Footnotes · for the preparer’s desk
A K-1 with a loss in box 1 is a question, not a deduction.
Four limits stand between the loss and the 1040, and they go in a fixed order.
Most of the trouble comes from running them out of order, or skipping the first one.
When a client brings a Schedule K-1 showing an ordinary loss, the software will happily put it on Schedule E and reduce the tax. Whether the law allows that depends on four separate tests, applied in a required sequence: basis first, then at-risk, then passive activity, then the excess business loss limit. A loss has to clear each gate before the next gate sees it, and whatever is stopped at each gate is suspended in a different place, under different rules, with a different path to being used later.
This page is the desk procedure for an S corporation loss, with the partnership differences called out where they matter. It assumes the entity return is done and the K-1 is in hand. The order is the whole point; if nothing else, keep the order.
The sequence is fixed by the regulations and by the forms themselves.
| Gate | Authority | Form | What stops here | Where it waits |
|---|---|---|---|---|
| 1. Basis | §1366(d) | 7203 | Loss exceeding stock plus debt basis | Carried forward indefinitely to the same shareholder; restored only by new basis |
| 2. At-risk | §465 | 6198 | Loss exceeding the amount at risk | Carried forward to the same activity |
| 3. Passive | §469 | 8582 | Loss from an activity without material participation, beyond passive income | Carried forward; released by passive income or a full taxable disposition |
| 4. Excess business loss | §461(l) | 461 | Aggregate business loss over $256,000 single / $512,000 joint (2026) | Becomes a net operating loss the next year |
Each gate applies only to what came through the one before. A $90,000 loss with $30,000 of basis is a $30,000 loss at the at-risk gate; the other $60,000 is a basis carryforward and never reaches Forms 6198, 8582 or 461. Software applies these in order if the inputs are entered in the right places; it cannot apply a basis limit it was never told about, and it will not warn you that Form 7203 is blank.
A fifth limit, the net operating loss 80%-of-taxable-income rule, applies the following year to whatever §461(l) converted.
↑ Back to topForm 7203 is required for any year the shareholder claims a loss or deduction, receives a distribution, disposes of stock, or receives a loan repayment from the corporation. Prepare it every year regardless; the alternative is reconstructing it later.
Beginning stock basis is last year’s ending basis. For the first year it is cost (purchase), the donor’s basis (gift), or fair market value at death (inheritance), or the basis of property contributed under §351.
The ordering rules inside a year (§1367 and Reg. §1.1367-1(f)) are where the first trap sits. Stock basis is adjusted in this order:
Distributions come out before losses. A shareholder with $40,000 of beginning basis, a $50,000 loss, and $40,000 of distributions has basis of zero after step 2, deducts none of the loss, and has no taxable distribution. If the distributions had been $60,000, $20,000 would be a capital gain under §1368(b)(2) and none of the loss is allowed. Clients see a loss year and take money out; the return then shows a gain. The explanation is this ordering rule and nothing else.
A shareholder may elect (Reg. §1.1367-1(g)) to take losses before nondeductible expenses, which preserves basis for the loss at the cost of carrying the nondeductible items forward. The election is binding for future years. Consider it only when the nondeductible items are large.
Debt basis exists only for bona fide indebtedness of the corporation that runs directly to the shareholder (Reg. §1.1366-2(a)(2)). A personal guarantee of a bank loan creates no basis until the shareholder actually pays on the guarantee (Estate of Leavitt, 4th Cir. 1989; Maloof, 6th Cir. 2006). A loan from a related entity the shareholder owns creates no basis. “Back-to-back” loans (bank to shareholder, shareholder to corporation) work if the shareholder is the real borrower and the second leg is a real loan, documented. Debt basis is reduced by losses only after stock basis reaches zero, and is restored by subsequent net increases before stock basis is restored (§1367(b)(2)). A repayment of reduced-basis debt is income to the shareholder; capital gain if the loan is evidenced by a note, ordinary if open account (Rev. Rul. 64-162; Reg. §1.1367-2).
Form 7203 mechanics: Part I computes stock basis through the ordering above; Part II computes debt basis loan by loan, with repayments; Part III allocates the allowable loss pro rata among the loss items when total losses exceed basis (Reg. §1.1366-2(a)(5)), so an ordinary loss and a §1231 loss and a charitable contribution are each cut by the same percentage. The disallowed portion of each carries forward as that same item.
The amount at risk (§465(b)) is the money and adjusted basis of property the shareholder contributed, plus amounts borrowed for which the shareholder is personally liable or has pledged unrelated property, less amounts protected by nonrecourse financing, guarantees from others, or stop-loss agreements. For most closely held S corporations the at-risk amount equals stock basis plus direct-loan debt basis, and the gate is open. It closes when the shareholder’s own loan to the corporation was itself borrowed from a related party or on a nonrecourse basis, or when the activity is one of the historic abuse areas (equipment leasing, films, farming with nonrecourse debt). Form 6198 is required when there is a loss and any amount is not at risk. Each activity is tested separately unless aggregated under §465(c)(3)(B). A recapture under §465(e) applies if the at-risk amount later goes negative.
↑ Back to topWhatever survives basis and at-risk is tested for material participation under Reg. §1.469-5T(a). The seven tests, with the ones that matter at the desk:
A spouse’s participation counts (§469(h)(5)). Investor-type work (reviewing financials, monitoring) does not count unless the person is also involved in day-to-day operations. Reasonable means of proof are allowed (calendars, logs, appointment books, narrative summaries), but a reconstruction after the audit letter arrives is weighed accordingly (Moss, 135 T.C. 365; Hassanipour, T.C. Memo 2013-88).
