Passive Activity Losses
The “passive loss rules” are aimed at preventing individual taxpayers from using their losses from passive activities to offset their income from active businesses. The rules operate by “disallowing” the current deduction of passive losses – the excess of an individual taxpayer’s losses from passive activities for the year over his or her income from such activities for the same year.
This excess is not completely disallowed; rather it is suspended and carried forward to such time as the taxpayer has passive income or disposes of his or her entire interest in the passive activity.
In most cases, a taxpayer would prefer not to have passive losses because they cannot be used to offset active income. Whether a trade or business activity is passive or active as to the taxpayer depends upon the taxpayer’s level of participation in the activity. If the taxpayer materially participates in the business, then the taxpayer’s share of losses arising from the business will not be treated as passive.
What Is A Passive Activity?
A passive activity is any trade or business in which the taxpayer does not “materially participate.” Generally, a taxpayer materially participates in a business if he or she is involved in the operations of the business on a regular, continuous, and substantial basis. Regulations promulgated by the IRS provide seven alternative tests to determine whether a taxpayer materially participates in a business activity.
In general, any work done by an individual (in whatever capacity) in connection with a business activity in which he or she owns an interest is treated as participation of the individual in the activity for purposes of these rules.
A taxpayer may establish the extent of his or her participation in an activity by any “reasonable means.” Although contemporaneous time reports, logs or similar documents are not required, they are worth the effort, as one taxpayer recently appreciated, to his relief.
Taxpayer’s Real Estate Activities
Taxpayer’s father funded three businesses for his children (including Taxpayer), and structured each business with one child as the 60% majority owner, and with the other two children each holding 20%.
Taxpayer owned 20% of KidCorp 1, an S corporation, and served on its board of directors. In early 2008, Taxpayer brought a derivative action against his sibling (the 60% owner) for mismanagement of the corporation. The litigation settled shortly thereafter, and during the balance of 2008 Taxpayer worked on behalf of KidCorp 1 to restore corporate assets to and to find additional investors for the corporation’s projects and to fill its capital needs.
In the latter half of 2008 the board of directors of KidCorp 1 named Taxpayer treasurer, made him an employee, and gave him an office at the company headquarters.
Taxpayer reported significant net operating losses (NOLs) arising out of KidCorp 1 on his 2008 personal income tax return, and carried them back to his 2006 return.
The IRS audited Taxpayer’s 2006 and 2008 returns, and determined no deficiency for 2008. However, it determined a deficiency for 2006 that was solely attributable to NOL carrybacks from 2008.
During the audit, Taxpayer’s sibling (the 60% shareholder against whom the derivative suit was brought) made inconsistent statements to the IRS about Taxpayer’s work for KidCorp 1, initially representing that Taxpayer “regularly and continuously works on behalf of the company,” then asserting that “[KidCorp 1] is a family owned company which does not create or maintain a record of the specific work activities, or the specific hours worked, by any Shareholder, Officer or Director,” and finally (after another dispute arose between the sibling and Taxpayer) submitting that Taxpayer did not perform any significant work for KidCorp 1.
The IRS issued a notice of deficiency for 2006 in which it recharacterized Taxpayer’s 2008 NOL from KidCorp 1 as passive instead of nonpassive. The Taxpayer had treated those losses as arising from a business in which he had materially participated. As permitted by the Code, he carried those losses back two years, to 2006, as a result of which he received a refund for that year. Passive losses cannot be carried back. Accordingly, the IRS’s notice of deficiency reduced the NOL for 2006, and denied the deduction for the NOL reported on Taxpayer’s 2008 return.
Taxpayer Goes to Court
The Tax Court considered whether Taxpayer had materially participated in KidCorp 1 during 2008. If he did, then the loss from that entity would not be subject to the passive loss limitation, described above, and would be respected as NOLs.
To establish the hours spent on an activity, the Court noted that taxpayers are not required to keep “[c]ontemporaneous daily time reports, logs, or similar documents” to substantiate their participation “if the extent of * * * [their] participation may be established by other reasonable means.”
Generally “reasonable means” includes “the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.” Taxpayers cannot merely make a “ballpark guesstimate” of their participation, the Court said.
According to the Court, Taxpayer presented credible testimony and phone records to show that he worked almost 700 hours for KidCorp 1 during 2008. Witnesses testified that he worked restoring corporate assets and seeking potential investors for the corporation’s projects and capital needs. Taxpayer presented phone records that further corroborated the witnesses’ accounts.
Taxpayer also produced KidCorp 1 corporate board meeting minutes and resolutions from 2008 naming Taxpayer as a director and treasurer of the corporation. Finally, he produced a Form W-2, Wage and Tax Statement, and biweekly earnings statements issued by the corporation to Taxpayer for 2008, confirming he was an employee.
On the basis of this evidence, the Court found that Taxpayer satisfied the material participation requirement by having participated in the business activity for more than 500 hours during the taxable year. It also found that Taxpayer satisfied the material participation requirement because “[t]he activity [was] a significant participation activity * * * for the taxable year, and the * * * [Taxpayer’s] aggregate participation in all significant participation activities during such year exceeds 500 hours.”
It is worth mentioning that, in the course of deciding in favor of Taxpayer, the Court also rejected two other arguments made by the IRS that are often applicable in the context of a close business: (1) that the Taxpayer’s work was not of a kind customarily done by owners, and (2) that the Taxpayer’s participation was that of an investor.
All That Ends Well?
The best time to prepare for an IRS audit of a particular tax year is well before the return for that year is prepared – indeed, the preparation should occur during the course of the year, as the transactions that will be the subject of the tax return develop and occur. The key to this preparation is knowing in advance what the IRS and the courts will be looking for in the way of important factors and substantiation.
As a general rule, a taxpayer would be well-served to consult with his or her tax advisers during the course of any “business event” that may reasonably be expected to generate an economic result that will have to be reported on a return – being mindful, of course, not to lose sight of the business goal at issue.
This will enable the taxpayer to develop, on a contemporaneous basis, the appropriate back-up for a reporting position. After all, years may pass before a transaction or return is challenged by the IRS. During the interim, records may be lost or destroyed, people may disappear or die, people may forget, and relationships may sour. A taxpayer cannot leave it to chance that the appropriate support will be available when the time comes.