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. Understanding how income from these entities is taxed and the various limitations on deducting losses is crucial for individuals involved in such ventures.

Income from Pass-Through Entities

Several common business structures operate as pass-through entities:

• Sole Proprietorships: The simplest form, where the business is owned and run by one person. Income and expenses are reported on Schedule C (Form 1040), Profit or Loss From Business, and the net profit or loss is directly included in the owner’s gross income under § 61(a)(2) (Gross income derived from business). Ordinary and necessary business expenses are deductible under § 162 (Trade or business expenses).
• Partnerships: 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. The allocation of income and losses is governed by the partnership agreement and § 704 (Partner’s distributive share).
• S Corporations: A corporation that has elected to pass its income, losses, deductions, and credits through to its shareholders. Like partnerships, 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).
• Limited Liability Companies (LLCs): An LLC is a business structure that provides limited liability to its owners (members). For tax purposes, an LLC can be treated as a sole proprietorship (if one member), a partnership (if multiple members), or a corporation (if it elects to be taxed as such). The tax implications depend on the chosen classification.

Income from pass-through entities is reported on the owners’ individual tax returns and is subject to their individual income tax rates. In addition to income tax, owners of sole proprietorships and partners are also subject to self-employment tax under § 1401 et seq. on their share of the business profits, which covers their Social Security and Medicare taxes. S corporation shareholders who actively work in the business are treated as employees and receive wages subject to employment taxes; any remaining profits are generally not subject to self-employment tax.

Loss Limitations from Pass-Through Entities

While pass-through entities allow owners to deduct their share of business losses, several rules can limit the amount of loss that can be deducted in a given year. These limitations are designed to prevent taxpayers from using business losses to excessively offset other sources of income. 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. Ta 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):

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.

At-Risk Rules (§ 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.

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

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

Active income: salaries and wages, guaranteed payment for services, business income or loss from activities in which taxpayer materially participates

Passive income: Income or loss from activities in which taxpayer does not materially participate (e.g., rental activities, limited partnership interest)

Portfolio income: Interest, dividends, annuities, royalties, capital gains and losses.

The PAL rules are designed to prevent taxpayers from using losses from passive activities to offset income from active businesses or other sources. A passive activity is generally defined as a trade or business in which the taxpayer does not materially participate, or any rental activity (with some exceptions for real estate professionals). Material participation generally means the taxpayer is involved in the operations of the activity on a regular, continuous, and substantial basis.

• Limitation: Losses from passive activities can only be deducted to the extent of income from other passive activities. For example, a loss from a rental property can offset income from another rental property or a passive business investment, but it cannot offset wages or active business income.
• Suspended Losses: 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.
• Exception for Real Estate Professionals: There is an exception to the passive activity rules for certain real estate professionals who meet specific criteria related to their involvement in real property trades or businesses.

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

For tax years beginning after December 31, 2020, and before January 1, 2026, 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.