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DanielleCPA, Certified Public Accountant (CPA)
Category: Tax
Satisfied Customers: 789
Experience:  Years of Experience in Business & Personal Taxes
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My adult daughter and her ex-husband own a small restaurant;

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My adult daughter and her ex-husband own a small restaurant; she is 60% owner. Although their separation agreement specifies distribution of profits or losses her ex has paid out nothing to her when the business reports positive earnings. She receives a Form K documenting her share of reported profits. Since she doesn't ever get paid for these reported profits is she still liable for the fed tax on them? This has pushed her tax bracket up for several years. Also when there has been a loss she is told she can't deduct the loss since she is not active in the business. Is this correct?
Welcome and thanks for your question!

Sorry to hear about your daughter's situation. If your daughter is receiving a K-1, then the business is structured/taxed as either an S corporation or partnership. Because both S Corps and partnerships are not taxed at the federal level, their owners receive K-1s reporting their share of the profits and losses. The owners are required to report the numbers on the K-1 on their personal return, regardless of whether the owner received any payment on these profits. So, unfortunately, your daughter does need to report the income even though her ex-husband is not paying her.

Owners that materially participate in the business are allowed to deduct their losses to the extent they have basis. Owners that do not materially participate are treated as passive owners and the IRS limits their abilities to deduct losses. Passive activity rules state that all income must be reported but losses are only deductible to the extent the individual has passive income from other activities. Unfortunately, if your daughter is not a material participant and does not have other sources of passive income, her share of the losses are not deductible. However, losses limited by the passive activity rules do carry over to future years and can be deducted against future income. Any unused losses become fully deductible in the year a business is disposed of through a sale or otherwise.

The question is - does your daughter meet the material participation criteria? If she does, then she would be able to deduct her losses, assuming she has basis. IRS Publication 925 lists 7 tests to determine if they materially participate in the business for a particular year.

Now, a little bit of good news - Because owners are taxed on profits regardless if they personally received any payments, they have the ability to take tax-free distributions in future years to the extent they have "basis" in their investment. Basis can be a complicated calculation depending on the circumstances, but generally would be your daughter's initial investment in the business plus/minus her share of accumulated profits/losses less any distributions she received . Your daughter may receive a basis calculation as part of her K-1 package, as I know many accountants include it as a standard part of the K-1 packages they provide.

I wish I could have offered you better news, but please let me know if you need clarification or if you have further questions on this subject and I will gladly assist you further.
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Customer: replied 3 years ago.

Thanks for the quick and complete reply. This is the first time I've used this service and I'm likely to use it again. Laughing

You're welcome. It was my pleasure. I'm glad I was able to assist you.