To understand the different tax treatments of different types of investments, taxpayers need to be familiar with the different categories of income. As a general rule, income can be categorized as falling into one of the following categories: active income, passive activity income, and portfolio income.
Active income is income for services rendered such as salaries, wages, or income from a trade or business that the taxpayer materially participates in. Active income commonly is called earned income. Passive activity income is income from a passive activity, which is an activity in which the taxpayer does not materially participate or, subject to certain exceptions, a rental activity. Portfolio income is income, other than income earned in the ordinary course of a trade or business, attributable to interest, dividends, royalties, annuities, and the disposition of property that produces portfolio income or is held for investment.
Having an activity classified as passive is not a good result for most taxpayers for many reasons, not the least of which is that the taxpayer cannot carry back or forward losses from those activities under the net operating loss (NOL) rules discussed below.
Tax shelters, at-risk rules, and passive activity losses
In response to the abusive use of tax shelters, Congress passed legislation that limits or disallows the deductibility of losses from these types of arrangements. The first major provision was the at-risk rules limitation under Sec. 465. Sec. 465 limits the amount of the loss a taxpayer can deduct to the amount that is “at-risk,” that is, the amount that taxpayer stands to lose. Generally, this is the amount the taxpayer originally invested in the activity. However, this figure is adjusted by the taxpayer’s share of profits or losses, additional investments, and distributions.
The second major piece of legislation passed by Congress to curb tax shelters was the limitation on passive activity losses under Sec. 469. This provision disallows losses from passive activities. In other words, if a taxpayer has a loss from a passive activity, he or she will not be able to deduct the loss except against passive income. Any disallowed passive activity losses are carried forward to the succeeding tax year where they again can be offset only against passive income. These rules apply until a taxpayer’s entire interest in the activity is disposed of in a fully taxable transaction with an unrelated party, at which point the taxpayer can usually recognize the suspended passive activity losses.
As mentioned earlier, rental activities are considered per se passive activities, and any losses from rental activities may be disallowed. Special rules and exceptions apply for real estate activities, including rules that apply to real estate professionals, but they are beyond the scope of this article. This article also does not address other limitations on the deductibility of losses, such as losses limited by a taxpayer’s basis in stock or a partnership or the limitations for activities not engaged in for profit under Sec. 183, commonly called “hobby losses.”
What is material participation?
Material participation is determined by applying the tests in Temp. Regs. Sec. 1.469-5T. If a taxpayer meets at least one of the seven tests under Temp. Regs. Sec. 1.469-5T, he or she is not subject to the passive activity loss rules and may be able to deduct the loss (limited by the at-risk rules). The taxpayer can also take advantage of any NOL carryovers that a business incurs.
The seven tests fall into three categories: tests based on current participation, tests based on prior participation, and a test based on facts and circumstances. The first test requires a taxpayer to participate in the activity for more than 500 hours during the year.
The second test has no hours requirement, but the taxpayer’s participation in the activity during the tax year must constitute substantially all of the participation in the activity of all individuals (including those who are not owners) for the year.
The third test does have an hours requirement: The taxpayer must participate in the activity for more than 100 hours during the tax year, and the taxpayer’s participation in the activity cannot be less than the participation in the activity of any other individual (including those who are not owners).
Under the next test, a taxpayer can be an active participant if the activity is a significant participation activity and the taxpayer’s aggregate participation in these significant activities during the year exceeded 500 hours. A significant participation activity is an activity a taxpayer participates in for more than 100 hours during the year.
The fifth test requires material participation for five tax years out of the prior 10; the years need not be consecutive.
Under the sixth test, the taxpayer must be involved in a personal service activity, and must have materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year. A personal service activity for these purposes includes activities in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting; or any other trade or business where capital is not a material income-producing factor.
The seventh test is a fact-and-circumstances test. The taxpayer must prove that he or she participates in the activity on a regular, continuous, and substantial basis during the year.
Taxpayers that meet any of these material participation tests should keep accurate, contemporaneous records in case the IRS disputes whether the taxpayer has met the test. Doing so may be cumbersome, but will help ensure the taxpayers will be able to offset any losses against their other nonpassive income.
NOL carryovers are helpful because they allow businesses to weather the normal ups and downs of the business cycle. Some years are profitable and some not, but Sec. 172 allows business taxpayers with losses in one year to carry that NOL back and forward into profitable years. However, to understand NOLs, taxpayers need to revisit the three categories of income: active, portfolio, and passive. As mentioned previously, active income is income for services rendered such as salaries, wages, or income from a trade or business that the taxpayer materially participates in.
To be able to take advantage of the NOL rules for losses from a trade or business, taxpayers must be actively involved in the business’s activities. For those taxpayers, when the business experiences periods of steady growth and periods of decline, NOLs will make it easier to survive.
Sec. 172(b)(1) allows a taxpayer to carry back an NOL to two preceding years and then carry forward any remaining loss 20 years. In other words, if a taxpayer has an NOL in tax year 2015, he or she can carry the loss back to 2013 and then 2014 to recover any taxes paid in those periods. The taxpayer can carry forward any remaining NOL to 2016 and beyond. Under Sec. 172(b)(3), a taxpayer can elect to forgo the carryback and simply carry the NOL forward.
A taxpayer who actively participates in a business, therefore, can potentially lower his or her taxes if the business has a bad year.
Luis Plascencia is a CPA licensed in Illinois who manages his own CPA practice and teaches accounting and tax courses at City Colleges of Chicago.