2.4 Income (loss) from Business Activities and Loss Limitations

Module Overview

Taxpayers can engage in various trade or business activities for profit. We will delve into the income and loss reporting from the three schedules: Schedule C (Profit or Loss from Business), Schedule E (Supplemental Income and Loss), and Schedule F (Profit or Loss from Farming). Those schedules represent the primary avenues from reporting all non-W2 business income and loss for individual taxpayers. While each schedule serves a distinct purpose, they share fundamental commonalities.

• Reporting Net Income (loss): The core function of all three schedules is to calculate the net profit or loss from a business activity. The net profit or loss derived from each schedule ultimately flows directly to Form 1040. This figure directly impacts the taxpayer’s Adjusted Gross Income (AGI).
• Loss Limitations:  Loss limitation rules need to be applied to ensure that deductions claimed reflect actual economic losses and prevent the abuse of tax laws for shelter purposes. These rules are applied in a specific order and are dependent on the type of the activities. Any losses suspended can be carried forward to future years.
• QBI Deductions: Qualified business income deduction could potentially apply to the profit from each schedule if the underlying activity constitutes a “trade or business” for purposes of Section 199A.

Income (loss) from Trade or Business Activities and Qualified Business Deductions

Schedules Reporting Trade or Business Activities

Income (loss) from trade or business activities can be from different sources. This section elaborates on the types of activities and the reporting nuances for each schedule.

Schedule C: Profit or Loss from Business (Sole Proprietorship)

Schedule C is the foundational form for individual self-employment. It caters to individuals who operate a business or practice a profession as a sole proprietor, meaning there’s no legal separation between the individual and their business for tax purposes.

Common Types of Activities Reported on Schedule C:

• Independent Contractors and Freelancers: This vast category includes individuals providing services directly to clients, such as consultants, software developers, writers, graphic designers, and various tradespeople.
• Small Business Owners:  Individuals running small retail stores, service-based businesses (e.g., beauty salons, tutoring services, landscaping), or small-scale manufacturing operations as a single member of LLC.
• Gig Economy Workers: The burgeoning gig economy frequently necessitates Schedule C reporting for income and expenses from platforms like ride-sharing services (Uber, Lyft), food delivery (DoorDash), and other on-demand work.

Schedule E: Supplemental Income and Loss

Schedule E encompasses various forms of supplemental income and loss not captured by Schedule C or F. Its primary focus is on passive activities and the flow-through of income from entities taxed as partnerships or S corporations.

Types of Activities and Income Reported on Schedule E:

• Rental Real Estate and Royalty Income:
  • Residential Rental Property: Income and expenses from renting out residential units, including houses, apartments, and vacation homes.
  • Nonresidential Rental Property: Income and expenses from renting commercial properties, office spaces, or undeveloped land.
  • Royalty Income: Income received for the use of intellectual property (e.g., patents, copyrights), natural resources (e.g., oil, gas, mineral rights), or other intangible assets.
• Income (Loss) from Pass-Through Entities: Pass-through entities are business structures where the entity itself is not subject to income tax. Instead, the entity’s income, losses, deductions, and credits are “passed through” to the owners (partners, shareholders, or members) and reported on their individual income tax returns- Form 1040 Schedule E
  • Partnerships: Income and losses from partnerships flow through to the partners as dictated by the partnership agreement and IRC Section 704. Partnerships is an association of two or more persons to carry on a trade or business. The partnership itself files an information return (Form 1065), and each partner receives a Schedule K-1 detailing their share of the partnership’s income, losses, deductions, and credits. Partners are taxed on their distributive share of income, as outlined in § 701 (Partnership not subject to income tax) and § 702 (Income and credits of partner), regardless of whether the income is actually distributed.
  • S Corporations: An S corporation is a type of corporation that elects to pass its corporate income, losses, deductions, and credits through to its shareholders for federal tax purposes, as provided by IRC Section 1366. S corporations file an information return (Form 1120-S), and shareholders receive a Schedule K-1 reporting their share of these items. The tax treatment is governed by § 1361 et seq. (Subchapter S – Tax Treatment of S Corporations), with income and losses generally passing through under § 1366 (Pass-through of items to shareholders).
  • Estates and Trusts: Beneficiaries of estates and trusts receive a Schedule K-1 (Form 1041) that reports their share of the entity’s income or loss, which is then reported on Schedule E.
    Real Estate Mortgage Investment Conduits (REMICs): Holders of REMIC interests receive a Schedule Q (Form 1066) reporting their share of the REMIC’s income or loss, which is subsequently reported on Schedule E.

