Software Club 210: Light Red/Club_Software_210_Light_Red_Micro_Star_1997.iso/sba/f109.sbe

Text File | 1997-01-01 | 7KB | 148 lines

@079 CHAP ZZ

              ┌───────────────────────────────────┐
              │ PASSIVE ACTIVITY LOSS LIMITATIONS │
              └───────────────────────────────────┘

As anyone who reads the newspapers knows by now, "passive
activity" losses (i.e., tax shelters) have become an
endangered species since the passage of the Tax Reform Act
of 1986.  In general terms, a so-called "passive activity"
is one that involves the conduct of a trade or a business,
or an investment activity, in which the taxpayer does not
materially participate.

Rental activities of any type have been considered to be
passive regardless of the taxpayer's material participation
in the business (but certain short-term rental activities,
such as hotel rooms, tuxedos, etc. where the average customer
uses the property for seven days or less are not considered
to be "rental" activities).

In addition, beginning in 1994, certain taxpayers who devote
more than half their time to one or more real estate trades
or businesses will no longer have to treat losses from rental
real estate activities as "passive," but will be able to
offset such losses against their other income in full.  An
individual will meet the eligibility requirements if:

   . More than half of the personal services he or she
     performs are performed in real property trades or
     businesses (such as development, construction, rental,
     management, brokerage, etc.) in which he or she
     "materially participates"; and

   . He or she performs more than 750 hours of services
     during the tax year in real property trades or
     businesses in which he or she "materially participates."

@IF159xx]Because your company is engaged in rental activities, it is
@IF159xx]possible that the passive loss restrictions described below
@IF159xx]could apply to @NAME.
@IF159xx]
@IF112xx]However, as long as your corporation is (as it appears) a
@IF112xx]C corporation, but is not considered a "closely-held C
@IF112xx]corporation," it may be exempt from these loss limitations,
@IF112xx]which could be very advantageous, from a tax-planning
@IF112xx]standpoint, for @NAME.
@IF112xx]
@IF112xx]However, see discussion in this program of "personal service
@IF112xx]corporations," which ARE subject to the passive loss rules.
@IF160xx]Because your firm's business is @BUSTYPE,
@IF160xx]the definition of "personal service corporation" probably
@IF160xx]does not apply to @NAME, fortunately.
@IF160xx]
@IF161  ]Because your firm's business is @BUSTYPE,
@IF161  ]the "personal service corporation" definition is likely to
@IF161  ]apply to @NAME, unfortunately.
@IF161  ]
Under the tax law as it now stands, all of a taxpayer's
income and losses go into 3 separate categories:

    . Active source income (such as salary, wages or
      income or loss from an "actively conducted"
      business);

    . Passive activity income or loss (as from a tax
      shelter, or from a rental property); and

    . Portfolio income and related expenses (interest,
      dividends, capital gains).

Thus, part of the "tax game," if you have passive losses you
are unable to use, is to find a way to generate net passive
income.  One way many small businesses have done this up
till now is by leasing real or personal property to their
corporation or partnership business, structured with a
fairly low mortgage or no debt financing at all, so that
the lease arrangement would generate substantial net passive
income.  However, the IRS has just turned the rules upside
down, in early 1995, by modifying the passive activity tax
regulations (Sec. 1.469).  Under the new regulations, net
income on rentals to any controlled entity will now generally
be treated as NON-passive income, thus closing off this tax
planning opportunity.  Worse yet, if such a lease to a
controlled business entity throws off losses (instead of
net profits), the losses WILL be treated as passive.... It's
the same old story:  Heads, the IRS wins; tails, you lose!

In general, net losses from passive activities for a taxable
year cannot be offset against other income, but must be
carried over to future years to be offset against passive
income (if any).  Similarly, net portfolio losses resulting
from investment interest expense can't be offset against
either of the other 2 categories.  Only losses from active
sources can be used to currently offset income from the
other 2 categories, generally.

Thus, if you are a passive investor in a partnership or
an S corporation business that has net losses that are
considered passive activity losses, you must carry those
losses forward to future tax years for an indefinite period,
and cannot use the losses until you generate net passive
income against which they can be offset, or else you sell
or otherwise dispose of the investment in a way that permits
you to recognize the deferred losses.

For small businesses, perhaps the most important exception
to these passive loss restrictions is the exception for up
to $25,000 a year of losses from rental real estate, where
the taxpayer is considered to "actively participate" in the
rental activity.  This allowable deduction phases out at
the rate of $1 for every $2 that the taxpayer's adjusted
gross income exceeds $100,000.  Thus, no such deduction is
allowed for rental losses if adjusted gross income is
$150,000 or more.  (Note that adjusted gross income for
this purpose is recomputed without taking into account any
passive losses, IRA deductions, or taxable Social Security
benefits.)

Only a natural person (not a corporation, trust, etc.) can
qualify for the special $25,000 rental loss exception.
Also, to qualify for such a current deduction of rental
losses, the taxpayer must own at least a 10% interest (by
value) in the property, such as a 10% interest in a real
estate partnership.  Thus, you can't obtain this loss by
buying 0.000001% of a large public real estate partnership.
In addition, you must "actively participate" in the activity.
This means only that you must make major management decisions
about the property, such as hiring a management company to
manage it, or by approving new tenants, setting rental terms,
approving major expenditures, or the like.

The passive loss restrictions apply not only to individual
taxpayers, but also to "personal service corporations," in
full.  They also apply, but only to a limited extent, to
certain other closely-held C corporations, which are allowed
to offset passive losses against "net active income," but
not against portfolio income.  C corporations that are not
classified as "personal service corporations" or as
"closely-held C corporations" aren't subject to passive
loss restrictions at all.

Finally, neither partnerships nor S corporations are subject
to the passive loss rules, but any passive losses they pass
through to their partners or shareholders will be subject to
the passive loss rules at the partner or shareholder level.