Passive Activity Loss Rules: Strategies for
Pass-Throughs to Maximize Deductions
presents
Leveraging Recent Federal Court Rulings to
Meet Material Participation Tests
A Live 110-Minute Teleconference/Webinar with Interactive Q&A
Today's panel features:
Edward Ptaszek, Partner, Baker Hostetler, Cleveland
Lucy Clark, Independent Tax Consultant, Rindge, N.H.
Diane Pallas, Owner, Forensic Accounting and Tax Consulting, Portland, Ore.
Noel Brock, Partner, National Tax Office, Grant Thornton, Washington, D.C.
Tuesday, October 20, 2009
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Passive Activity Loss Rules
Webinar
Oct. 20, 2009
Diane Pallas
Noel Brock
Forensic Accounting and Tax Consulting Grant Thornton
[email protected]
[email protected]
Lucy Clark
Independent Tax Consultant
[email protected]
Edward Ptaszek
Baker Hostetler
[email protected]
Today’s Program
•
•
•
•
•
•
Introduction To Passive Activity Losses; PAL Defined, slides 3
through 13 (Diane Pallas)
Overview, Material Participation Rules And Recent Cases Interpreting
Them, With Respect To LLC And Members, slides 14 through 26
(Noel Brock)
Overview, Grouping And Shareholder Concerns, slides 27 through 42
(Lucy Clark)
Particular Issues For C Corporations, slides 43 through 50 (Edward
Ptaszek)
Self-Rented Property And Land Overview, slides 51 through 61
(Diane Pallas)
Potential Audit Issues, slides 62 through 63 (Diane Pallas)
2
Introduction To Passive
Activity Losses; PAL Defined
3
Passive Activities Are:
•
Business activities in which a person does NOT materially participate,
or
•
Rental activities in which a person actively participates
4
Overview Of IRC Sect. 469 PAL
Sec. 469(a)(1) states: In general. If for any taxable year the taxpayer
described in paragraph (2), neither
(A) the passive activity loss, nor
(B) the passive activity credit
for the taxable year shall be allowed.
(2) Persons described. The following are described in this
paragraph:
(A) any individual, estate, or trust
(B) any closely held C corporation, and
(C) any personal service corporation.
(b) Disallowed loss or credit carried to next year.
5
Passive
•
Sole proprietors (Schedule C) or farms (Schedule F) with no material
participation
•
Rentals, even if there is active participation
•
Limited partnerships
6
Non-Passive = Material Participation
•
•
•
•
•
•
Schedule C or F activities with material participation
Salaries
Portfolio income
- Interest and dividends
- Gain on sale of stocks and bonds
- Gain on sale of investment property
Land rented or held for investment
Self-rental income from property leased to a business where the client
works
Lottery winnings
7
Non-Passive = Material
Participation (Cont.)
A non-passive activity is one in which an individual is participating in a
business on a regular, continuous and substantial basis
8
Activity Rules
The definition of an activity can be crucial for your client when
applying passive activity loss rules. How an activity is defined
determines what will be segregated or aggregated, when deducting
suspended losses on disposition and applying material participation
rules
9
General Rule
•
Every PAL (passive activity loss)
needs a
• PIG (passive income generator)
10
Exceptions To The General Rule
•
•
•
•
•
•
•
Rental real estate losses - $25,000 offset
Short-term rentals and leasing activities - Reg. 1.469-1T(e)(3)(ii)(A)(F)
Real estate professional’s rental losses with material participation
Dispositions
Corporate PALs
Oil and gas
Traders in stocks, bonds, securities, per Reg. 1.469-1T(e)(6)e 3a
11
Remember
•
Deductibility of passive losses is limited to passive income
•
Unlike NOLs, passive losses may not be carried back; they may only
be carried forward
•
To deduct the losses in full in the current year, the taxpayer
MUST materially participate in the activity
•
Non-passive losses = material participation
Claiming to be non-passive is the easiest way to avoid PAL limitations
12
Self-Rented Property
Your client leases property he/she owns personally to a business where
he/she works
•
Losses on self-rentals are passive!
