- December 8, 2011
The following article, prepared by the Firm’s Rich Lieberman, summarizes certain tax provisions which impact investors who are able to categorize investment losses as active instead of passive. As described in the following article, individuals looking to offset a 2011 business loss against 2011 non-passive income should take the time now to document such activity. We encourage you to contact Mr. Lieberman at 312/840-7011 or firstname.lastname@example.org for more information.
To combat the “cottage industry” in tax shelters that arose during the 1970s and early 1980s, the Tax Reform Act of 1986 added Internal Revenue Code (“IRC”) section 469, which limits an individual’s ability to deduct losses from businesses in which he or she does not materially participate, as well as from rental activities.
Generally, losses generated by passive activities may only be used to offset income generated by passive activities. IRC section 469(c) defines two types of passive activities:
A. Rentals, including equipment leasing and rental real estate; and
B. Businesses in which the individual does not materially participate (including activities from partnerships, S corporations and LLCs).
To avoid having a loss from an activity treated as a passive activity loss (“PAL”), an individual must “participate” in the activity. At the outset, it should be understood that the term “participate” is not synonymous with “working” in or being “employed” by the legal entity in which the activity occurs.
There are two distinct types of participation:
Material participation; and
Material participation generally applies to business activities. IRC section 469(h)(1) provides that an individual is treated as materially participating in an activity only if the individual is involved in the operations of the activity on a basis which is regular, continuous and substantial. If an individual is deemed to materially participate in an activity, his or her losses from the activity are treated as non-passive, which means that the losses are fully deductible against all income. If an individual does not “materially participate” in a business activity, losses from that activity are passive and generally are not deductible in the absence of passive income.
An individual materially participates in an activity only if he or she meets any one of the seven tests set forth in the regulations. The two “material participation” tests most often relied upon provide as follows:
A. The individual works more than 500 hours during the year in the activity (the “500-Hour Test”); or
B. The activity is a significant participation activity for the taxable year and the individual’s aggregate participation in all significant participation activities during that year exceeds 500 hours (the “SPA Test”).
For each significant participation activity, the regulations require:
• The individual to participate more than 100 hours during the year.
• The activity must be a business, i.e., it cannot be a rental or investment activity.
• The business must be a passive activity, i.e., if the individual satisfies the 500-Hour Test for the activity, the activity cannot be classified as a significant participation activity.
To satisfy the general recordkeeping requirements set forth in the regulations and substantiate participation in an activity, individuals may establish participation by any reasonable means. Such means include:
• An identification of the services provided; and
• The approximate number of hours spent, based on appointment books, calendars, or narrative summaries.
Contemporaneous daily records are not required if the individual’s participation can be reasonably established. The requisite standard for substantiating participation was succinctly summarized by the United States Tax Court in Estate of Stangeland v. Commissioner, T.C. Memo. 2010-185, as follows:
While contemporaneous records are not required, reasonable means may include appointment books, calendars, or narrative summaries. Sec. 1.469-5T(f)(4), Temporary Income Tax Regs., supra. The regulations do not allow a postevent "ballpark guesstimate", and we are not bound to accept the unverified, undocumented testimony of taxpayers.
Most of the cases involving the classification of losses as PALs are decided in favor of the IRS primarily because the taxpayer could not substantiate his or her participation in the activity. As the Tax Court made clear, little sympathy is shown to taxpayers who are only able to present unverified, undocumented accounts of participation.
Individuals looking to offset a 2011 business loss against 2011 non-passive income should take the time now, prior to year-end, to document their participation in the loss generating activity. If possible, individuals should prepare an activity log identifying the date, time spent, and description of the services performed in 2011. The activity log should also indicate how each event could be verified if requested by the Internal Revenue Service.
Waiting until the start of a tax audit to begin assembling the documents necessary to substantiate participation in a 2011 activity is much too late. The right time to begin preparing for a possible tax audit is during the tax year for which the loss is claimed. That means now is the best time to begin documenting your material participation in business activities generating 2011 losses.
Your Burke, Warren, MacKay & Serritella, P.C. tax and business advisor is available to help you prepare the required documentation. Mr. Lieberman can be reached at 312/840-7011 or email@example.com for more information.