There Are Two Kinds of Passive Activities: Rentals, including both equipment and rental real estate, regardless of the level of participation and businesses in which the taxpayer does not materially participate on a regular, continuous, and substantial basis.This information is provided as a public service, and should not be construed as individual accounting or tax advice. For information on how these general principles apply to your situation, please consult your Cook & Co. Agent.
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.
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
Income and losses from the following activities would generally be non-passive:Salaries, wages, and 1099 commission income
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
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 also an Accredited Tax Advisor and a Certified Public Accountant (CPA) licensed by the states of Alabama and Tennessee.
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.