When the Passive Activity Rules Are a Good Thingby
As we all know, the most popular way to avoid self-employment tax is to elect to be taxed as an S corporation. However, in doing so, you have to follow certain rules (like reasonable compensation) that can make the S corporation election cumbersome.
The question is: Could we use the passive activity rules to our clients’ benefit?
First, it is probably best to review the passive activity rules. The IRS defines passive activity rules as follows:
There are two kinds of passive activities.
- Trade or business activities in which you don’t materially participate during the year.
- Rental activities, even if you do materially participate in them, unless you’re a real estate professional.
The IRS has this to say about material participation:
Material participation is time sensitive. A taxpayer materially participates in an activity only if he or she meets any one of the seven material participation tests in Reg. § 1.469-5T(a). A taxpayer is required to identify the amount of his or her participation in a trade or business activity for each year.
Reg. § 1.469-5T(a), which is a temporary regulation, uses these seven tests:
§ 1.469-5T Material participation (temporary).
(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:
- The individual participates in the activity for more than 500 hours during such year;
- 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;
- 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;
- 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;
- 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;
- 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
- 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.
If you think about your clients who own more than one business, you can see how easy it would be to meet these rules. For instance, I have several doctors who own their own practice. Additionally, they are part of several other LLCs that are either surgery centers or completely different practices altogether.
Because material participation was satisfied with their practice, it leaves free the other LLCs to simply elect flow-through taxation without self-employment tax because they don’t spend more than 500 hours a year working in that particular business.
Passive losses can only be taken against passive income. Because of that, the determination of the income or loss being passive would have to be made based on an individual client basis. You wouldn’t want a client that will always have losses to have them treated as passive. You would want the ability to write the losses off against other income. You wouldn’t want an accumulation of losses that could only be taken when there was passive income.
Another reason to analyze the passive activity rules would be for distributions. The IRS clarified earlier this year that partners in a partnership are not supposed to receive paid salaries. Provided the limited partner in the LLC has basis in the partnership, distributions wouldn’t be taxable, much less subject to self-employment tax.
However, when using this strategy, you would need to consider closely if the distribution could be considered a guaranteed payment. Guaranteed payments to all partners are subject to self-employment tax. Typically, a partnership agreement or an LLC operating agreement will detail minimum payments that are made to partners. These are the guaranteed payments.
The passive activity rules can be used in your client’s favor. What’s most important is scanning each scenario per partner and making the determination.
Craig W. Smalley, EA is the CEO and Founder of CWSEAPA®, PLLC, located in Orlando, Florida, with clients all over the country in every industry. He has been admitted to practice before the IRS as an Enrolled Agent, and has a Master's Certificate in Taxation from UCLA. He has been in practice since 1994, specializing in individual, partnership...