Small Business Taxes & ManagementTM--Copyright 2013, A/N Group, Inc.
You can't deduct losses from a trade or business unless you materially participate in the business. If you don't materially participate, the income or loss, to you, from the business is passive. For example, you provided venture capital to help fund Madison, Inc., an S corporation that operates a car dealership. As a result you own 30% of the stock. Your only participation in the business is reviewing the monthly financials and spending a few hours a month providing business advice. You're not considered to be materially participating in the business. Thus, for your tax purposes, Madison Inc. is a passive activity. You can't deduct the losses currently. Instead, they're carried forward indefinitely and can be used to offset passive income from Madison, or another passive activity you may participate in. Fred Flood, the service department manager owns 10% of the stock works there full time. He materially participates and can take the loss.
Should Madison produce income, that income is taxable to you (unless there are offsetting losses from prior years or another activity). The same rules apply to some deductions, such as the Section 179 expense option, and credits.
These rules apply to S corporation shareholders, LLC members, partners, and sole proprietors.
In the example above, the treatment of the income or loss depends on whether or not you materially participate. In some cases the activity is inherently passive. For example, the long-term rental of a second home or the bare bones rental of a sailboat. In the case of rental real estate, the activity would be passive, regardless of participation, were it not for a special rule. As long as you actively participate, you can deduct up to $25,000 of losses annually (subject to some special rules). Active participation requires only a minimal involvement in the management--approving tenants, deciding on maintenance, etc.
The good news is that most small business owners easily meet the material participation requirement. On the other hand, if you have multiple businesses, invest in small businesses, etc. you should be aware of the rules.
A trade or business activity is not a passive activity if you materially participated in the activity. Material participation tests. You materially participated in a business for a tax year if you satisfy any of the following tests.
1. You participated in the activity for more than 500 hours.You did not materially participate in the activity under test (7) if you participated in the activity for 100 hours or less during the year. Your participation in managing the activity does not count in determining whether you materially participated under this test if:
2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.
3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year.
4. The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you did not materially participate under any of the material participation tests, other than this test.
5. You materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
6. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.
7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
In general, any work you do in connection with an activity in which you own an interest is treated as participation in the activity. But you can't treat the work you do in connection with an activity as participation in the activity if both of the following are true.
For example, you own a 51% interest in Madison, Inc. a marina operator with ongoing losses. You review the financials and other business records for a few hours every month, but are otherwise involved in other businesses. In order to meet the 500 hour participation test, you work on weekends and nights as a security guard. It's unlikely that work will allow you to meet the material participation test.
You can't count the work you do in your capacity as an investor in an activity as participation unless you are directly involved in the day-to-day management or operations of the activity. Work you do as an investor includes:
Your participation in an activity includes your spouse's participation. This applies even if your spouse did not own any interest in the activity and you and your spouse do not file a joint return for the year.
Most business owners will easily pass the test 1, more than 500 hours of participation. If you have more than one activity that can't be grouped, you should be able to meet test 4, significant participation or test 7. If you're a one-man show, you can qualify under test 2. If there's any question, you should consult your tax adviser. More than likely you'll have a number of options, but you've got to set up the fact pattern before the IRS questions your participation.
Real Estate Professional
Net rental real estate losses on your personal tax return are generally considered passive and limited to $25,000. The $25,000 exception is phased out $1 for every $2 that your modified AGI exceeds $100,000. Thus, if your AGI exceeds $150,000, no net losses can be taken (unless you sell your entire interest in the property). The losses can be carried forward and used in future years when your AGI is lower or passive income offsets the losses.
There's a special exception for real estate professionals. They are allowed to take such losses without any restriction. More than a few taxpayers have claimed to be real estate professionals. The IRS has challenged this position and usually won. You may qualify as a real estate professional if:
Thus, you have to pass two tests. First spend more than half your working time in real estate trades and spend more than 750 hours per year doing so. If you've got a regular job (not in the real estate field) you almost automatically fail the first test. For example, you work 9-5 for Madison Inc. as a medical technician. That amounts to 1,800 or so hours per year. You'd have to show you worked 1,801 hours in the real estate field. You'll have trouble convincing the IRS or a judge of that. If you're retired you could pass the first test. You might be able to pass the second test if you have several properties, but even that's tougher than it looks.
If you work in the real estate trades, it's much easier to qualify. Real estate trades can include work in a construction company, a real estate developer, a real estate management company, real estate broker, etc. If you're an employee you must have at least a 5-percent interest in the business. Thus, simply working as a real estate broker for Chatham Properties won't help.
The IRS has been aggressive in this area. You should keep a log to prove your time spent. There are other issues. Talk to your tax advisor.
Proof of participation. You can use any reasonable method to prove your participation in an activity for the year. You do not have to keep contemporaneous daily time reports, logs, or similar documents if you can establish your participation in some other way. For example, you can show the services you performed and the approximate number of hours spent by using an appointment book, calendar, or narrative summary. That's what the IRS says in Publication 925. But a contemporaneous log should be kept if you're close to a threshold or your participation isn't obvious. For example, you have a full-time job that involves business travel in addition to your interest in the activity in question.