They go on Form 8582 and may not be deductible
•
Net income on self-rentals is non-passive
It should not be on line 1a of Form 8582
It cannot be used to trigger unrelated passive losses
13
Overview, Material Participation
Rules And Recent Cases Interpreting
Them, With Respect To LLC And
LLP Members
14
General Rules
•
Passive activity loss can generally offset only passive income
•
A passive activity is a trade or business in which the taxpayer does not
materially participate
•
Material participation is defined generally as regular, continuous and
substantial involvement in the business operations
•
Seven tests for material participation
15
General Rules – Seven Material
Participation Tests
•
•
For a taxable year, the individual
– Participates in the activity more than 500 hours
– (’s) participation in the activity constitutes substantially all of the
participation in such activity of all individuals for such year
– Participates in the activity for more than 100 hours, and such
participation is not less than the participation of any other
individual
– Materially participated in the activity during the 10 taxable years
that immediately precede the taxable year
– Based on all facts and circumstances, participates in the activity on
a regular, continuous and substantial basis
The activity is a significant participation activity for the tax year, and
the individual’s aggregate participation in all significant participation
activities during such year exceeds 500 hours
16
General Rules – Seven Material
Participation Tests (Cont.)
•
The activity is a personal service activity, and the individual materially
participated in the activity for any three tax years preceding the current
tax year
17
Special Rule For Limited Partners
•
•
Sect. 469(h)(2) presumptively treats losses from certain limited
partnership interests as passive
– “Interests in limited partnerships. Except as provided in
regulations, no interest in a limited partnership as a limited partner
shall be treated as an interest with respect to which a taxpayer
materially participates.”
Limited partners may rebut the statutory presumption and prove
material participation, but they are limited to three of the seven
regulatory material participation tests outlined previously Temp.
Treas. Reg. § 1.469-5T(e)(1) and (2)
– Participation in the activity for more than 500 hours during the tax
year
– Materially participate in the activity for any five of the last 10 tax
years
– Materially participate in a personal service activity for any three
prior tax years
18
Special Rule For Limited Partners
(Cont.)
•
The regulations define two categories of limited partnership interests:
– Those designated as limited partnership interests in the limited
partnership agreement or the certificate of limited partnership
– Those for which the liability of the holder of such interest is
limited under state law (in the state where organized) to a
determinable fixed amount
Temp. Treas. Reg. § 1.469-5T(e)(3)
• General partner exception: A partnership interest of an individual shall
not be treated as a limited partnership interest for the individual’s
taxable year, if the individual is a general partner in the partnership at
all times during the partnership’s taxable year ending with or within
the individual’s taxable year. Temp. Treas. Reg. § 1.469-5T(e)(3)
19
Garnett V. Commissioner, 132 T.C. No.
19 (June 30, 2009)
•
•
Taxpayer held interests in limited liability companies (LLCs), limited
liability partnerships (LLPs) and tenancies in common (TICs). The
LLCs and LLPs generated losses, and taxpayer used to offset other
ordinary income on taxpayer’s individual income tax return. IRS
asserted that taxpayer failed to satisfy the material participation
requirements of Sect. 469
Issue: Whether the taxpayer’s interests in LLCs and LLPs should be
considered interests in limited partnerships “as a limited partner,” so as
to be treated presumptively passive under the special rule of Sect.
469(h)(2)
20
Garnett v. Commissioner, 132 T.C. No.
19 (June 30, 2009) [Cont.]
Taxpayer arguments
Sect. 469(h)(2) is inapplicable
because:
• No interest in any the companies
was a “limited partnership interest,”
as that term is used in the code. State
law governs what is a “limited
partnership interest in a limited
partnership
• Taxpayer is considered a general
partner (not a limited partner)
IRS arguments
Sect. 469(h)(2) is applicable because:
• Taxpayer’s interests in the LLCs
and LLPs satisfy the definition of
“limited partnership interest,” in
the temporary regulations
• Taxpayer is not properly
considered a general partner
21
Garnett v. Commissioner, 132 T.C. No.
