Most newly formed businesses operate as pass-through entities – the business itself pays no taxes as taxable income is passed through to its owners. In recent years, there has been a proliferation of Limited Liability Companies (LLCs), which, in most instances, are treated as partnerships. Many newly formed corporations make an S corporation election shortly after being incorporated. When an individual is an owner of an interest in a partnership or S corporation, a Schedule K-1 is issued.
The K-1 recipient needs to determine whether they are nonpassive or passive with regard to the pass-through entity ownership interest. This can have a significant impact on the individual’s federal income taxes. If a taxpayer is nonpassive, any losses that are reported can be claimed against all other income. On the other hand, losses from a passive activity can only be claimed to offset income from other passive activities, unless the interest in the pass-through entity was disposed of. Passive activity losses that cannot be used in the year they were incurred are suspended and carried forward to subsequent years. A special rule applies to publicly traded partnerships (PTPs), whereby passive income and losses cannot offset passive income and losses from other sources.
There are seven criteria used in determining whether a taxpayer materially participated in a partnership or S corporation. Only one of the seven criteria below needs to be met to be treated as nonpassive.
1. Participation was for more than 500 hours;
2. Participation was substantially full participation in the activity by all individuals including non-owners (basically a one person business);
3. Participation for more than 100 hours was at least as much as that of any other individual including non-owners;
4. Participation was for more than 100 hours in each of two or more activities, aggregating to more than 500 hours;
5. Material participation was for any five of the 10 immediately preceding tax years;
6. Material participation was in a personal service activity (health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting) for any three preceding years; or
7. Based on all of the facts and circumstances, participation occurred on a regular, continuous and substantial basis during the tax year for more than 100 hours.
The IRS is routinely challenging taxpayers who claim sizable nonpassive losses. In its Audit Techniques Guide (ATG) for Passive Activity Losses, the IRS lists several examination techniques for the auditor, including:
- Review of W-2 forms and other nonpassive activities to determine how much time was spent on the activity in question.
- Determining the location for each activity. For example, if the activity occurred far from the taxpayer’s residence, how likely is it that the taxpayer spent substantial time on the activity?
- In reviewing hours, the auditor should look for “investor” activities – the time spent reviewing financial statements and monitoring the activity in a non-managerial capacity does not count.
Due to stringent limitations, few taxpayers can meet the facts and circumstances standard.
The ATG also lists indicators that the taxpayer did not materially participate, including:
- The taxpayer was not compensated for services.
- The taxpayer is elderly or has health issues.
- There is on-site management and/or employees providing day-to-day oversight of operations.
- The taxpayer has numerous other investments, rentals, business activities, or hobbies that absorb significant amounts of time.
States that piggyback the Internal Revenue Code, such as New York, follow the same treatment. On the other hand, states that do not piggyback the Internal Revenue code, such as New Jersey, have their own unique rules. The New Jersey gross income tax places income and losses into categories. For example, partnership income from a law firm can be offset by partnership losses from real estate holdings. Many states do not permit unused losses to be carried forward.
Neil Becourtney, CPA
CohnReznick LLP
