Section 465 of the Internal Revenue Code (IRC), also known as the at-risk rules, is part of the Tax Reform Act of 1976. These tax regulations were enacted at a time when tax rates were 70% and the tax laws were being heavily manipulated in an effort to reduce taxable income. One approach taxpayers used to reduce taxable income was to shelter it using losses in investments financed through loans not collectable from the taxpayers.
What Are At-Risk Rules?
At-risk rules prevent taxpayers from claiming losses on their taxes that are greater than what they have at risk in a business and could actually lose. Only the amount of capital a partner can lose can be counted toward their at-risk basis. A partner’s at-risk basis is calculated by adding the amount the partner has contributed to a business and the amount the business has borrowed for which the partner is personally liable or has pledged property as security.
Before the at-risk rules were adopted, the amount partners could write off in losses was equal to their outside tax basis in the partnership. The outside tax basis in a partnership included both recourse and nonrecourse liabilities, which opened a large loophole. Because nonrecourse liabilities (debt the taxpayer is not personally responsible for) were used to determine a partner’s outside tax basis, taxpayers were able to claim losses far greater than what they actually lost. Section 465 and at-risk tax basis were created to stop taxpayers from abusing this loophole.
Who Needs to Determine Their At-Risk Basis?
Most companies in the United States are small businesses and not subject to corporate income taxes. Instead, the profits generated by these small businesses flow through the company to the owners and they are taxed under the individual income tax laws. These types of entities are called passthrough businesses and include the following structures:
- Sole proprietorships
- Limited liability companies
Calculating a Partner’s At-Risk Basis in a Partnership
At-risk rules were designed to stop investors from deducting more than they had invested in a business — typically a passthrough business entity. Only the amount of capital an investor is risking — or might lose — can be included in an investor’s at-risk tax basis. To calculate at-risk basis in a partnership, start with the amount of capital the partner has invested in the business. Then, add the amount of any loans the partner has borrowed or is personally liable for that have been used to fund the partnership’s business activities.
At-risk basis is calculated at the end of every tax year. Partners’ at-risk basis increases when they add additional investments to the business or receive income from the business in excess of deductions. At-risk basis decreases if the amount in deductions exceeds the amount of income received.
Get the Latest At-Risk Basis Information from CCH® CPELink
For the latest information on at-risk basis and IRC Section 465, rely on CCH CPELink. Among our popular self-study courses, we offer Basic Partnership Taxation, which reviews the most current developments for at-risk basis in a partnership