other deductible losses include:
- Trade or business losses
- Transactions entered into for profit (e.g. investments)
- Passive activity losses (limited to passive income)
Important note:
- Hobby losses are not deductible beyond hobby income.
- Losses on personal-use property sales are not allowed, even if under $3,000.
- Capital loss limits ($3,000 per year) only apply to transactions entered into for profit — not personal use.
Key rule: The only way a personal-use loss is deductible is if it’s a casualty or theft loss from a federally declared disaster area.
How do you determine the amount of a partnership loss a partner may deduct?
1) A partner can only deduct a loss up to their adjusted basis in the partnership at the end of the year.
2) Basis is adjusted annually as follows:
- Increased by: share of income (including capital gains), contributions, and liability increases.
- Decreased by: share of losses, withdrawals/distributions, and liability reductions.
3) Basis can never fall below zero — any excess loss is suspended and carried forward.
Example:
- Beginning basis = $75,000
- Add $30,000 capital gain
- Subtract $35,000 cash distribution
- Ending basis = $70,000
- Loss = $85,000 → deductible amount limited to basis = $70,000
- Excess $15,000 is carried forward
Key rule: A partner’s deductible loss is limited to their ending outside basis, even if the allocated loss is larger.
How much of a partnership loss can a partner deduct on their tax return?
1) A partner may only deduct a loss up to the lesser of:
- Their adjusted basis at year-end
- Their amount at risk (usually equals basis unless there’s nonrecourse debt)
2) Basis includes capital contributions, share of income, and liabilities, minus distributions and prior losses.
3) Amount at risk excludes nonrecourse debt unless the partner is personally liable for it.
Example:
- Ending basis = $10,000
- At-risk amount = $8,000
- Reported loss on K-1 = $12,000
- Deductible loss = $8,000 (lesser of basis and at-risk)
Key rule: A partner’s deductible loss is capped at the lower of basis or at-risk amount. The rest is suspended until limits are met in future years.
How are gains and losses treated on the sale of personal-use property?
1) Gains on personal-use property (e.g. car, furniture, home) must be recognized and reported as taxable income.
2) Losses on personal-use property are not deductible — they’re considered personal consumption losses.
3) This rule applies regardless of whether the property was sold at a gain or loss.
Example:
- Automobile 1: Basis = $20,000, Sold for $15,000 → $5,000 loss → not deductible
- Automobile 2: Basis = $10,000, Sold for $15,000 → $5,000 gain → must be reported
Key rule: You pay tax on gains from personal property, but you cannot deduct losses.
Which types of personal asset losses are deductible, and how much can reduce AGI?
Losses from personal-use property (e.g. cars, recreational items, hobby assets) are not deductible.
1) Losses are only deductible if from:
- Rental real estate (subject to active participation rules and AGI limits)
- Capital assets (e.g. stock) — but net capital losses are limited to $3,000 per year
2) Hobby losses and recreational use property losses are completely disallowed.
Example:
- Loss on rental property: $10,000 → fully deductible
- Loss on common stock: $10,000 → limited to $3,000
- Loss on personal-use automobile: $10,000 → not deductible
- Loss on show dog (hobby): $10,000 → not deductible
Total AGI reduction = $10,000 (rental) + $3,000 (stock) = $13,000
Key rule: Only rental and investment losses may reduce AGI — personal and hobby losses are never deductible.
Can a taxpayer deduct a loss on abandoned personal-use property like a home?
1) Losses on personal-use property (e.g. homes, vehicles, furniture) are not deductible, even if abandoned or sold at a loss.
2) Abandonment does not convert personal property into a deductible loss — it remains nondeductible unless used in a trade or business.
3) Only gains on personal-use property are recognized; losses are ignored for tax purposes.
Example:
- Bought home for $350,000
- Abandoned it when FMV was $300,000
- Realized loss = $50,000 → Not deductible
- Deductible loss on tax return = $0
Key rule: Losses on personal-use assets, even when abandoned, are never deductible on the tax return.
What are the rules for deducting promotional item expenses and distinguishing a business from a hobby?
Promotional items deduction rule:
- Fully deductible if cost is $4 or less per item
- Example: 50 items × $3 = $150 deductible
Hobby vs. business test:
- Must show profit in at least 3 of the last 5 years to be treated as a business
- If this test is met, losses and ordinary expenses are deductible on Schedule C
Example: Peabody had 3 profitable years → qualifies as a business → $150 fully deductible on Schedule C
What limitations apply to losses from a limited partnership interest and a sole proprietorship on an individual tax return?
Losses from pass-through entities like partnerships and sole proprietorships are subject to multiple layers of limitations:
1) Limited Partnership Loss (Passive Activity):
- Basis limitation: Cannot deduct more than your tax basis in the partnership.
- At-risk limitation: Cannot deduct more than what you are financially at risk for.
- Passive activity limitation: If you’re not materially participating, loss is passive and can only offset passive income.
- If no passive income exists, the loss is suspended and carried forward until passive income becomes available.
2) Sole Proprietorship Loss (Schedule C):
- Not subject to passive activity rules because it’s an active business.
- However, the Excess Business Loss (EBL) rule limits the amount of deductible loss from all non-passive business activities.
- In 2024, the EBL threshold is $305,000 (single) and $610,000 (married filing jointly).
- Any loss exceeding this is disallowed in the current year and treated as a Net Operating Loss (NOL) carryforward under Sec. 172.
Example:
- $15,000 partnership loss with $10,000 basis and no passive income → $0 deductible now
- $425,000 Schedule C loss → $305,000 deductible now, $120,000 becomes NOL
