The passive activity rules
generally limit your losses from
passive activities to your passive
activity income. Generally, you are
in a passive activity if you have a
trade or business activity in which
you do not materially participate
during the tax year, or you have a
rental activity.
The passive activity rules apply to
personal service corporations and
closely held C corporations.
Personal service corporation - For
the passive activity rules, a
corporation is a personal service
corporation if it meets all of the
following requirements.
It is not an S corporation.
Its principal activity during the
"testing period" is performing
personal services, defined later.
The testing period for any tax year
is the previous tax year. If the
corporation has just been formed,
the testing period begins on the
first day of its tax year and ends
on the earlier of:
The last day of its tax year, or
The last day of the calendar year in
which its tax year begins.
Its employee-owners substantially
perform the services in (2). This
requirement is met if more than 20%
of the corporation's compensation
cost for its activities of
performing personal services during
the testing period is for personal
services performed by
employee-owners.
Its employee-owners own more than
10% of the fair market value of its
outstanding stock on the last day of
the testing period.
Personal services. Personal services
are those performed in the fields of
accounting, actuarial science,
architecture, consulting,
engineering, health (including
veterinary services), law, and the
performing arts by employee-owners.
Employee-owners - A person is an
employee-owner of a personal service
corporation if both of the following
apply.
He or she is an employee of the
corporation or performs personal
services for, or on behalf of, the
corporation (even if he or she is an
independent contractor for other
purposes) on any day of the testing
period.
He or she owns any stock in the
corporation at any time during the
testing period.
Closely held corporation. For the
passive activity rules, a
corporation is closely held if all
of the following apply.
It is not an S corporation.
It is not a personal service
corporation (defined earlier).
At any time during the last half of
the tax year, more than 50% of the
value of its outstanding stock is,
directly or indirectly, owned by
five or fewer individuals.
"Individual" includes certain trusts
and private foundations.
More information
See Publication 925.
Generally, a passive activity is any
rental activity OR any business in
which the taxpayer does not
materially participate. Non-passive
activities are businesses in which
the taxpayer works on a regular,
continuous, and substantial basis.
In addition, passive income does not
include salaries, portfolio, or
investment income.
As a general rule, the passive
activity loss rules are applied at
the individual level. Although
Internal Revenue Code Section 469
was enacted to discourage abusive
tax shelters, its impact extends far
beyond shelters to virtually every
business or rental activity whether
reported on Schedules C, F, or E, as
well as to flow through income and
losses from partnerships, S-
Corporations, and trusts. Generally,
the law does not apply to regular
C-Corporations although it does have
limited application to closely held
corporations.
Types of Income and Losses
Income and losses on a tax return
are divided into two categories:
Passive: Rentals and businesses
without material participation. A
limited partner is generally passive
due to more restrictive tests for
material participation. As a result,
limited partners will generally have
passive income or losses from the
partnership.
Non-passive: Businesses in which the
taxpayer materially participates.
Also, salaries, guaranteed payments,
1099 commission income and portfolio
or investment income are deemed to
be non-passive. Portfolio income
includes interest income, dividends,
royalties, gains and losses on
stocks, pensions, lottery winnings,
and any other property held for
investment.
Income and losses from the following
activities would generally be
passive:
Equipment leasing
Rental real estate (with some
exceptions)
Sole proprietorship or farm in which
the taxpayer does not materially
participate
Limited partnerships with some
exceptions
Partnerships, S-Corporations, and
limited liability companies in which
the taxpayer does not materially
participate
Non-passive Activities
Income and losses from the following
activities would generally be
non-passive:
Salaries, wages, and 1099 commission
income
Guaranteed payments
Interest and dividends
Stocks and bonds
Sale of undeveloped land or other
investment property
Royalties derived in the ordinary
course of business
Sole proprietorship or farm in which
the taxpayer materially participates
Partnerships, S-Corporations, and
limited liability companies in which
the taxpayer materially participates
Trusts in which the fiduciary
materially participates
"Although Internal Revenue Code Section 469 was enacted to discourage abusive tax shelters ... its impact extends far beyond shelters to virtually every business or rental activity."
Gregory J. Cook, EA, CPA+
Accredited Tax Advisor
Past President Alabama Society of Enrolled Agents
Past President Alabama Association of Accountants
contact:
secure email 1-800-551-6253 voice mail 117
Cook and Co., Enrolled Agents are licensed by the U.S. Treasury Department
to represent taxpayers before the Internal Revenue Service (IRS). Greg Cook is a
Certified Public Accountant (CPA) licensed by the states of Alabama and Tennessee.
