When a tax practitioner reviews a client’s K-1 that passes through losses from a partnership, one of the primary considerations that comes (or should come) to the practitioner’s mind is, “Does the partner have enough basis to take this loss?”
Adequate basis, however, is only one sieve through which a pass-through loss must flow before determining its deductibility. Subsequent to passing the basis test, the next test to be applied is that of the “at-risk” test of Sec. 465. After all, a partner may have sufficient basis for taking a loss but may not have a sufficient amount at risk for the loss to be deductible.
An overview of the at-risk provisions
Congress originally enacted the at-risk provisions as part of the Tax Reform Act of 1976 to deter deductions from losses generated by tax shelters. Prior to the enactment, a taxpayer could deduct losses to the extent of his or her basis in the partnership. Non-recourse loans provided additional basis against which losses could be taken while limiting the partner’s economic risk. Although IRS attempted to limit this practice, its attempts were only marginally effective until the enactment of IRC Sec. 465.
As they currently stand, the at-risk rules apply to all activities with the exception of equipment leasing by a qualified C corporation.1 In regard to activities carried on by a partnership, the Sec. 465 provisions are applicable at the partner level rather than at the partnership level.2
Determining the partner’s amount at-risk
For purposes of Sec. 465, a partner is considered at risk with respect to an activity for: