Understanding At-Risk Rules for Partnerships and S Corporations

The U.S. tax code allows business owners to deduct losses from their businesses, but these deductions are subject to strict limitations. One of the most critical limitations is the at-risk rules under IRC §465, which restricts loss deductions to the amount a taxpayer has personally at risk in a business.

For partnerships and S corporations, at-risk rules prevent taxpayers from deducting losses beyond their actual investment and economic exposure. This ensures that taxpayers do not artificially claim excessive deductions.

In this blog post, we’ll explore the history, purpose, mechanics, examples, and impact of the at-risk rules on business owners.

Legislative History and Purpose of IRC §465

The at-risk rules were enacted as part of the Tax Reform Act of 1976 to combat tax shelter abuses. Before these rules, taxpayers could claim unlimited losses from leveraged investments even when they had minimal personal financial exposure.

Congress designed the at-risk rules to ensure that:

1. Taxpayers only deduct losses for which they have a real economic risk.

2. Loss deductions align with actual financial exposure.

3. Artificial tax shelters are limited.

   
   

These rules primarily affect real estate investors, limited partners, and S corporation shareholders, who may contribute little personal capital while leveraging debt financing.

How the At-Risk Rules Work

Under IRC §465, a taxpayer’s deductible loss is limited to the amount they have "at risk" in the activity at the end of the tax year.

What Counts as At-Risk Amounts?

A taxpayer’s at-risk amount includes:

✅ Cash contributions to the business.

✅ Adjusted basis of contributed property (property contributed to the partnership or S corp).

✅ Personal recourse loans (where the taxpayer is personally liable).

✅ Qualified nonrecourse financing (for real estate investments only).

What Does Not Count as At-Risk?

🚫 Nonrecourse loans (except for real estate qualified nonrecourse financing).

🚫 Loans guaranteed by someone else (unless the taxpayer is personally liable).

🚫 Non-contributed business assets.

Example: At-Risk Limitations in Action

Scenario: A Partner Investing in a Business

Lisa joins a partnership and contributes:

• $50,000 in cash

• A vehicle worth $20,000 (basis = $15,000)

The partnership also takes out a $100,000 loan, but Lisa is not personally liable for the debt.

Lisa’s At-Risk Basis Calculation:

Component	Amount Considered At-Risk
Cash Contribution	$50,000
Basis in Property Contributed	$15,000
Nonrecourse Loan	$0
Total At-Risk Amount	$65,000

If the partnership reports a $100,000 loss for the year, Lisa can only deduct $65,000 of her share. The remaining $35,000 loss is suspended until she increases her at-risk basis (e.g., contributing more capital or assuming personal liability for a loan).

How At-Risk Rules Affect Partnerships and S Corporations

Partnerships (Form 1065)

• Partners calculate their at-risk amount separately from their capital accounts.

• Limited partners typically have lower at-risk amounts because they are not personally liable for partnership debts.

• Recourse loans increase at-risk basis only for the partners who are personally liable.

S Corporations (Form 1120S)

• Shareholders’ at-risk amounts are based on direct contributions and personal loan guarantees.

• Unlike partnerships, S corp shareholders cannot count entity-level debts unless they personally guarantee them.

• Shareholder loans to the S corp increase at-risk basis (e.g., if a shareholder lends money to their S corp, they can deduct losses up to that amount).

  
  

Suspended Losses and Carryforward Rules

If a taxpayer’s share of business losses exceeds their at-risk amount, the excess loss is suspended and carried forward until they increase their at-risk amount.

To restore suspended losses, taxpayers can:

✅ Contribute additional capital.

✅ Personally guarantee business loans.

✅ Convert nonrecourse debt into recourse debt.

Impact of At-Risk Rules on Business Owners

1. Prevents Artificial Loss Deductions

   • Business owners cannot deduct losses they are not truly exposed to.

   • Prevents tax shelters from using excessive debt financing to generate paper losses.

2. Limits Tax Benefits of Debt Financing

   • Nonrecourse loans do not increase at-risk basis (except for real estate).

   • Businesses must consider how to structure debt to maintain deductibility.

3. Affects Investor Decisions

   • Limited partners and S corp shareholders must assess at-risk limitations before investing.

   • Personal guarantees and capital contributions become key factors in structuring ownership.

4. Creates Tax Compliance Challenges

   • Tax preparers must track at-risk basis separately from tax basis and capital accounts.

   • Business owners may be surprised when losses are suspended and not immediately deductible.

     
     

Final Thoughts

The at-risk rules under IRC §465 are a critical part of the tax code, ensuring that business owners and investors only deduct losses tied to their actual financial risk.

For partnerships and S corporations, these rules impact tax planning, financing decisions, and loss utilization. Business owners should carefully monitor their at-risk basis and consider strategies to maximize deductions while staying compliant.

Understanding these rules can help businesses make smarter financial decisions and avoid unexpected tax liabilities. If you are dealing with at-risk limitations, consulting with a tax professional can help you navigate complex tax rules effectively.