@Q01 旼컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴커 � ARE LOSSES INCURRED BY MY BUSINESS � � LIMITED BY THE PASSIVE LOSS RULES? � 읕컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴켸 As a general rule, tax losses and tax credits generated by a business may be used to offset other income of the owner(s) of the business, in the case of a sole proprietorship, part- nership, of S corporation. Or, in the case of a C corpora- tion, such losses or credits may, in many cases, be used to offset other income of the corporation, such as portfolio income or active business income. However, if the losses or credits are considered to be from "passive activities," there are severe limits on the use of such losses or credits to offset current income other than income from "passive activities." QUESTION: Is your business set up as a "C corporation"? @YN 01\Q02 02\Q11 @Q02 CONCLUSION: Then you will not be able to offset losses or credits generated by your corporation against your personal income. This is always true in the case of a C corporation, whether or not the losses or credits it incurs are "passive" in nature. Thus the real questions in your case are (1) Whether your corporation has any "passive" losses or credits and (2) whether your corporation is considered to be a "per- sonal service corporation" or a "closely-held C corporation." (Note: A "passive" activity, for purposes of the question below, is a trade or business that is carried on by a corpor- ation, where the major shareholders do not "materially parti- cipate" in the activity. If any one or more shareholders owning more than 50% of the stock "materially participate" in the activity, it is not considered a "passive activity.") (Most rental activities are automatically "passive.") QUESTION: Does your C corporation generate any losses or credits that are from "passive activities"? @YN 01\Q04 02\Q03 @Q03 CONCLUSION: Then you do not need to be concerned about the usability of "passive" losses or credits, since your corpor- ation does not have any such losses or credits. Therefore, any losses or credits your corporation generates from a trade or business should, in general, be allowable as an offset against income from any other trades or businesses it carries on, or against "portfolio income" such as taxable interest or dividend income. @STOP @Q04 TENTATIVE CONCLUSION: Then your C corporation may be limi- ted, under the passive activity loss rules, in its ability to currently utilize such losses or credits, IF it is ei- ther: (a) a "personal service corporation"; or (b) a "closely-held C corporation." For a C corporation to be a "personal service corporation," the corporation's principal activity must consist of the per- formance of personal services. Personal services would cov- er a wide range of activities, including professional ser- vices such as law, medicine, dentistry, accounting, architec- tural and engineering services, actuarial sciences, and the like. It would also cover areas such as consulting services, the incorporated professional athlete or entertainer, and miscellaneous other service businesses, such as an incorpor- ated salesperson. QUESTION: Does your corporation perform personal services as its principal activity? @YN 01\Q08 02\Q05 @Q05 CONCLUSION: Your company is not a "personal service corpor- ation" for purposes of the passive loss rules, and thus is not fully subject to the passive activity loss limitations. However, your company may be a "closely held C corporation" that is partially subject to the passive loss rules, depen- ding on its stock ownership. (See below) QUESTION: Did 5 or fewer individuals (directly or indirec- tly) own more than 50% (in value) of the stock of the corporation during the last half of the tax year? @YN 01\Q06 02\Q07 @Q06 FURTHER CONCLUSION: While your corporation is not consid- ered a "personal service corporation," and thus is not fully subject to the passive loss restrictions, it is considered to be a "closely held C corporation," and thus is partially subject to the passive loss rules. That is, it may offset passive activity losses against its "net active income," but not against its "portfolio income." @STOP @Q07 FURTHER CONCLUSION: Your C corporation is not a "personal service corporation" (within the meaning of the passive loss rules), and is also not considered a "closely held C corpor- ation." This means, if the above conclusions are both cor- rect, that your corporation is not subject to ANY of the passive loss restrictions. Thus, losses incurred by your corporation on passive activity investments should be fully available to offset against either portfolio income or other income ("net active income") of the corporation, without restriction. @STOP @Q08 SERVICES MUST BE "SUBSTANTIALLY PERFORMED" BY SHAREHOLDER- EMPLOYEES: To be considered a "personal service corpor- ation," the personal services performed by the corporation must be "substantially performed" by employees who own stock in the corporation. To determine whether the services to customers, clients, etc. are "substantially" performed by employee-owners, the Income Tax Regulations say that more than 20% of the corporation's compensation expense attribut- able to its service activities have to be attributable to personal services performed by its employee-owners. If it is clear that over 20% of the cost of performing services (of the types described in the previous question) are attri- butable to services performed by owners, you should answer "Y" ("YES") to the following question. If it is clear that less than 20% of such compensation costs are attributable to services rendered by employee-owners, then answer "N" ("NO"). QUESTION: Are the services rendered by the corporation "sub- stantially" performed by employee-owners of the corporation? @YN 01\Q09 02\Q05 @Q09 STOCK OWNERSHIP REQUIREMENT: A corporation cannot be treat- ed as a "PSC" for tax purposes unless employees own more than 10% of its stock (by value), directly or indirectly. QUESTION: Do employee-owners own (directly or indirectly) more than 10% of the stock of your corporation, by value? @YN 01\Q10 02\Q05 @Q10 CONCLUSION: It appears from your responses that