What Are at-Risk Rules?

At-risk rules are tax shelter laws that limit the amount of allowable deductions that an individual or closely held corporation can claim for tax purposes as a result of engaging in specific activities–referred to as at-risk activities–that can result in financial losses. A closely held corporation is defined by the IRS as a corporation that has more than 50% of its outstanding stock owned by five (or fewer) individuals at any time during the last half of the tax year.

At-risk rules are detailed in Section 465 of the Internal Revenue Code (IRC). These rules originated with the enactment of the Tax Reform Act of 1976; they were intended to help guarantee that losses claimed on returns are valid and that taxpayers do not attempt to manipulate their taxable income using tax shelters.

Key Takeaways

  • At-risk rules are tax shelter laws that limit the amount of allowable deductions that an entity can claim as a result of engaging in specific activities–referred to as at-risk activities–that may result in financial losses.
  • At-risk rules originated with the enactment of the Tax Reform Act of 1976; they were intended to help guarantee that losses claimed on returns are valid and that taxpayers do not attempt to manipulate their taxable income using tax shelters.
  • If a specific investment has no risk, or limited risk, the entity may be disallowed from claiming any losses that it incurred when filing an income tax return.
  • The amount that a taxpayer has at-risk is measured annually at the end of the tax year.
  • An investor's at-risk basis is calculated by combining the amount of the investor's investment in the activity with any amount that the investor has borrowed or is liable for with respect to that particular investment.

Understanding at-Risk Rules

The IRC permits certain losses incurred from investments to be deducted in order to reduce the tax liability of an entity. For the losses to be deducted, the tax code stipulates that the entity's activity (via making the investment) must have caused the entity to experience a certain level of risk. If a specific investment has no risk, or limited risk, the entity may be disallowed from claiming any losses that it incurred when filing an income tax return.

The amount that a taxpayer has at-risk (also called their "at-risk basis") is measured annually at the end of the tax year. An investor's at-risk basis is calculated by combining the amount of the investor's investment in the activity with any amount that the investor has borrowed or is liable for with respect to that particular investment. An investor's at-risk basis may be increased annually; this would occur if the investor made any additional contributions to the investment, or by the amount of income they receive from the investment (in excess of deductions). At-risk basis is decreased annually by the amount by which deductions exceed income and distributions. 

Specifically, at-risk rules are intended to prevent investors from writing off more than the amount they invested in a business, generally a flow-through entity. Businesses structured as flow-through entities include S corporations, partnerships, trusts, and estates.

A taxpayer cannot deduct any more than the amount of money that they had at risk at the end of the tax year in any activity for which the taxpayer was not a material participant.

In addition, a taxpayer can only deduct amounts up to the at-risk limitations in any given tax year. Any unused portion of losses can be carried forward until the taxpayer has enough positive at-risk income to allow the deduction.

Example of at-Risk Rules

For example, assume an investor invests $15,000 in limited partnership (LP) units (a type of flow-through entity). The business structure of an LP is such that this investor shares the profits or losses of the business pro-rata with other partners and owners, as is characteristic of investing in flow-through entities.

Assume that the business goes downhill, and the investor’s share of the loss incurred is $19,000. Since they are only able to deduct their initial investment in the first year, they will have an excess amount of loss which will be suspended and carried forward. In this situation, their excess loss is their share in the limited partnership’s loss minus their initial investment (or $4,000). If this investor decided to put an additional $10,000 towards this investment the following year, this investor's at-risk limit will be $6,000, because the suspended loss is then subtracted from the amount of the additional investment.