Posted Tuesday, April 22, 2024
This is aimed at business owners where they no longer materially participate in the business activity, and as such they are now considered passive investors. Seems easy right, but why would 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-
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.
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 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, 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!
Just because you call yourself a limited partner in a limited liability limited-partnership 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.
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