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Text File | 1996-08-23 | 20KB | 559 lines

@Q01
                ┌────────────────────────────────────┐
                │ ARE LOSSES INCURRED BY MY BUSINESS │
                │ LIMITED BY THE PASSIVE LOSS RULES? │
                └────────────────────────────────────┘

As a general rule, tax losses and tax credits generated by a
business may be used to offset other income of the owner(s)
of the business, in the case of a sole proprietorship,
partnership, of S corporation.  Or, in the case of a C
corporation, such losses or credits may, in many cases, be
used to offset other income of the corporation, such as
portfolio income or active business income.

However, if the losses or credits are considered to be from
"passive activities," there are severe limits on the use of
such losses or credits to offset current income other than
income from "passive activities."

  QUESTION:  Is your business set up as a "C corporation"?
@YN
01\Q02
02\Q11

@Q02

CONCLUSION:  Then you will not be able to offset losses or
credits generated by your corporation against your personal
income.  This is always true in the case of a C corporation,
whether or not the losses or credits it incurs are "passive"
in nature.  The key questions in your case are (1) Whether
your corporation has any "passive" losses or credits and (2)
whether your corporation is considered to be a "personal
service corporation" or a "closely-held C corporation."

(Note:  A "passive" activity, for purposes of the question
below, is a trade or business carried on by a corporation,
where the major shareholders do not "materially participate"
in the activity.  If any one or more shareholders owning
more than 50% of the stock "materially participate" in the
activity, it is not considered a "passive activity.")  (Most
rental activities are automatically "passive.")

  QUESTION:  Does your C corporation generate any losses or
             credits that are from "passive activities"?
@YN
01\Q04
02\Q03

@Q03

CONCLUSION:  Then you do not need to be concerned about
the usability of "passive" losses or credits, since your
corporation does not have any such losses or credits.
Therefore, any losses or credits your corporation generates
from a trade or business should, in general, be allowable as
an offset against income from any other trades or businesses
it carries on, or against "portfolio income" such as taxable
interest or dividend income.

@STOP

@Q04

TENTATIVE CONCLUSION:  Then your C corporation may be
limited, under the passive activity loss rules, in its
ability to currently utilize such losses or credits, IF it
is either:  (a) a "personal service corporation"; or (b) a
"closely-held C corporation."

For a C corporation to be a "personal service corporation,"
the corporation's principal activity must consist of the
performance of personal services.  Personal services would
cover a wide range of activities, including professional
services such as law, medicine, dentistry, accounting,
architectural and engineering services, actuarial sciences,
and the like.  It would also cover areas such as consulting
services, the incorporated professional athlete or
entertainer, and miscellaneous other service businesses,
such as an incorporated salesperson.

  QUESTION:  Does your corporation perform personal
             services as its principal activity?
@YN
01\Q08
02\Q05

@Q05

CONCLUSION:  Your company is not a "personal service
corporation" for purposes of the passive loss rules, and
thus is not fully subject to the passive activity loss
limitations.

However, your company may be a "closely held C corporation"
that is partially subject to the passive loss rules,
depending on its stock ownership.  (See below)

 QUESTION:  Did 5 or fewer individuals (directly or
            indirectly) own more than 50% (in value)
            of the stock of the corporation during
            the last half of the tax year?

@YN
01\Q06
02\Q07

@Q06

FURTHER CONCLUSION:  While your corporation is not considered
a "personal service corporation," and thus is not fully
subject to the passive loss restrictions, it is considered
to be a "closely held C corporation," and thus is partially
subject to the passive loss rules.  That is, it may offset
passive activity losses against its "net active income,"
but not against its "portfolio income."

@STOP

@Q07

FURTHER CONCLUSION:  Your C corporation is not a "personal
service corporation" (within the meaning of the passive loss
rules), and is also not considered a "closely held C
corporation."  This means, if the above conclusions are
both correct, that your corporation is not subject to ANY
of the passive loss restrictions.  Thus, losses incurred by
your corporation on passive activity investments should be
fully available to offset against either portfolio income
or other income ("net active income") of the corporation,
without restriction.