19 (June 30, 2009) [Cont.]
•
Holding
– The temporary regulations do allow for entities other than state law
limited partnerships to be treated as “limited partnerships” under
Sect. 469(h)(2).
– Sect. 469(h)(2) does not apply, because interests in LLPs and
LLCs are properly considered general partner interests and thus,
the general partner exception of the temporary regulations applie.
– The decision turned on the fact that members of LLCs and partners
in LLPs are not restricted as to their participation under state law
22
Thompson v. U.S., No. 06-211 Ct. Fed.
Cl. (July 20, 2009)
•
•
Taxpayer held interests in LLCs that generated losses that taxpayer
used to offset items of ordinary income on taxpayer’s individual
income tax return. The parties stipulated that if the member interest is a
limited partnership interest, then the taxpayer cannot material
participation in the LLC. The parties also stipulated that if the member
interest is not a limited partnership interest, then the taxpayer can
demonstrate material participation
Issue: Whether these interests should be treated as presumptively
passive under Sect. 469(h)(2), such that the losses flowing from the
LLCs could be used to offset only passive income (not ordinary
income)
23
Thompson v. U.S., No. 06-211 Ct. Fed.
Cl. (July 20, 2009) [Cont.]
•
The Thompson court’s holding is broader than the holding in Garnett.
In addition to holding the taxpayer to be a general partner, the Court of
Federal Claims held that it is not possible for an interest in an LLC to
be properly treated as an “interest in a limited partnership as a limited
partner”
24
Other Possible Ramifications
•
•
Sect. 1402(a)(13)
– “(13) there shall be excluded the distributive share of any item of
income or loss of a limited partner, as such, other than guaranteed
payments described in section 707(c) to that partner for services
actually rendered to or on behalf of the partnership to the extent
that those payments are established to be in the nature of
remuneration for those services.”
Sect. 469(c)(3)(A)
– “The term ‘passive activity’ shall not include any working interest
in any oil or gas property which the taxpayer holds directly or
through an entity which does not limit the liability of the taxpayer
with respect to such interest.”
25
Heart Of The Confusion
•
Delaware Code § 17-303 “Liability to third parties”
– Allows a limited partner to retain its limited liability from the
obligations of the limited partnership so long as the limited
partners (1) are not also a general partner and (2) do not participate
in the control of the business
– When does a limited partner “participate in the control of the
business” of a limited partnership?
– The statute allows limited partners to do almost anything, except to
hold themselves out as limited partners and continue to be immune
from the obligations of the limited partnership
26
Overview, Grouping And Shareholder
Concerns
27
General Rules
•
Passive activity loss can offset only passive income
•
Passive activity is:
- Rental real estate or equipment leasing
(rentals are passive regardless of whether TP materially participated)
- Business in which the taxpayer does not materially participate
•
Passive activity loss is not deductible if no passive income (ouch!)
•
Unlike an NOL, passive loss cannot be carried back
28
Who?
•
•
•
•
•
Individuals
Estates
Trusts
Personal service corporations
Closely held corporations
What are not included?
• S corporations and partnerships
PAL rules apply at the individual investor level
• Widely held C corporations
Simply exempted from the passive loss limitations
29
Passive Loss Limitations
Apply To C Corporations!
•
All personal service corporations (PSCs)
Doctors, vets, attorneys, engineers, actors, consultants, accountants,
actuaries, financial Planners
•
Closely held C corporations, but liberal rules … except for PSCs
five or few shareholders during last half of year
•
Consolidated corporation
All corps = One single entity
30
All Personal Service Corps (PSCs)
•
Passive loss limitations apply in full
•
No passive business loss deductible without passive income
Example: K-1 line 1 business loss
•
No rental loss deductible without passive income
Passive income is: (1) Net rental income or
(2) Net income from a business in which 50% shareholder(s) do not
materially participate
•
No $25,000 special allowance for rental real estate
31
PSCs , Even If Closely Held …
•
Business and portfolio income cannot be offset by any rental loss
Rental losses cannot offset PSC income!