your C cor- poration may be a "personal service corporation" under the definitions used in the passive activity loss rules and for determining whether a C corporation is restricted in its choice of a fiscal tax year. If so, this means that if your corporation has losses from "passive activities," it may not generally offset those losses against its "net active income" (business income, generally) or against its "portfolio income" (income from dividends, interest, annuities, certain royalties, etc.). However, such losses (or credits) can be used to offset oth- er passive income of your corporation. Also, when you fin- ally dispose of a passive activity (by selling off such a business, for instance), the corporation should than be al- lowed to deduct any "suspended" passive losses related to that activity which it had accumulated over the years, but had not been able to utilize because of the passive loss li- mitations. @STOP @Q11 "Passive" losses or credits of unincorporated businesses, or of S corporations, generally cannot be used to offset income of the owners of the business to whom such business losses are allocated, unless there is passive income against which such losses can be offset. Note: A "passive" activity, is a trade or business that is carried on by a business, where you, as sole proprietor, partner, or S corporation shareholder, do not "materially participate" in such activity. However, if you, individual- ly, are considered to "materially participate" in the activ- ity in question, it is not a passive activity with regard to YOU (even if it is for some of your fellow partners or S corporation shareholders). (Note also that most rental acti- vities are automatically considered to be "passive" in na- ture, regardless of your "material participation.") QUESTION: Does the unincorporated business in question gener- ate any losses or credits from "passive activities"? @YN 01\Q13 02\Q12 @Q12 CONCLUSION: Then this consulting session may not be rele- vant to your situation. Since your business is not genera- ting any "passive" losses or credits, you are not subject to the restrictions on utilization of passive losses. (Unless you HAD passive losses in prior years which have been suspended and carried over. In that case, you will not generally be able to deduct those "suspended" prior year passive losses until you generate passive income against which the suspended losses can be offset, or until you dis- pose of the activity, by sale or in certain other ways, and are allowed to offset the accumulated suspended losses against non-passive income in the year of the disposition.) @STOP @Q13 There are special, especially strict, rules on deducting passive losses from certain "publicly-traded partnerships." (Most such partnerships are limited partnerships, whose units trade much like common stocks of corporations.) QUESTION: Is the business in question a publicly- traded partnership? @YN 01\Q14 02\Q15 @Q14 CONCLUSION: Then your ability to deduct any passive losses from such a publicly traded partnership will be EXTREMELY limited. As a practical matter, so long as you own your interest in such partnership, you will not be able to uti- lize any passive losses from it against other income, EVEN AGAINST OTHER PASSIVE INCOME, with one very limited excep- tion: You may only carry such losses forward as "suspended losses"; then, if the same partnership later generates net passive income, only then may you offset the suspended los- ses against the passive income of that same partnership. @STOP @Q15 In general, such "passive" losses will not be currently de- ductible for you, unless you have other "passive income" which they can be used to offset. However, there is a lim- ited exception for passive losses from certain real estate rental activities, for some individuals who have adjusted gross incomes of less than $100,000 (phasing out at income levels between $100,000 and $150,000, or in the case of low income housing projects, between $200,000 and $250,000). Un- der this exception, an individual who is deemed to "actively participate" (this is not the same as "material participa- tion") in the rental activity is allowed to offset up to $25,000 a year of passive rental losses against other tax- able income (or the "credit equivalent" of such deductions, in the case of low-income housing credits. QUESTION: Does the "passive activity" in question consist of rental real estate? @YN 01\Q17 02\Q16 @Q16 CONCLUSION: Then it appears that your passive losses from your sole proprietorship, partnership or S corporation busi- ness may not be currently deductible, unless you have other "passive income" against which such losses can be offset (other than "passive income" from "publicly-traded partner- ships"). @STOP @Q17 To qualify for the right to offset such rental real estate losses against non-passive income, you must "actively parti- cipate" in the management of the property. Part of the def- inition of "active participation" is that you must own at least 10% of the property in question, either directly, or as a 10% or more partner in a partnership. (An ownership interest as a limited partner is not counted towards the 10% ownership requirement.) Note that there is NO "active participation" test for inves- tors in low-income housing activities that qualify under special provisions of the tax code. QUESTION: Do you meet the "active participation" re- quirements described above (if applicable)? @YN 01\Q18 02\Q16 @Q18 CONCLUSION: Then, in any year in which your "adjusted gross income" is less than $150,000 ($250,000 in the case of cer- tain low-income housing), you may be able to offset all or some portion of your net rental losses against other, non- passive income, on your individual income tax return. The maximum such passive loss that you may deduct in one year is limited to the lesser of: . $25,000; or . $25,000, reduced by half the amount your adjusted gross income exceeds $100,000 ($200,000 in the case of low-income housing acquired before 1990). Thus, for each dollar of adjusted gross income you have above $100,000 (or $200,000, for low-income housing ac- quired before 1990), the maximum $25,000 loss allowable for the year is reduced by 50 cents. 