Schedule F: Farm Income and Loss

Schedule F reports a broad spectrum of agriculture activities for individual farmers.

Common Types of Activities Reported on Schedule F:

• Crop Farming: Growing and selling various crops such as grains, fruits, vegetables, and specialty crops.
• Livestock and Poultry Farming: Raising and selling animals for meat, dairy, eggs, or other products.
• Horticulture: Growing and selling plants, flowers, and nursery stock.
• Forestry Operations: Income and expenses related to timber harvesting, though specific reporting may vary depending on the nature and scale of the operation.
• Other Agricultural Activities: This can include custom harvesting, agricultural services, and the direct sale of farm products at farmers’ markets.

Qualified Business Income Deduction (§ 199A)

The Qualified Business Income (QBI) Deduction, enacted under the Tax Cuts and Jobs Act (TCJA) of 2017, is a significant tax benefit for owners of pass-through entities, such as sole proprietorships, partnerships, S corporations, and certain limited liability companies (LLCs). Also referred to as the Section 199A deduction, it allows eligible taxpayers to deduct up to 20% of their qualified business income (QBI) from their federal income taxes. This deduction aims to provide tax relief to small business owners, aligning their tax treatment with the reduced corporate tax rates introduced by the TCJA.

QBI is the net income (profit) from a qualified trade or business, calculated as the business’s gross income minus allowable business expenses. A business must be conducted in the U.S. and qualify under Section 199A. Specified Service Trades or Businesses (SSTBs), such as law or accounting, face additional restrictions at higher income levels. When a taxpayer has multiple business activities reported on Schedules C, E, and F, the QBI deduction is calculated by aggregating the QBI from each qualified trade or business, and applying limitations based on taxable income, W-2 wages or UBIA. The QBI deduction is calculated and reported on either Form 8995 (Simplified Computation) or Form 8995A (Regular computation).

Loss Limitation Rules

Loss limitation rules are primarily designed to prevent taxpayers from unduly using losses from certain activities to offset other, higher-taxed income. Without these limitations, individuals might engage in business primarily for tax benefits rather than genuine economic profit. These rules are applied in a specific order, which is crucial for determining the amount of deductible loss. The primary loss limitation rules include basis limitations, at-risk rules, passive activity loss (PAL) rules, and the excess business loss limitation. It’s important to note that these loss limitations are generally applied in a specific order. Typically, the basis limitations are applied first, followed by the at-risk rules, then the passive activity loss rules, and finally the excess business loss limitation. Tax basis limitation and at-risk limitation are applied at entity/activity level. PALs and excess business loss limitation will be applied at the individual tax return level. A loss must clear each hurdle to be deductible. For example, even if a taxpayer has sufficient basis and is at risk for the amount of the loss, it may still be disallowed if it is considered a passive activity loss and the taxpayer has no passive income to offset it.

Basis Limitations (§ 704(d) for Partnerships, § 1366(d) for S Corporations):

Application to Schedule E: Partners and S corporation shareholders can only deduct losses to the extent of their tax basis in the partnership or S corporation. A partner’s basis generally includes their contributions to the partnership, their share of partnership income, and certain partnership liabilities. An S corporation shareholder’s basis typically includes their contributions to the corporation and direct loans they have made to the corporation. Losses that are disallowed due to insufficient basis can be carried forward indefinitely and deducted in future years when the owner has sufficient basis.

Basis limitations generally do not apply directly to Schedule C or F activities in the same way they do for pass-through entities. For a sole proprietorship (Schedule C) or a farming business (Schedule F), the taxpayer is the business, and their “basis” is essentially their at-risk amount in the business. Therefore, for these direct ownership structures, the at-risk rules effectively cover the concept of investment limitation.

At-Risk Limitations (§ 465):

The at-risk rules further limit the deductibility of losses to the amount the taxpayer has at risk in the activity. The amount at risk generally includes the taxpayer’s cash contributions and the adjusted basis of other property contributed to the activity, as well as certain amounts borrowed for use in the activity for which the taxpayer is personally liable. Nonrecourse debt (debt for which the taxpayer is not personally liable) generally does not increase the amount at risk. Losses that are disallowed under the at-risk rules can be carried forward indefinitely and deducted in future years when the taxpayer has an increased amount at risk.

