Section 465(d) Carryover - Cash Flow Impacts
We recently received a call on the Bukers Hotline from an analyst who was spreading a Schedule C for a sole proprietorship. The analyst noticed an item of Other Expense listed in Part V titled “Section 465(d) carryover.” Their question to us was: What is this item of expense and how does it affect cash flow?
At-Risk Basis Explained
For starters, Section 465 of the tax code addresses the “at-risk” rules and limitations imposed on individuals conducting business activities through sole proprietorships, partnerships, and S Corporations. Essentially, the at-risk limitation for the individual equals the amount of money that they invested in the company plus their share of the company’s liabilities. In other words, their at-risk basis is the monetary extent to which they are “on the hook.” Their at-risk basis is further increased by additional cash or property contributions, their share of net income, and the value of additional liabilities assumed. Their at-risk basis can be decreased by their share of net losses deducted in a year and by any distributions received.
Section 465(d) Carryover and Cash-Flow Implications
For tax purposes, an owner of a sole proprietorship can only deduct losses up to the amount of at-risk basis they have in the current year. Any losses incurred in a year that exceed the owner’s at-risk basis cannot be deducted. These excess losses are disallowed and are carried forward to future years, as is permitted under Section 465(d). Hence, these disallowed losses due to at-risk limitations garner the name – Section 465(d) carryover.
But how can we use this information to help answer our analyst’s question? What do we do when we encounter a Section 465(d) carryover as an expense item on Schedule C? Let’s look at an example scenario to guide our analysis.
Example Scenario
Mark owns ABC Company, a sole proprietorship, and his at-risk basis in the company is $50,000. In Year 1, Mark’s company doesn’t perform well and incurs a $75,000 loss on its Schedule C. He is only able to deduct $50,000 on his tax return, which is equal to his at-risk basis, meaning the remaining $25,000 of losses are disallowed and carried forward under IRC Section 465(d). Since Mark takes a $50,000 deduction, his at-risk basis is reduced to zero. For cash flow purposes, we are still going to count the entire $75,000 as a cash outflow for Mark (assuming no other cash flow adjustments are required) even though he is only able to deduct $50,000 for tax purposes.
In Year 2, Mark contributed $40,000 of cash to his company which increased his at-risk basis accordingly. ABC Company has stabilized since its disappointing first year. As a credit analyst, you notice an item of Other Expense listed on Part V of Schedule C called “Section 465(d) Carryover” for $25,000. Since Mark’s at-risk basis in the sole proprietorship increased and he didn’t incur large losses in Year 2, the company is able to carry forward the disallowed loss from Year 1 and receive a tax deduction in Year 2 accordingly.
Rather than include the Section 465(d) carryover as a cash outflow in Year 2, we correctly add it back to cash flow after first deducting total expenses from Schedule C. Since we considered the entire $75,000 loss in Year 1 to be a cash outflow for the sole proprietorship, we cannot classify the 465(d) carryover in Year 2 as a cash outflow because that would result in double-counting the $25,000 disallowed expense. For cash flow purposes, we typically add back Section 465(d) carryovers because we accurately account for excess expenses in the year of disallowance.
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