•
Business income and portfolio income cannot be offset by losses from
partnership in which corporation does not materially participate.
Material participation – 50%-plus shareholder; out-of-state partnership loss
could raise an IRS examiner’s eyebrows!
•
Passive losses are suspended and carried to the next year: Form 8810
32
Closely Held C Corps (But Not PSCs)
•
Passive loss can offset corporation’s business income
•
Passive loss cannot offset portfolio income
•
To materially participate, shareholders owning more than 50% must
meet one of seven tests in Reg. 1.469-5T(a), OR an employee must
work full-time in the business, etc
•
No $25,000 offset for rental real estate
•
Unused passive losses and credits are suspended on Form 8810
33
Grouping Activities
•
May avoid passive loss limitations!
Material participation is in an “activity”
•
Notice 2008-64 requires a written statement to group
Revenue procedure expected
•
An “activity” is a grouping that forms an economic unit based on:
– Similarities
– Common ownership
– Common control
– Location
– Interdependencies
34
When You Might Want To Group
•
Related businesses, especially if losses
•
Business and related rental real estate
Only allowed if owned in identical percentage or one is insignificant
S corporation can group business and a rental activity
But, a C corporation cannot ever group a business with a rental
•
Business and related equipment leasing activity
Only allowed if owned in identical percentage or one is insignificant
S corporation can group business and rental
But, C corporation can never group a business with a rental
35
When You Might Not Want To Group
•
Business with net income (PIG), if no material participation
•
Note: You can still group activities with losses, but IRS may re-group
including the income activity if abusive
•
Business and rental, if rental has net income
36
Disclosure Of Grouping
•
No form
•
Written statement with original return
– Names
– Addresses
– Employer identification numbers
– Declaration: Grouped activities form an appropriate economic unit.
•
Must disclose only once – in initial year, or when there is an addition
to the grouping
37
Entities: Form 1065 And Form 1120S
•
In year change occurs, i.e. group acquired
•
Disclose to partner/shareholder – attachment to K-1s
•
Partner/shareholder must follow consistently
38
Failure To Report Grouping
•
If no statement is attached to return in year of grouping,
then each business or rental is a separate activity
•
If no statement with return in year a new activity is acquired,
then it is a separate activity!
•
Possible consequence: Losses not deductible!
•
Reasonable cause exception: Reasonable cause is not defined.
Returns must be consistent with grouping
39
Shareholder Issues
•
Rental real estate leased to corporation (K-1 line 2 or Schedule E)
– Losses are passive activity losses
unless TP is a real estate pro and materially participated in each rental
Or, unless grouped with a business
– S corporation business and rental can group if identical percentage or
insubstantial
– C corporation cannot group a rental with a business
– If rental has net income, and TP materially participated in the
corporation, income is non-passive, i.e. doesn’t go on Form 8582
40
Shareholder Issues
•
Equipment leased to corporation (K-1 line 3 or Schedule C)
– Losses are passive activity losses
unless grouped with a business
– S corporation business and rental can group, if identical percentage
or insubstantial
– C corporation cannot group equipment lease with a business
41
Shareholder Issues (Cont.)
•
Excess compensation – be careful of your arguments!
Corporate issue,
but could affect non-passive losses at Form 1040 level
Only 24 hours in a day!
If the taxpayer argues he works 16 hours a day at the corporation,
no time left for any partnership or S corporation activities!
