Passive vs. Active Businesses: The IRS “gotcha” limiting deductions.

Partners and members of a limited liability company taxed as a partnership are restricted in deducting losses from so-called “passive activities.”

What is a Passive Activity? A passive activity is any activity that involves the conduct of any trade or business, where the owner does not materially participate. To be materially participating in an activity the owner must be involved in the operations of the activity:

! regularly,
! continuously, and
! substantially

The following are the requirements to be treated as materially participating:

(1) you participate in the activity for more than 500 hours during the year; or

(2) your participation in the activity is all of the activity in the business (including activities of employees.); or

(3) you participate in the activity for more than 100 hours during the tax year, and no one else (including employees) participates more for the year; or

(4) Your aggregate participation in all significant participation activities during the year exceeds 500 hours;

(5) you materially participated in the activity for any five tax years during the ten tax years that immediately precede the tax year;

(6) the activity is a personal service activity, and you materially participated in the activity for any three tax years preceding the tax year; or

(7) based on all of the facts and circumstances, you participate in the activity on a regular, continuous, and substantial basis during the year.

Exclusion for Real Estate Rentals: The material participation tests generally do not apply to rentals, except the rental real estate of a real estate professional.

IRS Rule: The IRS treats an interest in an LLC and Partnership as presumptively passive if:

! They classify the entity in which such interest is held as a partnership for federal income tax purposes, and

! The owner of the interest does not have rights to manage the entity always during the entity’s tax year. Rights to manage include the power to bind the entity.