Under IRC section 469(c)(1), the losses from a passive activity can generally be deducted only against passive income. So the characterization of an activity as active or passive controls whether a taxpayer can deduct the losses of such activity against other active income. An activity is not characterized as an active trade or business with respect to the taxpayer unless the taxpayer materially participates in the activity. A taxpayer is treated as materially participating in an activity by meeting at least one of the seven tests in Treas. Reg. section 1.469-5T. As an example, a taxpayer is considered to materially participate if: (1) the taxpayer participates in the activity for more than 500 hours during the year (first test); or (2) on the basis of all of the facts and circumstances, the taxpayer’s participation was regular, continuous, and substantial during the year (seventh test). In determining whether any of the tests are satisfied, the participation of the taxpayer’s spouse is considered.
A taxpayer can demonstrate his or her participation in an activity by any reasonable means. Contemporaneous daily time logs, calendars, appointment books, reports, or similar documents aren’t required. Reasonable means includes identification of services performed over a period of time and the approximate number of hours spent performing the services during the period, based on appointment books, calendars, or narrative summaries.
If you have any questions about how to properly characterize an activity as active or passive, or how to best structure your business and investment activities, contact one of our tax and business attorneys at 937-223-1130 or Jsenney@pselaw.com.
AND ONE MORE THING. An S corporation shareholder may deduct his or her pro-rata share of any loss sustained by the corporation. However, the shareholder’s deduction of such loss is limited to the sum of the shareholder’s basis in his or her stock and the amount of any debt owed to him or her by the corporation. For this purpose, a shareholder’s guarantee of a loan made by a third person to the S corporation is not treated as a debt from the S corporation to the shareholder. In a recent tax court case, the Court looked at whether the guarantee of a corporate note to a bank would give a shareholder basis in his or her stock or debt at the time the corporation defaulted and the Bank looked to the shareholder-guarantor for payment. The Court found that the mere fact that the corporation defaulted and thereby rendered the shareholder-guarantor liable was not sufficient. The Court found that, the shareholder-guarantor had not changed his position to that of the primary obligor prior to the default. If you have questions about deductibility of losses, contact 937-223-1130 or Jsenney@pselaw.com.