Under normal circumstances, you are able to offset business losses against other types of income (wages, interest and dividends). However, losses from passive activities may not be deducted against these types of income. Passive losses in excess of passive income are suspended and carried forward in the next succeeding year. Only when you sell your entire interest in the activity will you be allowed to take all of the suspended passive losses in a single year.
The best way to prove that you are not passive, but active and materially participate in a trade or business is to prove any one of the following seven rules:
- You participate more than 500 hours;
- Your participation constitutes substantially all of the participation in the activity;
- You participate for more than 100 hours and this participation is not less than the participation of any other individual;
- The activity is a “significant participation activity” and your participation in all such activities exceeds 500 hours;
- You materially participated in the activity for any five years of the 10 years that preceded the year in question;
- The activity is a “personal service activity” and you materially participated in the activity for any three years preceding the tax year in question; or
- You satisfy a facts and circumstances test that requires you to show that you participated on a regular, continuous, and substantial basis.
Methods of Proof
To meet the record-keeping requirements, the taxpayer must establish his material participation by reasonable means.These may 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 taxpayer’s participation can be reasonably established. If records provided are not reasonable, i.e., there is a credibility issue, they may request contemporaneous records.
Indicators that the taxpayer did not materially participate:
- The taxpayer was not compensated for services.
- The taxpayer’s residence is hundreds of miles from the activity.
- The taxpayer has a W-2 wage job requiring 40+ hours a week for which he or she receives significant compensation.
- The taxpayer has numerous other investments, rentals, business activities, or hobbies that absorb significant amounts of time.
- There is paid on-site management/foremen/supervisor and/or employees who provide day-to-day oversight and care of the operations.
- The taxpayer is elderly or has health issues.
- The majority of the hours claimed are for work that does not materially impact his time or business.
Key Points the IRS Reviews
- Does the taxpayer work on a regular basis in the operations of the business activity?
- Has the entity been grouped by the taxpayer with another related entity as a single activity?
- Is the entity a significant participant activity (SPA) and if so, are there other SPAs (passive businesses) with which it can be grouped, and does the sum of all SPA hours exceed 500 hours for the tax year?
- Is the time claimed plausible in terms of the taxpayer’s other commitments or from a common sense standpoint?
The IRS will try to treat some of your time performed as investor hours such as:
- Studying or reviewing financial statements or reports
- Preparing or compiling summaries or analysis for individuals own use
- Monitoring financing or operations in a more managerial capacity
- Reading articles and trade publications
- Whether, and how regularly, the taxpayer is present at the place or places where the principal operations of the activity are conducted.
The above list is not all-inclusive. Other activities could also be investor-type activities such as organizing records, preparing taxes and paying bills.
In summary, the IRS is doing their best to win on this issue issue. Preparation for the possibility of an IRS Audit, such as record-keeping for all of your activities, will give you a better chance of winning these audits.