@STOP

@Q08

SERVICES MUST BE "SUBSTANTIALLY PERFORMED" BY SHAREHOLDER
EMPLOYEES:  To be deemed a "personal service corporation,"
the personal services performed by the corporation must be
"substantially performed" by employees who own stock in the
corporation.  To determine whether the services to customers
and clients are "substantially" performed by employee-owners,
the Income Tax Regulations say that more than 20% of the
corporation's compensation expense attributable to its
service activities have to be attributable to personal
services performed by its employee-owners.  If it is clear
that over 20% of the cost of performing services (of the
types described in the previous question) are attributable
to services performed by owners, you should answer "Y"
("YES") to the following question.  If it is clear that less
than 20% of such compensation costs are attributable to
services rendered by employee-owners, then answer "N" ("NO").

QUESTION:  Are the services rendered by the corporation
"substantially" performed by its employee-owners?
@YN
01\Q09
02\Q05

@Q09

STOCK OWNERSHIP REQUIREMENT:  A corporation cannot be
treated as a "PSC" for tax purposes unless employees own
more than 10% of its stock (by value), directly or
indirectly.

  QUESTION:  Do employee-owners own (directly or indirectly)
             more than 10% of the stock of your corporation,
             by value?

@YN
01\Q10
02\Q05

@Q10

CONCLUSION:  It appears from your responses that your C
corporation may be a "personal service corporation" under
the definitions used in the passive activity loss rules
and for determining whether a C corporation is restricted
in its choice of a fiscal tax year.

If so, this means that if your corporation has losses from
"passive activities," it may not generally offset those
losses against its "net active income" (business income,
generally) or against its "portfolio income" (income from
dividends, interest, annuities, certain royalties, etc.).

However, such losses (or credits) can be used to offset
other passive income of your corporation.  Also, when you
finally dispose of a passive activity (by selling off such
a business, for instance), the corporation should than be
allowed to deduct any "suspended" passive losses related to
that activity which it had accumulated over the years, but
had not been able to utilize because of the passive loss
limitations.

@STOP

@Q11

"Passive" losses or credits of unincorporated businesses,
or of S corporations, generally cannot  be used to offset
income of the owners of the business to whom such business
losses are allocated, unless there is passive income against
which such losses can be offset.

Note:  A "passive" activity,  is a trade or business that
is carried on by a business, where you, as sole proprietor,
partner, or S corporation shareholder, do not "materially
participate" in such activity. However, if you, individually,
are considered to "materially participate" in the activity
in question, it is not a passive activity with regard to YOU
(even if it is so, for your fellow partners or S corporation
shareholders).  (Note also that most rental activities are
automatically considered to be passive in nature, regardless
of your "material participation."  However, AFTER 1993, REAL
ESTATE PROFESSIONALS CAN "materially participate.")
QUESTION: Does this unincorporated business generate any
          losses or credits from "passive activities"?
@YN
01\Q13
02\Q12

@Q12

CONCLUSION:  Then this consulting session may not be relevant
to your situation.  Since your business is not generating
any "passive" losses or credits, you are not subject to the
restrictions on utilization of passive losses.

(Unless you HAD passive losses in prior years which have
been suspended and carried over.  In that case, you will
not generally be able to deduct those "suspended" prior year
passive losses until you generate passive income against
which the suspended losses can be offset, or until you
dispose of the activity, by sale or in certain other ways,
and are allowed to offset the accumulated suspended losses
against non-passive income in the year of the disposition.)

@STOP

@Q13

There are special, especially strict, rules on deducting
passive losses from certain "publicly-traded partnerships."
(Most such partnerships are limited partnerships,  whose
units trade much like common stocks of corporations.)

  QUESTION:  Is the business in question a publicly-traded
             partnership?

@YN
01\Q14
02\Q15

@Q14

CONCLUSION:  Then your ability to deduct any passive losses
from such a publicly traded partnership will be EXTREMELY
limited.   As a practical matter, so long as you own your
interest in such partnership,  you will not be able to
utilize any passive losses from it against other income,
EVEN AGAINST OTHER PASSIVE INCOME, with one very limited
exception:  You may only carry such losses forward as
"suspended losses"; then, if the same partnership later
generates net passive income, only then may you offset the
suspended losses against the passive income of that same
partnership.