42
Particular Issues For C Corporations
43
Material Participation
•
Seven tests may be applied to determine if an individual materially
participates in an activity
– Participates for more than 500 hours
– Provides substantially all participation
– Participates for more than 100 hours and more than anyone else
– Participation in multiple activities if:
• Participation in each activity exceeds 100 hours; and
• Total participation in all such activities exceeds 500 hours
– Materially participated in an activity in at least five of the past 10
years
– Materially participated in a personal service activity for any three
prior years
– Facts and circumstances demonstrate regular, continuous
involvement
44
Material Participation By C
Corporations
•
The seven tests are not directly applied to determine material
participation by a C corporation
•
A personal service corporation is treated as materially participating in
an activity only if shareholders that own directly or indirectly more
than 50% of the equity value materially participate in the activity in
accordance with the seven tests (the “shareholder test”)
•
A closely held C corporation is treated as materially participating in an
activity if:
– The shareholder test is satisfied; or
– The activity is a “qualified business” within the meaning of the “at
risk” rules, as modified by the passive activity rules
45
The Shareholder Test
•
Each shareholder is treated as owning an interest in each activity
owned by the corporation for purposes of applying the seven tests
•
However, participation by a shareholder in an activity not owned by
the corporation is not taken into account to apply the seven tests
•
Therefore, only the activities owned by the corporation may be taken
into account to determine if the 500-hour aggregate participation
requirement in the significant participation test is met
•
If are two equal shareholders, both shareholders must satisfy one of the
seven tests or the shareholder test cannot be met
•
Issues
– Indirect ownership: Which attribution rules, if any, apply?
– How is fluctuating ownership treated?
46
Qualifying Business Test
•
A closely held corporation that is not also a personal service
corporation materially participates in an activity if:
– The corporation had at least one fulltime employee who devoted
substantially all of his or her time at all times during the year to the
active management of the activity
– The corporation had at least three non-owner employees whose
services were directly related to the activity; and
– The corporation incurred ordinary business expenses in excess of
15% of the corporation’s gross income from the activity
•
A closely held C corporation will qualify as a real estate professional if
more than 50% of its gross receipts are from real estate activities in
which the corporation materially participates
47
Publicly Traded Partnership
•
A taxpayer’s net passive loss from a PTP cannot be used to offset
passive income from other sources
– Net passive loss from a PTP may only be used to offset passive
income (but not portfolio income) from the PTP
– Any disallowed passive loss must be carried forward and may be
recognized when the taxpayer disposes of his entire interest in the
PTP
•
A taxpayer’s net passive income from a PTP is treated as portfolio
income and cannot be offset by passive loss from other sources
•
These limitations would not apply to a holder of equity interest in a
PTP, if the holder materially participates in the activities of the PTP
48
Carryovers/Carrybacks
•
Unlike net operating losses, disallowed passive losses are carried
forward but not carried back
•
If an allowed passive loss increases a net operating loss, the passive
losses rules do not apply again with the respect to that passive loss
•
Planning opportunities
49
Passive Activity Credits
•
The following credits are subject to the limitations imposed by the
passive loss rules if the credits are generated by a passive activity:
– General business credits
– Puerto Rico and possessions credits
– Electric vehicle credits
– Alternative motor vehicle credit
– Refueling property credit
•
Foreign tax credits are not subject to the passive activity rules, even
though income and deductions from foreign activities are subject to the
rules
50
Self-Rented Property And Land
Overview
51
Losses On Self-Rented Property
•
Losses on self-rented property or land are considered to be passive
•
Losses go on Form 8582
•
These losses are deductible up to $25,000, if modified AGI is less than
$150,000
52
Non-Passive Income
•
Does not go on Form 8582
•
Therefore, income cannot be used to offset passive losses
•
Passive losses are found on:
* The front of Schedule E (rental losses)
* In the passive loss column on the back of Schedule E (1065 and
1120S losses)
53
Income That Might Be Considered
Passive
•
IRC 469(c) & (d) generally hold that rental income is passive
•
Reg. 1.469-2T(c) generally holds that gain on sale is passive
However, Reg. 1.469-2T(f) recharacterizes certain types of income
54
Schedule E Income That Is
Non-Passive
Income that might be considered passive could be treated as non-passive!
Self-rented property
*Buildings (or equipment) leased to the business where the client
works Reg. 1.469-2(f)(6)
•
Non-depreciable property
Leased land Reg. 1.469-2T(f)(3)
Royalties IRC 469(e)
Income treated as non-passive cannot be used on Form 8582 to offset
passive losses
55
Income From Self-Rented Property Is
Not Passive Income!