旼컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� � EXAMPLE OF PHASE-OUT OF THE $25,000 � � LIMIT ON PASSIVE LOSSES FOR "ACTIVE � � PARTICIPATION" RENTAL REAL ESTATE: � � =================================== � � Say your adjusted gross income for � � the year before passive losses, IRA � � deduction, taxable Social Security, � � and the exclusion for savings bond � � interest used for higher education � � expenses, is $115,000, and you have � � a $27,500 rental loss from property � � in which you "actively participate" � � in management. Your allowable loss � � for the year would be $25,000, less � � $7,500 (one-half of $115,000 minus � � $100,000), or a net deduction equal � � to $17,500. The remaining, unused � � loss of $10,000 would be suspended � � and carried forward indefinitely, � � until, if ever, it can be used. � 읕컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� @STOP @HELP @H\01 A "C corporation" is a technical term, but, fortunately, is a relatively easy one to understand. A C corporation is, quite simply, any corporation (other than a not-for-profit one) OTHER THAN an "S corporation" (formerly known as a Subchapter S corporation). Thus, unless your corporation is one that has made an election to be taxed as an S corpor- ation, it is an C corporation. There- fore, answer this question "N" ("NO") only if your company is an S corpora- tion, or is not a corporation at all. @H\02 An individual is considered to "materi- ally participate" in an activity if: . He participates in the activity more than 500 hours in the year; or . His participation constitutes sub- stantially ALL participation in that activity by anyone for the year; or . He participates more than 100 hours in the activity and no other indi- vidual participates more than he. (IRS regulations go on for many pages...) @H\04 Businesses that sell some form of prop- erty, rather than purely services, are not considered to be engaged in perform- ing services. Although such activities as wholesale or retail sales of goods or sales of insurance, real estate, or fin- ancial services or products have a large service component, they are not consid- ered to be performance of personal ser- vices, for purposes of this definition. @H\05 Don't think you can get around the "five or fewer persons owning over 50% of the value of the stock" rule by putting 10% of the stock in the hands of each of 10 related people. The "attribution" rules of the tax law lump all related parties together and treat them as one person. @H\06 "Net active income" is simply all tax- able income OTHER THAN portfolio income and expenses or passive activity income and losses. "Portfolio income and ex- penses" include the following items of income (less all allocable expenses): . Gross income from interest, divi- dends, annuities, or royalties not derived in the ordinary course of a trade or business (less expenses); . Gain or loss not derived in the ordinary course of business from disposition of assets (non-passive). @H\08 The Regulations contain a number of very technical rules explaining this test as to whether services are "substantially" performed by owner-employees, which are much too complex and detailed to explain here, so in some cases it may not be to- tally clear one way or the other whether your corporation's owner-employees per- form enough of the company's services to meet this test. Thus, in some cases, you may have to take your best shot at gues- sing whether to answer "YES" or "NO" to this question, in which case the answer you finally arrive at as to PSC status may well be wrong. @H\09 If the total combined ownership of stock in the corporation by employees, includ- ing shares they are deemed to own (stock owned by their children, related enti- ties and so forth), is more than 10% of the corporation's stock (by value), you should answer "Y" ("YES") to this ques- tion. Otherwise, answer "N" ("NO"). @H\10 "Net active income" is simply all tax- able income OTHER THAN portfolio income and expenses or passive activity income and losses. "Portfolio income and ex- penses" include the following items of income (less all allocable expenses): . Gross income from interest, divi- dends, annuities, or royalties not derived in the ordinary course of a trade or business (less expenses); . Gain or loss not derived in the ordinary course of business from disposition of assets (non-passive). @H\11 An individual is considered to "materi- ally participate" in an activity if: . He participates in the activity more than 500 hours in the year; or . His participation constitutes sub- stantially ALL participation in that activity by anyone for the year; or . He participates more than 100 hours in the activity and no other indi- vidual participates more than he. (IRS regulations go on ad infinitum....) @H\13 A "publicly traded partnership" is any partnership whose capital interests are traded on an established securities mar- ket (such as a stock exchange) or which are readily tradable on a secondary mar- ket (or its substantial equivalent). @H\15 Note that "rental real estate" does not include very transient rentals, such as operation of hotels or motels. Thus, the income from any such operations are not automatically treated as passive. Also, note that for low-income property acquired after 1989, there is no phase- out of the $25,000 deduction (or credit equivalent) if adjusted gross income is over $200,000. That limit was removed by the 1989 Revenue Reconciliation Act. @H\17 "Active participation" is a much less stringent participation requirement than the "material participation" rule that applies to non-real estate activities. The "active participation" requirement can be satisfied without regular, con- tinuous and substantial involvement in operations, provided that you partici- pate in a significant way, such as by making management decisions or by arran- ging for others to provide services. For example, approving rental agreements may constitute "active participation." @H\18 Special rules apply to allowance of low- income housing credits under the passive loss rules for acquisitions of such pro- perties made after 1989. @END