@STOP

@Q15

In general, such "passive" losses will not be currently
deductible for you, unless you have other "passive income"
which they can be used to offset. However, there is a limited
exception for passive losses from certain real estate rental
activities, for some individuals who have adjusted gross
incomes of less than $100,000 (phasing out at income levels
between $100,000 and $150,000, or in the case of low income
housing projects, between $200,000 and $250,000). Under this
exception, an individual who is deemed to "actively
participate" (this isn't the same as "material participation")
in the rental activity is allowed to offset up to $25,000 a
year of passive rental losses against other taxable income
(or the "credit equivalent" of such deductions, in the case
of low-income housing credits.

  QUESTION:   Does the "passive activity" in question
              consist of rental real estate?

@YN
01\Q17
02\Q16

@Q16

CONCLUSION:  Then it appears that your passive losses from
your sole proprietorship, partnership or S corporation
business may not be currently deductible, unless you have
other "passive income" against which such losses can be
offset (other than "passive income" from "publicly-traded
partnerships").

@STOP

@Q17

To qualify for the right to offset such rental real estate
losses against non-passive income, you must "actively
participate" in the management of the property.  Part of
the definition of "active participation" is that you must
own at least 10% of the property in question, either
directly, or as a 10% or more partner in a partnership.

(An ownership interest as a limited partner is not counted
towards the 10% ownership requirement.)

(Note that there is NO "active participation" test required
for investors in low-income housing activities that qualify
under special provisions of the tax code.)

  QUESTION:   Do you meet the "active participation"
              requirements described above (if applicable)?

@YN
01\Q18
02\Q16

@Q18

CONCLUSION: Then, in any year in which your "adjusted gross
income" is less than $150,000 ($250,000 in the case of
certain low-income housing), you may be able to offset all
or some portion of your net rental losses against other,
non-passive income, on your individual income tax return.
The maximum such passive loss that you may deduct in one
year is limited to the lesser of:

   . $25,000; or

   . $25,000, reduced by half the amount your adjusted
     gross income exceeds $100,000 ($200,000 in the case
     of low-income housing, if acquired before 1990).

Thus, for each dollar of adjusted gross income you have
above $100,000 (or $200,000, for low-income housing
acquired before 1990), the maximum $25,000 loss allowable
for the year is reduced by 50 cents.

             ┌─────────────────────────────────────┐
             │ EXAMPLE OF PHASE-OUT OF THE $25,000 │
             │ LIMIT ON PASSIVE LOSSES FOR "ACTIVE │
             │ PARTICIPATION" RENTAL  REAL ESTATE: │
             │ =================================== │
             │ Say your adjusted  gross income for │
             │ the year before passive losses, IRA │
             │ deduction, taxable Social Security, │
             │ and the exclusion  for savings bond │
             │ interest used for  higher education │
             │ expenses, is $115,000, and you have │
             │ a $27,500 rental loss from property │
             │ in which you "actively participate" │
             │ in management.  Your allowable loss │
             │ for the year would be $25,000, less │
             │ $7,500  (one-half of $115,000 minus │
             │ $100,000), or a net deduction equal │
             │ to $17,500.  The remaining,  unused │
             │ loss of $10,000 would be  suspended │
             │ and carried  forward  indefinitely, │
             │ until, if ever, it can be used.     │
             └─────────────────────────────────────┘


@STOP

@HELP

@H\01

A "C corporation" is  a technical term,
but, fortunately,  is a relatively easy
one to understand.  A C corporation is,
quite  simply,  any corporation  (other
than a  not-for-profit  one) OTHER THAN
an "S corporation" (formerly known as a
Subchapter S corporation). Thus, unless
your corporation  is one that has filed
an S corporation election of Form 2553,
it is considered an C corporation.  You
should answer this  question "N" ("NO")
if your company is not incorporated  or
if it is an S corporation.