If the shareholder does not materially participate, the loss is passive, goes to Form 8582, and is allowed only against passive income from any source. The $25,000 rental allowance does not apply to an operating business. Suspended passive losses are released in full in the year the shareholder disposes of the entire interest in a fully taxable transaction to an unrelated party (§469(g)); a gift releases nothing (the suspended loss is added to the donee’s basis), and a sale to a related party under §267(b) suspends the loss until the related party disposes of it.
A passive S corporation loss that is allowed against passive income from a rental is a common and legitimate use. A passive loss “allowed” against wages because the material-participation box was checked by default is the most common error on these returns.
↑ Back to topAfter the three gates above, all of the taxpayer’s business losses for the year (Schedule C, E business items, F, and the K-1 losses that got this far) are netted against all business income, including W-2 wages for this purpose under the 2025 act’s clarification (verify: the 2025 act’s treatment of wages in the §461(l) computation). If the net loss exceeds $256,000 single or $512,000 joint for 2026 (the 2025 act reset the indexing base; the figure is lower than 2025’s), the excess is disallowed on Form 461 and becomes a net operating loss carryforward under §172, usable the following year against up to 80% of taxable income. The 2025 act made §461(l) permanent. It does not matter whether the shareholder materially participated; §461(l) is a dollar limit, not a participation test. Capital gains and losses are outside the computation except that net capital gain from business property is counted as business income only up to the lesser of the capital gain net income from business or total capital gain net income.
↑ Back to top| S corporation | Partnership | |
|---|---|---|
| Basis form | Form 7203, attached | None; preparer’s worksheet (the K-1 item L capital account is tax-basis capital, which is outside basis minus the partner’s share of liabilities, not outside basis) |
| Entity-level debt in basis | Never, unless the shareholder is the lender | Yes: the partner’s share of recourse and nonrecourse liabilities (§752; K-1 item K) is in outside basis |
| Debt in at-risk amount | Only direct loans the shareholder is liable on | Recourse debt the partner is liable for, and qualified nonrecourse financing on real property (§465(b)(6)); other nonrecourse debt is in basis but not at risk |
| Ordering: distributions vs. losses | Distributions first (§1367) | Distributions first too (Reg. §1.704-1(d)(2)), with the same result: a distribution in excess of basis is gain under §731 and the loss is suspended under §704(d) |
| Guaranteed payments | n/a (salary is W-2) | Ordinary income to the partner regardless of partnership loss; they do not increase basis except as income |
| Suspended basis-limited loss on sale | Lost | Lost (§704(d) carryforward is personal) |
| Decrease in liabilities | n/a | A deemed distribution (§752(b)); a debt payoff or refinancing can produce gain with no cash |
The practical consequence: a passive partner in a leveraged real estate LLC usually has basis and at-risk amount to absorb losses that a passive S corporation shareholder with the same cash investment would have suspended at gate 1. The passive gate then catches both.
↑ Back to topBeginning stock basis per the 2025 Form 7203: $35,000. No debt basis; Dale guaranteed the corporation’s $200,000 line of credit but has paid nothing on it. During 2026 he contributed $10,000 and took $20,000 of distributions. Nondeductible expenses on the K-1: $2,000. He worked 300 hours; his co-owner worked 1,800. Dale is single with $190,000 of wages and $15,000 of net rental income from a condo.
Gate 1, basis. $35,000 + $10,000 = $45,000; less distributions $20,000 = $25,000 (no gain; distributions did not exceed basis); less nondeductible $2,000 = $23,000. Allowable loss: $23,000. Suspended under §1366(d): $67,000. The guarantee adds nothing. Ending basis: zero.
Gate 2, at-risk. His contributions are his own money; the $23,000 is at risk. Passes.
Gate 3, passive. 300 hours; the co-owner worked more, so tests 1, 2 and 3 fail; no prior-year history for 5 or 6. The $23,000 is passive. Form 8582: offset against the $15,000 of rental income (also passive). $15,000 allowed; $8,000 suspended under §469.
Gate 4, §461(l). $15,000 is far below $256,000. Passes.
Result on the 1040: $15,000 of the $90,000 reduces taxable income. $67,000 waits for basis; $8,000 waits for passive income or a sale. If Dale had instead loaned the corporation $60,000 of his own money in December, documented by a note, basis would have been $83,000, the allowable loss $83,000, and the passive gate would have suspended $68,000 of it; nothing more would have reached the return this year. Basis is necessary, not sufficient.
No. The corporation tracks AAA and retained earnings; basis is each shareholder’s own number and is affected by things the corporation doesn’t see (stock purchased from another shareholder, inherited stock, the shareholder’s own loans). Ask for the prior Form 7203 or build one.
Not until the shareholder actually pays on it. A guarantee is a contingent obligation; the Fourth, Sixth and other circuits have said so for decades, and the 2014 regulations confirm it. Payment on the guarantee creates debt basis in the amount paid.
Only if he materially participates (for a sole owner who works the business, test 1 or 2 is usually met) and he has basis. Sole ownership doesn’t supply basis; capital contributions and direct loans do.
Verify them. Reconstruct basis from the first S year forward with the K-1s and the shareholder’s records; if the prior preparer’s numbers hold up, carry them. If they don’t, the correct carryforward is what the reconstruction shows, and the client may need to hear that some of the loss was never there.
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Written for the Tax Shop desk; figures are for the 2026 tax year as currently published. Items marked (verify) are to be confirmed against primary sources before the figures freeze in December. Last updated October 16, 2026.
