Being Considered a Passive Business Owner

This section is for business owners who no longer materially participate in the business activity and want to be treated as passive investors. Seems easy, right? But why would you care? For two big reasons-

• Passive income absorbs passive losses. If you have suspended passive losses from a rental property or another passive investment, your newfound passive business income can soak them up (IRC Section 469). You enjoy your tax benefits now rather than delaying the pleasure to future years. Yay!
• Stepping away from the work can mean stepping away from payroll. In an S Corp, the reasonable salary requirement follows the services you perform, not your passive status. An owner who truly stops working generally does not need a salary and can take distributions only. Every $10,000 in owner salary costs about $1,530 in combined Social Security and Medicare taxes, up to the Social Security wage base ($192,300 for the 2027 tax year). Yay again!

The Catch: Net Investment Income Tax

The world is always trending towards harmony, so here is the first downside. Passive business income is subject to the 3.8% Net Investment Income Tax (IRC Section 1411(c)(2)(A)) once your modified adjusted gross income exceeds $250,000 married filing jointly or $200,000 for most other filers, and those thresholds are not indexed for inflation. Non-passive ordinary business income from an S Corp K-1 generally escapes this tax.

As such, going passive can trade payroll taxes on a salary for a 3.8% tax on some or all of your K-1 income. The tax is imposed on the lesser of your net investment income or the amount your modified adjusted gross income exceeds the threshold, so the household math matters. If your other income has already pushed you well beyond the threshold and the S Corp throws off $400,000 of passive K-1 income, the additional NIIT can reach $15,200. Run the numbers before you retire from material participation.

The Material Participation Tests

The second downside is that it is difficult to claim passive status given the material participation tests in Treas. Reg. 1.469-5T(a), restated in IRS Publication 925 Passive Activity and At-Risk Rules. Meet any one of the seven and you are materially participating, which means you are not passive. Here is the list-

Material participation tests.
You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests.

1. You participated in the activity for more than 500 hours.
2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
4. The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test. See Significant Participation Passive Activities under Recharacterization of Passive Income, later.
5. You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
6. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.

One fine-print item on Test #7: “facts and circumstances” does not mean anything goes. You must participate for more than 100 hours during the year. Also, your management time does not count for this test if someone else is paid to manage the activity or another person spends more time managing it than you do. Treas. Reg. 1.469-5T(b)(2). So much for facts and circumstances being the easy one.

Ok, back at it. Most taxpayers want the material participation tests on their side, such as with the short-term rental loophole, where meeting a test converts passive losses into non-passive losses that can offset other income such as W-2 earnings. However, the IRS can use the same list against someone who wants to be passive.

Sidebar: What is the short-term rental loophole? If the average guest stay at your rental is seven days or less, the property is not a “rental activity” under the passive activity rules (Treas. Reg. 1.469-1T(e)(3)(ii)(A)). Clear that hurdle, then meet one of the material participation tests above (usually more than 100 hours and more than anyone else, including your cleaners), and the losses become non-passive and can offset W-2 wages without qualifying as a real estate professional. The details and traps are in our rental book, I Just Got a Rental, What Do I Do?

The 5-of-10 Rule and the Personal Service Trap

The hardest ones to overcome are #5 and #6. Let’s look at #5 again, but with some verbiage from the IRS Audit Techniques Guide (ATG) for Passive Activity Losses–

You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.

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 10 years, and if 5 of those years had material participation by you in the business activity as defined by any of the above, then the IRS will disallow your passive claim. 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!

Test #6 is even harsher if you are a doctor, lawyer, CPA, consultant, engineer or anyone else whose business is selling your expertise. Materially participate in that personal service activity for any three prior tax years and that same activity is non-passive to you forever. Not 5 of the last 10. Forever. A retired physician who still owns a slice of the same practice is not getting passive treatment no matter how much golf they play.

Limited Partners, LLC Members and Self-Employment Tax

Two different questions get mashed together here, and the tax code answers them separately-

• Passive or not (IRC Section 469). Your title matters a little. A true limited partner can only prove material participation under tests 1, 5 and 6 (Treas. Reg. 1.469-5T(e)(2)), which makes it easier to be passive. Courts have generally refused to extend that treatment to LLC members (Garnett v. Commissioner, 132 T.C. 368 (2009)), so for most readers it comes down to your actions.
• Self-employment tax (IRC Section 1402). Passive status does not get you out of it. A sole proprietor or single-member LLC owes self-employment tax on business income whether they show up or not, and so does a general partner. A limited partner might escape it under the limited partner exception discussed in the Multi-Member LLC section, but that is a separate test from Section 469. In an S corporation, K-1 income is never self-employment income; the only question is whether you perform enough services to require a reasonable salary.

A quick recap-

• Going passive lets your newfound passive income absorb passive losses.
• Stepping away from the work, not passive status, is what ends the S Corp reasonable salary requirement.
• Going passive does not, by itself, eliminate self-employment tax.
• Going passive adds the 3.8% Net Investment Income Tax.

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.