@H\02
An individual is  deemed to "materially
participate" in an activity if:

 . She participates in the activity
   more than 500 hours in the year; or

 . Her participation is substantially
   ALL of the participation in that
   activity by anyone for the year; or

 . She participates over 100 hours in
   the activity and no other individual
   participates more than she.

(IRS regulations go on for many pages...)
@H\04

Businesses that sell some form of
property, rather than purely services,
are not deemed to be engaged in
performing services.  Although such
activities as wholesale or retail sales
of goods or sales of insurance, real
estate or financial services or products
have a large service component, they are
not considered to be performance of
personal services, for purposes of this
definition.

@H\05

Don't think you can get around the "five
or fewer persons owning  over 50% of the
value of the  stock" rule by putting 10%
of the stock in the  hands of each of 10
related people.  The "attribution" rules
of the tax law lump  all related parties
together and treat them as one person.

@H\06
"Net  active  income" is:   all taxable
income, OTHER THAN portfolio income and
expenses or passive activity income and
losses. "Portfolio income and expenses"
include  the following  items of income
(less all allocable expenses):

 . Gross interest, dividends,
   annuities, or royalties not derived
   in the ordinary course of a trade
   or business (less expenses);

 . Gain or loss not derived in the
   ordinary course of business from
   disposition of assets (non-passive).
@H\08
The Regulations contain a number of very
technical  rules explaining this test as
to whether services  are "substantially"
performed by owner-employees,  which are
much too complex and detailed to explain
here,  so in some  cases it  may  not be
clear one way or the other  whether your
corporation's   owner-employees  perform
enough of the company's services to meet
this test.  Thus, in some cases, you may
have to take  your best shot at guessing
whether to answer "YES"  or "NO" to this
question,  in which  case the answer you
finally  arrive at as  to PSC status may
not necessarily be correct.
@H\09

If the total combined ownership of stock
in   the   corporation   by   employees,
including shares they  are deemed to own
(stock owned by  their children, related
entities and so forth), is more than 10%
of the  corporation's  stock (by value),
you  should answer  "Y" ("YES")  to this
question.  Otherwise, answer "N" ("NO").

@H\10
"Net  active  income" is:   all taxable
income, OTHER THAN portfolio income and
expenses or passive activity income and
losses. "Portfolio income and expenses"
include  the following  items of income
(less all allocable expenses):

 . Gross interest, dividends,
   annuities, or royalties not derived
   in the ordinary course of a trade
   or business (less expenses);

 . Gain or loss not derived in the
   ordinary course of business from
   disposition of assets (non-passive).
@H\11
An individual is deemed to "materially
participate" in an activity if:
  . She participates in the activity
    more than 500 hours in the year; or
  . Her participation is substantially
    ALL of the participation in that
    activity by anyone for the year; or
  . She participates over 100 hours in
    an activity and no other individual
    participates more than she does.
  . For rental real estate (after 1993),
    she must perform over 750 hours a
    year in real estate trade(s) & more
    than half her total services must
    be in real estate trades/businesses.
@H\13

A "publicly traded partnership" is any
partnership whose capital interests are
traded on an established securities
market (such as a stock exchange) or
that are readily tradable on a secondary
market (or its substantial equivalent).

@H\15

Note that  "rental real estate" does not
include very transient rentals,  such as
operation of hotels or motels. Thus, the
income from any such  operations are not
automatically treated as passive.

Also, note that for  low-income property
acquired after 1989, there is no phasing
out of the $25,000  deduction (or credit
equivalent) if  adjusted gross income is
over $200,000.   That limit was  removed
by the 1989 Revenue Reconciliation Act.

@H\17

"Active participation" is a much  less
stringent participation requirement than
the "material participation" rule that
applies to non-real estate activities.

The "active participation" requirement
can be met without regular, continuous
& substantial involvement in operations,
provided that you participate in a
significant way, such as by making
management decisions or by arranging for
others to provide services. For example,
approving rental agreements may
constitute "active participation."
@H\18

Special rules apply to allowance of low
income housing credits under the passive
loss rules for acquisitions of such
properties made after 1989.

@END