Losses from Schedule C, Schedule E, or Schedule F are always subject to the at-risk limitations under IRC Section 465. This means that if the taxpayer has invested less than the amount of the loss (e.g., if they funded the business with nonrecourse debt where they are not personally liable), their deductible loss will be limited to their at-risk amount.

Passive Activity Loss (PAL) Limitations (§ 469):

The primary limitation under IRC Section 469(a) states that losses from passive activities can only be deducted to the extent of income from other passive activities. Losses that are disallowed under the PAL rules are considered “suspended passive losses” and can be carried forward indefinitely. These suspended losses can be deducted in future years when the taxpayer has passive income or when they sell their entire interest in the passive activity. The fundamental purpose of the PAL rules is to limit the ability of taxpayers to use losses from passive activities to offset income from active businesses or other sources (such as active income or portfolio income).

Under the passive activity loss rules, all income and loss items are sorted into three categories.

• Passive income: Income or loss from activities in which taxpayer does not materially participate (e.g., rental activities, limited partnership interest). Material participation generally means the taxpayer is involved in the operations of the activity on a regular, continuous, and substantial basis.
• Portfolio income: Portfolio income includes Interest, dividends, annuities, royalties, capital gains and losses. The Internal Revenue Code (IRC) doesn’t have a single, direct section explicitly titled “Definition of Portfolio Income.” Instead, portfolio income is defined largely by exclusion—it refers to income specifically excluded from the definition of passive income under the passive activity loss (PAL) rules in IRC Section 469(e)(1)(A).
• Active income: An activity in which the taxpayer does materially participate generates active income. It includes salaries and wages, guaranteed payment for services, business income or loss from activities in which taxpayer materially participates.

The very nature of the activities reported on each schedule dictates the typical application of PAL rules: Schedule E often involves investments or activities designed to be passive or where material participation is absent, while Schedules C and F primarily reflect businesses where the taxpayer is directly and actively involved.

Key Exceptions to PAL Limitations:

• Exception for Real Estate Professionals (IRC Section 469(c)(7)): There is a significant exception for individuals who qualify as “real estate professionals.” If they meet specific rigorous criteria regarding their involvement in real property trades or businesses, their rental activities are not automatically treated as passive. If they also materially participate in those rental activities, any losses generated can be deducted against other forms of income (active or portfolio), bypassing the PAL limitations.
• $25,000 Special Allowance for Rental Real Estate (IRC Section 469(i)): For taxpayers who “actively participate” in rental real estate activities (a lower standard than material participation), a limited amount (up to $25,000) of passive rental losses may be deducted against non-passive income. This allowance phases out for higher-income taxpayers.
• Publicly Traded Partnerships (PTPs) (IRC Section 469(k)): PTPs have a unique rule: passive losses from a specific PTP can only offset passive income from that same specific PTP. These losses cannot offset passive income from other PTPs or other non-PTP passive activities. Suspended PTP losses are also only deductible when income is generated by that specific PTP or upon the full disposition of the interest in that specific PTP.

Noncorporate taxpayers (individuals, estates, and trusts) who have passive activity losses subject to these limitations must use Form 8582, “Passive Activity Loss Limitations,” to calculate the amount of passive loss allowed for the current tax year. Form 8582 aggregates income and losses from all passive activities to determine the overall limitation. The allowable loss calculated on Form 8582 is then transferred to the appropriate lines on Schedule E.

Excess Business Loss Limitation (§ 461(l)):

Noncorporate taxpayers (including individuals, estates, and trusts) are subject to a limitation on the amount of deductible business losses. This limitation, known as the excess business loss limitation, restricts the total amount of net business losses that can offset other income. These amounts of limitation are adjusted annually for inflation and reported on Form 461. Business losses include those from sole proprietorships, partnerships, and S corporations. Any business losses exceeding these thresholds are considered excess business losses and are not deductible in the current year. Instead, these excess losses are treated as net operating losses (NOLs) and can be carried forward to future tax years.

Income from pass-through entities is a significant component of many individuals’ taxable income. While these structures offer the benefit of passing through losses, the deductibility of these losses is subject to several complex limitations under the Internal Revenue Code. Understanding the basis limitations, at-risk rules, passive activity loss rules, and the excess business loss limitation is crucial for effective tax planning for individuals involved in pass-through entities. Careful tracking of basis amounts at risk, and the level of participation in business activities is essential to maximize the deductibility of losses and manage overall tax liability.

The excess business loss (EBL) limitation is calculated and reported on Form 461, “Limitation on Business Losses.”