This applies to:
• Partnerships
• LLC
• S corporations
• C corporations
in which the client materially participates
Husband and wife are considered as one taxpayer IRC 469(h)(5)
56
Material Participation Considerations
•
If the 1065 or 1120S is treated as non-passive on the back of the
Schedule E, then there is material participation
Remember
Non-passive = Material participation
•
If the business is conducted as a C corporation, and the client has a W2, then there is material participation
57
Rental Income From Non-Depreciable
Property Is Also Non-Passive
Income from land is non-passive! It should NOT be on F8582
•
Net income from leased land
• Gain on sale of leased land
Regardless of whether the land is self-rented, income from leased land is
always non-passive
58
Examples Of Income From Leased
Land
•
Ground rents
•
Fields rented by farmers
•
Income from parking lots
•
Income from land leased for cell towers
59
Gain On Sale Of Self-Rented Property
And Land
Reg. 1.469-2(f)(6) for self-rented property and Reg. 1.469-2T(f)(3) treat
the sale of these two activities as non-passive
The gain should not be reported on F8582
60
Property Held By An LLC Or
Partnership
•
Net rental income is still non-passive, if the individual partner works in
the business that leases the property
•
The fact that there is an LLC or partnership between the individual and
his corporation has no impact on the self-rental characterization. Net
rental income is still non-passive if the client materially participates in
the business activity that leases the property
61
Potential Audit Issues
62
Considerations
•
•
•
•
•
Is the client a real estate professional?
Does he/she materially participate in EACH property?
Does the client own interest in one or more S corporations or
partnerships?
With non-passive losses being fully deductible in the year incurred, if
the client owns several non-paassive entities, there must be material
participation in each one
Erroneous placement of leased land, self-rented property and gain on
sale on Form 8582
63
ACTIVITY RULES
(GROUPING RELATED ACTIVITIES)
By Lucy H. Clark, [email protected]
Concerns:
 Do related entities form a single activity, i.e. an appropriate economic unit?
 Were they grouped in prior years and always treated as an economic unit?
 Should a statement be filed with the return?
 Did the taxpayer materially participate in the grouped activities? .
Required Statement: Beginning with 2010 year (likely Revenue Procedure expected shortly), a written
statement must be included with the return on a grouping in the initial year. Also in year of an acquisition.
Notice 2008-64; Rev Proc expected
What is the basic tax law for grouping activities? Reg. 1.469-4
Material participation is in “an activity” (IRC 469(h)). If related businesses form an economic unit, the taxpayer
(TP) may group entities as a single activity. Factors: similarities, common control, common ownership,
location, and interdependencies. A Sch. C, Sch. F, C or S corporation, partnership or LLC company may be
grouped as one activity, making it easier to meet the 500 hour test for material participation. It is also possible
that a 1065 or 1120S may contain two separate and distinct activities. Once the grouping decision has been
made, TP must follow it consistently in all future years.
What about rental activities? Reg. 1.469-4(d)
A rental activity cannot be grouped with a business unless –
 Insubstantial or

Owned in identical percentage with the business and leased back to the business. Reg. 1.469-4(d)
A rental or leasing activity may be grouped with an S corporation, but never with C corp. Reg. 1.469-4(d)(5)(ii)
Note: There is no prohibition on grouping a rental with a rental. However, as a practical matter, two or more rental real estate activities
generally do not form an economic unit as they are not in the same location nor interdependent. To group rental real estate of a real
estate professional, TP must file a separate statement stating he is a real estate pro and elects to group all rentals. Reg 1.469-9(g)
Time for grouping? Time to group is when first return with entity on it is filed. Material participation is in “an
activity”. The taxpayer cannot determine material participation without knowing what the “activity” is.
When you might want to group
 Related business entities, especially if losses
 Business and related rental (but only if owned in identical percentages or if rental is insubstantial)
 Several condo units in same complex
When you might not want to group
 Business entity with net income & TP does not materially participate (passive income generator)
 Business with losses today, but significant possibility of income in future
 Business and rental, if rental produces net income
What must the taxpayer do to group related entities? Notice 2008-64; Rev Proc expected
 Disclose on original tax return in initial year.