Limited partner. If you owned an activity as a limited partner, you generally are not treated as materially participating in the activity. However, you are treated as materially participating in the activity if you met test (1), (5), or (6) under the seven material participation tests discussed above.
You are not treated as a limited partner, however, if you also were a general partner in the partnership at all times during the partnership's tax year ending with or within your tax year (or, if shorter, during that part of the partnership's tax year in which you directly or indirectly owned your limited partner interest).
Retired or disabled farmer and surviving spouse of a farmer. If you are a retired or disabled farmer, you are treated as materially participating in a farming activity if you materially participated for 5 or more of the 8 years before your retirement or disability. Similarly, if you are a surviving spouse of a farmer, you are treated as materially participating in a farming activity if the real property used in the activity meets the estate tax rules for special valuation of farm property passed from a qualifying decedent, and you actively manage the farm.
Corporations. A closely held corporation or a personal service corporation is treated as materially participating in an activity only if one or more shareholders holding more than 50% by value of the outstanding stock of the corporation materially participate in the activity.
Significant participation passive activity. A significant participation passive activity is any trade or business activity in which you participated for more than 100 hours during the tax year but did not materially participate. If your gross income from all significant participation passive activities is more than your deductions from those activities, a part of your net income from each significant participation passive activity is treated as nonpassive income.
If you're only business is Chatham LLC, a web developer, that has no other activities, you don't have to worry about grouping. But assume Chatham also owns several stores that sell personal computers and associated hardware. None of the stores are located in the same state as the web developer. Chatham has two activities. While there's common ownership, each activity is operated separately. Whether or not profits and losses of the two activities can offset each other depends on the facts and circumstances.
You can treat one or more trade or business activities, or rental activities, as a single activity if those activities form an appropriate economic unit for measuring gain or loss under the passive activity rules.
Grouping is important for a number of reasons. If you group two activities into one larger activity, you need only show material participation in the activity as a whole. But if the two activities are separate, you must show material participation in each one. On the other hand, if you group two activities into one larger activity and you dispose of one of the two, then you have disposed of only part of your entire interest in the activity. But if the two activities are separate and you dispose of one of them, then you have disposed of your entire interest in that activity.
Grouping can also be important in determining whether you meet the 10% ownership requirement for actively participating in a rental real estate activity.
Appropriate economic units. Generally, to determine if activities form an appropriate economic unit, you must consider all the relevant facts and circumstances. You can use any reasonable method of applying the relevant facts and circumstances in grouping activities. The following factors have the greatest weight in determining whether activities form an appropriate economic unit. All of the factors do not have to apply to treat more than one activity as a single activity. The factors that you should consider are:
1. The similarities and differences in the types of trades or businesses,
2. The extent of common control,
3. The extent of common ownership,
4. The geographical location, and
5. The interdependencies between or among activities, which may include the extent to which the activities:
1. Buy or sell goods between or among themselves,Example 1--Fred Flood owns a bakery and a movie theater at a shopping mall in Albany, NY and a bakery and movie theater in Syracuse, NY. Based on all the relevant facts and circumstances, there may be more than one reasonable method for grouping Fred's activities. For example, he may be able to group the movie theaters and the bakeries into:
2. Involve products or services that are generally provided together,
3. Have the same customers,
4. Have the same employees, or
5. Use a single set of books and records to account for the activities.
- One activity,
- A movie theater activity and a bakery activity,
- An Albany activity and a Syracuse activity, or
- Four separate activities.
Example 2--Sue is a member in Chatham LLC, which sells nonfood items to grocery stores. She is also a member in Madison LLC (a trucking business). Chatham and Madison are under common control. The main part of Madison's business is transporting goods for Chatham. Madison is the only trucking business in which Sue is involved. Based on the rules of this section, Sue treats Chatham's wholesale activity and Madison's trucking activity as a single activity.
As always, there are many fine points we haven't covered. The bad news is that it can get very complicated. The good news is, most small business owners won't have to face those complications. You should be aware that if you materially participate in the activity for less than 500 hours you've got to pass one of the other tests to qualify for material participation. You should also be aware that if you have more than one distinct activity or the activities are significantly geographically separated, you should talk to your tax adviser to determine if there's a problem in grouping them.
__ more than 500 hr. test
__ substantially all participation test
__ more than 100 hr. at least as much as anyone else test
__ significant participation activity; more than 100 hrs. per activity; more than 500 hrs. all activities
__ material participation 5 of 10 immediately preceding years
__ personal service activity; any 3 preceding years
__ facts and circumstances test
__ management involvement
__ grouping activities
__ limited partner
__ retired or disabled farmer
__ significant participation passive activity
__ activity disposed of during the year
__ separately stated items
__ carryforward of disallowed losses
__ rental of tangible personal property
__ self-charged interest
__ rentals to related business
__ active participation in real estate rental
__ former passive activities
__ 7 days or less average rental period
__ 30 days or less average rental and significant personal services
__ extraordinary personal services
__ rental of property to nonpassive activity
__ rental real estate and real estate professional
__ substantially appreciated property
__ rental of property where less than 30% of unadjusted basis is subject to depreciation
__ licensing of intangible property by pass-through entities
Copyright 2011-2013 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 12/04/13