Nicholas Fiore
Nicholas Fiore
Understanding the complicated at-risk rules

These important rules affect taxpayers’ ability to deduct business losses.

January 15, 2015
by Nicholas Fiore, J.D.

Under Sec. 465, a taxpayer that engages in certain activities may deduct losses from those activities only to the extent the taxpayer is “at risk” for those activities at the end of the tax year. Any loss from one of these activities that is not allowed in that tax year under the at-risk rules is carried over and treated as a deduction allocable to the same activity in the next year. If losses from an at-risk activity are allowed, these losses are subject to recapture in later years if the at-risk amount is reduced below zero.

Taxpayers must carefully examine and track these activities to determine whether they are separate activities or whether they must be aggregated before applying the at-risk rules.

Taxpayers subject to at-risk rules

Under Sec. 465(a)(1), the at-risk rules apply to individuals (including partners and S corporation shareholders), estates, trusts, and certain closely held corporations.

Closely held corporations. For this purpose, a C corporation is closely held if, at any time during the last half of the tax year, more than 50% in value of the outstanding stock is owned (directly or indirectly) by or for five or fewer individuals (i.e., using the personal holding company stock ownership rules of Sec. 542(a)(2)).

Leasing by closely held corporations. For a closely held corporation actively engaged in equipment leasing, the equipment leasing activity is treated as a separate activity; losses from this activity are not covered by the at-risk rules (Sec. 465(c)(4)).

Activities covered by the at-risk rules

The at-risk rules apply to activities that taxpayers conduct as a trade or business or in the production of income, including:

  • Holding, producing, or distributing motion picture films or videotapes;
  • Farming;
  • Leasing Sec. 1245 property, including personal property and certain other depreciable or amortizable tangible property;
  • Exploring for (or exploiting) oil and gas; and
  • Exploring for (or exploiting) geothermal deposits (for wells started after September 1978).

But the at-risk rules also cover any activity other than those described above that is carried on as a trade or business or for the production of income (Sec. 465(c)(3)).

Qualifying corporations. A qualifying corporation is not subject to the at-risk rules for any qualifying business that it conducts. For these corporations, each qualifying business is treated as a separate activity.

A qualifying corporation is a closely held corporation that is not a personal holding company or a personal service corporation (as defined in Sec. 269A(b)(2) but determined by substituting 5% for 10% in Sec. 269A(b)(2)) (Sec. 465(c)(7)).

Qualifying businesses. A qualifying business is any active business if:

  • During the 12-month period ending on the last day of the tax year, the corporation had at least one full-time employee whose services were in the active management of the business and three full-time nonowner employees whose services were directly related to the business.
  • Business deductions allowable to the corporation as business expenses and as contributions to certain employee benefit plans exceed 15% of the business’s gross income.
  • The business is not an excluded business. (Generally, excluded businesses include equipment leasing or any business involving the use, exploitation, sale, lease, or other disposition of master sound recordings, motion pictures, videotapes, or tangible or intangible assets associated with literary, artistic, musical, or similar properties.)

Separation of activities. Generally, a taxpayer must treat its activity involving each film or videotape, item of leased Sec. 1245 property, farm, oil and gas property, or geothermal property as a separate activity. In addition, each investment that is not part of a trade or business is treated as a separate activity.

A partnership or S corporation must treat all leasing of Sec. 1245 property placed in service in a tax year as one activity.

Aggregation of activities. Activities considered a trade or business are treated as one activity if:

  • The taxpayer actively participates in the management of the trade or business; or
  • The trade or business is carried on by a partnership or S corporation, and 65% or more of its losses are allocable to persons who actively participate in the trade or business’s management.

Active participation. This is a facts-and-circumstances determination. Factors indicating active participation include making decisions involving the operation or management of the activity, performing services for the activity, and hiring and discharging employees.

Factors that indicate a lack of participation include lack of control in managing and operating the activity, having authority only to discharge the activity’s manager, and having an activity manager who is an independent contractor (rather than an employee).

At-risk amounts

Under Sec. 465(b)(1), a taxpayer is at risk for money and the adjusted basis of any property contributed to an activity and amounts borrowed for use in the activity, if the taxpayer is personally liable for repayment or the taxpayer pledged property (other than the property used in the activity) as security for the loan.

Certain borrowed amounts excluded. A taxpayer may not be considered at risk if he or she borrowed money from a person with an interest in the activity or from someone related to a person with an interest in the activity (Sec 465(b)(3)(B)).

Reduction of at-risk amounts. The amounts at risk in any activity may be reduced by any losses allowed in previous years. These amounts may also be reduced because of distributions received from that activity; debts changed from recourse to nonrecourse; or the initiation of a stop-loss or similar agreement. Note: If the at-risk amount is reduced below zero, any previously allowed losses are subject to recapture.

Amounts not at risk

Under Sec. 465(b)(4), a taxpayer is not at risk for amounts protected against loss through nonrecourse financing, guarantees, stop-loss agreements, or other similar arrangements.

Nonrecourse financing. Nonrecourse financing is financing for which a taxpayer is not personally liable. If a taxpayer borrows money to contribute to an activity and the lender’s only recourse is to the taxpayer’s interest in the activity or the property used in the activity, the loan is nonrecourse.

Generally, a taxpayer is not at risk for his or her share of any nonrecourse loan used to finance an activity or to acquire property used in the activity unless the loan is secured by property not used in that activity. However, a taxpayer will be considered at risk for qualified nonrecourse financing secured by real property used in the activity of holding real property. “Qualified nonrecourse financing” is financing for which no one is personally liable for repayment and that is:

  • Borrowed by the taxpayer in connection with the activity of holding real estate;
  • Secured by real property used in the activity;
  • Not convertible from a debt to an ownership interest; and
  • Loaned or guaranteed by any federal, state, or local government, or borrowed by the taxpayer from a qualified person (Sec. 465(b)(6)(B)).

A qualified person is a person who actively and regularly engages in the business of lending money (e.g., a bank), subject to certain exceptions.

Other loss-limiting arrangements. Any capital contributed to an activity is not at risk if the taxpayer is protected against economic loss by an agreement or arrangement for compensation or reimbursement.

Recapture rules

If the amount a taxpayer has at risk in any activity is less than zero at the end of the tax year, the taxpayer must recapture at least a portion of the previously allowed losses. The taxpayer calculates the recapture amount by adding to its income from the activity for the year the lesser of (1) the negative at-risk amount (treated as a positive amount) or (2) the total amount of losses, deducted in previous tax years after 1978, less any amounts previously added to the taxpayer’s income from that activity under this rule (Sec. 465(e)(2)).

The recapture income is not used to reduce the current year net loss from the activity; instead the taxpayer treats the recaptured amount as a deduction for the activity in the next year.

Form 6198

Form 6198, At-Risk Limitations, is used to compute the deductible loss from an at-risk activity. A taxpayer must file Form 6198 if he or she has a loss from any part of an activity that is covered by the at-risk rules, and he or she is not at risk from some of the investment in that activity.

 Rate this article 5 (excellent) to 1 (poor). Send your responses here.

Nicholas Fiore, J.D., is an attorney with more than 30 years of tax editing and writing experience, primarily with The Tax Adviser. He has worked on the Uniform CPA Examination, written and edited both tax and nontax continuing education courses, and provided tax and business information for a variety of audiences.