If a shareholder materially participates in the operations of an S corporation, the passthrough of nonseparately stated (ordinary) income or loss is nonpassive. The income or loss passed through is passive if the shareholder does not materially participate. Congress gave the IRS broad powers to determine whether income or loss from an activity is active or passive (Sec. 469(l)).
A shareholder materially participates in an S corporation if the shareholder or the shareholder’s spouse is involved in the corporation’s trade or business on a regular, continuous, and substantial basis (Secs. 469(h)(1) and (h)(5)). Temporary regulations expand the definition of material participation by providing six objective tests and one subjective test for determining whether a taxpayer materially participates in an activity. This column discusses three tests that practitioners are likely to encounter when dealing with S corporation shareholders.
The first test states that a shareholder who participates in the activity for more than 500 hours during the tax year will be deemed to materially participate.
The second and third tests apply to a shareholder who no longer meets the 500-hour requirement. These state that the taxpayer materially participates in an activity if the individual materially participated:
1. For any five tax years during the ten immediately preceding tax years; or
2. In a personal service activity for any three tax years preceding the tax year (Temp. Regs. Sec. 1.469-5T(a)).
The years of participation do not have to be consecutive. A personal service activity for these purposes is an activity in the field of health (including veterinarians under Rev. Rul. 91-30), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.
The two tests based on previous participation are designed to prohibit a taxpayer from converting nonpassive income to passive income by cutting back on the hours worked in the business.
Under the five-out-of-ten-year test, an S corporation shareholder who materially participates in the business for at least five years and then retires will continue to receive nonpassive income or loss from the corporation through the sixth tax year following retirement (Regs. Sec. 1.469-5(k), Example (5)). If the shareholder materially participated in a personal service activity for three years, the nonseparately stated income or loss will never be passive.
A taxpayer cannot bypass the rules by having the spouse work in the business. Participation by a spouse (whether or not the spouse has an ownership interest) is considered participation of the shareholder (Sec. 469(h)(5); Temp. Regs. Sec. 1.469-5T(f)(3)).
Planning tip: These rules can be favorable if the S corporation passes through nonseparately stated loss (or other nonpassive losses) and the shareholder is deemed to have materially participated. If the activity is not a personal service activity, the losses are nonpassive for the first six years after the shareholder retires and can offset other nonpassive income. For a personal service activity, the losses will continue to be nonpassive for as long as the shareholder has an interest in the activity.
Example 1: D is 62 years old. He started S Corp., a department store, 25 years ago and now has varied sources of income. His grown children, who own 49% of the stock, are active in S . However, D makes all major decisions and spends 35 hours a week at the S store. D has a relatively stable income consisting of $50,000 salary from S , portfolio income of $45,000, and S passthrough income of $30,000. In addition, D is a limited partner in a partnership that is projected to pass through a $40,000 loss to him for each of the next several years. D decides to retire and turn over all the corporation’s management to his children, although he continues to own 51% of the stock.
materially participates in
’s operation, the income from
will be nonpassive and
cannot offset it with passive
’s adjusted gross income (AGI)
in the years before his retirement
is $125,000, as determined in
Exhibit 1. The limited partnership loss will carry forward and can be deducted in the future when D has passive activity income or disposes of his entire interest in the partnership.
Example 2: D has retired, transferred management to his children, and is no longer active in the business. D no longer receives a salary, but he maintains a level income by receiving $50,000 annually from his retirement plan. Passthrough income from S remains at $30,000. For the first six years of retirement, D is deemed to materially participate, and his AGI continues to be $125,000, as computed in Exhibit 2.
Beginning with the seventh year after D ’s retirement, the passthrough income from S is passive activity income, and D can deduct the loss from the limited partnership to the extent of his passive income. D ’s AGI then is $95,000, as computed in Exhibit 3.
If D works part-time in the business, his tax planner must be on guard for activities in which he significantly participates. Generally, significant participation occurs when the taxpayer works in an activity for more than 100 but fewer than 500 hours in a year. If the taxpayer works for more than 500 hours in all significant participation activities combined, he is deemed to materially participate in all such activities. For example, if D works 400 hours in S and 300 hours in another trade or business, he is deemed to materially participate in both businesses. In that situation, when the planner makes the five-out-of-ten-year test, those significant participation years will be counted as material participation years.
Converting Nonpassive Business Income into Passive Income
The regulations make it very difficult for a taxpayer to convert nonpassive business income into passive income. If a taxpayer has materially participated in a business for any five out of the previous ten tax years, six full tax years must elapse from when the taxpayer ceases to materially participate before income converts to passive from nonpassive. Taxpayers who have materially participated for any three years in a personal service activity can never convert income from that activity to passive income.
Planning opportunities do arise for taxpayers after they have discontinued material participation in an S corporation for six years (if the activity is not a personal service activity). Once a shareholder has not materially participated in a business for any five of the previous ten tax years, the shareholder can invest in a passive activity, and the passive income from the S corporation will be available to offset passive loss from the investment.
Changing Participation to Increase Nonpassive Losses
A taxpayer who has not been materially participating in a business may start materially participating. This causes the income or loss to change from passive to nonpassive. If the business had passive losses while the taxpayer was not materially participating and the taxpayer has not deducted those losses, a special rule allows the taxpayer to offset those losses against nonpassive income from the same activity while he or she materially participates. Any loss not applied in that manner remains passive, and the taxpayer can apply it only against passive income (Sec. 469(f)(1)).
Example 3: D has not materially participated in S for several years. The business suffers a downturn and begins to incur losses. D resumes management responsibility in S , and the corporation returns to profitability. The income from S can offset the losses carried forward from S because D ’s participation changed from not material to material. D cannot offset the losses from other passive activities against the active income from S ; thus, D cannot use the partnership losses until he has passive activity income.
This case study has been adapted from PPC’s Tax Planning Guide—S Corporations, 25th Edition, by Andrew R. Biebl, Gregory B. McKeen, George M. Carefoot, and James A. Keller, published by Practitioners Publishing Company, Ft. Worth, TX, 2010 ((800) 323-8724; ppc.thomson.com).
Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.