Your Small Business As A Passive Income Activity

By Jason Watson, CPA
Posted Saturday, August 10 2024

This is aimed at the business owner real estate investor combo where there is a need to consider the business income as passive activity income. This would include the married couple where one person operates a business yet the household also has rental properties. Why do you care? For two big reasons- first, if you have other non-deductible passive losses due to income limitations, such as those from a rental property, you can now have your passive income absorb these passive losses. This allows you to enjoy your tax benefits now rather than delaying the pleasure to future years. Yay!

Second, as a passive owner you might be able to only draw distributions from your business (no salary) rather than salary plus distributions. Since you are pulling money from the business as passive income, this saves you several thousands of dollars in avoided Social Security and Medicare taxes. Every $10,000 in owner salary is about $1,500 in payroll taxes. Yay again!

The world is always trending towards harmony, so here are the passive business owner downsides. It is difficult to claim passive business owner given the material participation tests. The hardest one to overcome is #5 from IRS Publication 925 Passive Activity and At-Risk Rules. Here is the list from Treasury Regulations Section 1.469-5T–

(a) In general. Except as provided in paragraphs (e) and (h)(2) of this section, an individual shall be treated, for purposes of section 469 and the regulations thereunder, as materially participating in an activity for the taxable year if and only if-

(1) The individual participates in the activity for more than 500 hours during such year;

(2) The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;

(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;

(4) The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours;

(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;

(6) The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or

(7) Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

IRS Publication 925 Passive Activity and At-Risk Rules cleans this up a bit and is more reader friendly. If this is your first brush with this material participation list, buckle up. You’ll see it in various forms including commentary in other portions of our book.

Let’s look at #5 again, but with some verbiage from the IRS Audit Techniques Guide (ATG) for Passive Activity Losses–

(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;

IRS ATG: An activity is non-passive if the taxpayer would have been treated as materially participating in any 5 of the previous 10 years (whether or not consecutive). This test usually applies when a taxpayer “retires from material participation” but maintains an ownership interest in the activity. Yikes (emphasis added).

IRS Examination Techniques: Even if the taxpayer performs no services for a business currently, the examiner should inquire about involvement in prior years and review the returns to see if income or losses were treated as non-passive.

In other words, you need to look back for 10 years and if 5 of those years had material participation by you in the business activity as defined by any of the above participation tests (1-7), then the IRS will disallow your passive activity claim including the claim of having passive activity income. Could you start a brand-new business without the history? Perhaps, but this might be viewed as an end-around especially if the new business magically looks, walks, talks and smells like the old. Transitioning from material participation to passive is certainly tough!

Just because you call yourself a limited partner in a limited liability limited-partnership (the triple-“L” P) or some other variant does not matter. It is all about your actions and the reliance on your participation by the entity or enterprise for its success. Should you be considered materially participating in the business, then your income will be typically considered self-employed income and subject to self-employment taxes (Social Security and Medicare taxes). If the entity is taxed as an S Corporation, then you would need to be paid a reasonable salary.

A quick recap- you would like to be considered a passive business owner to either-

• have passive losses be deductible against your newfound passive income,

• to avoid having to pay yourself a reasonable salary in an S Corp environment (and only take shareholder distributions), or

• have your income avoid self-employment taxes in a sole proprietor, single-member LLC or partnership environment.

However, the tax code has seen you (and a zillion others) coming a mile away and mostly says No unless you can slip and slide around the rules above.