 Names, addresses, EI#s, statement that grouped activities form an appropriate economic unit.
 Disclose again if new activity added.
 No statement needed for a grouping which existed before 2010.
 1065s and Form 1120S disclose new groupings or additions on K-1s.
Failure to report grouping Notice 2008-64; Rev Proc expected
 If no statement in initial year, each activity is a separate activity.
 Reasonable cause exception if returns consistent with grouping.
When does IRS group or ungroup? See Reg. 1.469-4(f).
In abusive situations, where the purpose is to avoid passive loss limitations. Often when income is treated as
passive when, in fact, the entity generating the income is related to an entity where TP works. IRS may hold
that two entities form a single activity, turning income nonpassive (if TP materially participated in either entity,
i.e. income should not be on Form 8582 triggering deductibility of otherwise nondeductible losses).
C CORPORATIONS
By Lucy H Clark, [email protected]
Concerns

For all personal service corporations (PSC):
 Are rental losses or rental credits offsetting corporate or portfolio income?
 Are business losses or credits from a 1065 or 1120S in which a 50%+ shareholder does not
materially participate offsetting corporate or portfolio income?
For corporations with 5 or less shareholders that are not PSCs:
 Are rental losses or losses from a 1065/1120S business in which a 50%+ shareholder does not
materially participate improperly offsetting portfolio income?
 Have rental losses or losses from a business without material participation been incorrectly used to
create an NOL? A passive activity loss cannot be carried back; it can only be carried forward.
Code & Regs: IRC 469(a)(2)(C), IRC 469(j)(1), 469(h)(4), Reg. 1.469-1T(g)(4), IRC465(1)(1)(B)
Basic tax law for personal service corporations (PSC)
 Passive loss limitations apply in full to all PSCs, including those that are closely held.
 A passive loss is any rental loss, or a loss from a business in which the shareholder(s) do not
materially participate.
 Material participation requires one or more shareholders with more than 50% of the stock to meet
one of 7 tests in Reg. 1.469-5T(a). Most common test: working 500 or more hours for the year.
 Passive losses are not deductible in the absence of passive income.
 A passive loss cannot offset PSC corporate business income.
 A passive loss cannot create an NOL.
 To materially participate, one or more shareholders owning more than 50% of the stock must meet
one of the 7 tests in Reg. 1.469-5T(a). Employee time cannot be used for material participation.
 There is no $25,000 offset for rental real estate as a corporation is not a natural person. IRC 469(i)
Basic tax law for a closely held C corporation that is not a PSC
Closely held = more than 50% of the stock is owned by 5 or fewer shareholders during the last half of the year.
 Passive losses can offset corporate business income, but not portfolio income.
 A passive loss cannot create an NOL.
 There is no $25,000 offset for rental real estate as a corporation is not a natural person.
But …
 Rental losses are excepted from passive loss limitations if corporation is a real estate pro
and materially participated in the rental real estate activity.
 Corporation is a real estate Pro if more than 50% of its gross receipts are from real property
businesses and/or rental real estate.
Material participation in 1065/1120S owned by the corporation requires:
 Shareholders owing more than 50% meet one of the 7 tests in Reg. 1.469-5T(a) OR
 If for entire 12 months (1) A full-time employee of the corporation spends all his time managing the activity AND
(2) Corp has 3 or more non-owner employees performing services for the business AND
(3) Corp's expenses exceed 15% of gross income, excluding interest, taxes and depreciation.
Basic tax law for consolidated corporations
For purposes of section 469, the consolidated corporation is treated as a single entity, in other
words, as one corporation. See IRC 469(j)(11) & Final Reg 1.469-1(h)(4)(ii)(A). As a practical
matter, there generally are not many PAL issues with consolidated returns.
More info
 Instructions to Form 8810, IRS Publication 925
 www.IRS.gov MSSP Guide: Passive Activity Losses Training 3149-115