When investing in pass-through entities—such as S corporations, partnerships, and LLCs—losses reported on Schedule K-1 can provide valuable tax deductions. However, these deductions are not unlimited. The tax law imposes four key limitations that apply in sequence. Understanding these rules is critical to avoid surprises at tax time and to maximize future tax benefits.

The first hurdle is the basis limitation. Before deducting a loss, an investor must have sufficient basis in the entity. Basis represents your investment in the entity, adjusted annually for contributions, distributions, income, and losses. For S corporations, this is stock or loan basis (direct shareholder loan only); for partnerships and LLCs, this is often referred to as outside basis. Losses are deductible only to the extent of this basis. If your basis is reduced to zero, excess losses are suspended and carried forward until additional basis is created, such as through new capital contributions, income allocations, or debt (in certain cases).

The next limitation is the at-risk rules. Even with adequate basis, losses are deductible only to the extent that the investor is considered “at risk” in the activity. The at-risk amount generally includes cash or property contributed, along with certain recourse debt for which the investor is personally liable. Unlike basis rules, at-risk calculations generally exclude nonrecourse debt where the investor does not bear personal economic risk. Any losses exceeding the at-risk amount are suspended and carried forward to future years.

Once the basis and at-risk limitations are satisfied, losses must also pass the passive activity loss (PAL) rules. Under these rules, losses from passive activities—those in which the investor does not materially participate—can only offset passive income, not wages, interest, dividends, or active trade or business income. Unused passive losses are suspended and carried forward until the investor generates passive income or disposes of the activity in a taxable transaction.

Finally, noncorporate taxpayers face the excess business loss limitation (EBL). Even after clearing the first three hurdles, business losses above a certain threshold—$610,000 for joint filers and $305,000 for single filers in 2025, adjusted annually for inflation—cannot be deducted in the current year. Instead, these excess amounts are treated as a net operating loss (NOL) carryforward and are subject to limitations in future years.

Tracking basis is particularly important for investors because it determines whether losses are deductible in the current year, helps preserve suspended losses for future use, and supports IRS compliance if the deductions are ever examined. Moreover, accurate basis tracking prevents surprises with distributions, as distributions in excess of basis can create taxable gain. For these reasons, maintaining a detailed and up-to-date basis schedule is one of the most important steps investors can take to optimize their tax outcomes and avoid unpleasant surprises.