Cream of the Crop 1/Cream of the Crop 1.iso/BUSINESS/SBA62.ARJ/FSBA.EXE/F309.SBE

Text File | 1992-04-30 | 20KB | 539 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.  Thus the real 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 that is 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 busi-
nesses 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 enter-
tainer, and miscellaneous other service businesses, such as an incor-
porated 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 "SUBSTANTIALLY PERFORMED" BY SHAREHOLDER-EMPLOYEES:  To be
considered 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, clients, etc. 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 per-
forming 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, you should answer "N" ("NO").

  QUESTION:  Are the services rendered by the corporation
             "substantially" performed by employee-owners of
             the corporation?

@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 cor-
poration 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 cor-
porations,  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,  for purposes of the question below, 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 for some of
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.")

  QUESTION:   Does the unincorporated business in question generate any
              losses or credits that are 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 de-
duct those  "suspended"  prior year passive  losses until  you generate
passive income against which the suspended losses can be offset, or un-
til 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 income of less than $100,000 (phasing out at income lev-
els 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 is not 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 tax-
able 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 cur-
rently 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 partici-
pation" 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 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 hous-
ing), 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
     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 made
an election to be taxed as an S corpor-
ation,  it is an C corporation.  There-
fore,  answer this  question "N" ("NO")
only if your  company is an  S corpora-
tion, or is not a corporation at all.

@H\02
An individual is  considered to "materi-
ally participate" in an activity if:

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

  . His participation constitutes sub-
    stantially ALL participation in that
    activity by anyone for the year; or

  . He participates more than 100 hours
    in the activity and no other indi-
    vidual participates more than he.

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

Businesses that  sell some form of prop-
erty,  rather than purely services,  are
not considered to be engaged in perform-
ing services.   Although such activities
as wholesale or retail sales of goods or
sales of insurance, real estate, or fin-
ancial services or products have a large
service component,  they are not consid-
ered to be  performance of personal ser-
vices, 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 simply  all tax-
able income OTHER THAN portfolio income
and expenses or passive activity income
and losses.   "Portfolio income and ex-
penses" include the following items  of
income (less all allocable expenses):

 . Gross income from interest, divi-
   dends, 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 to-
tally clear one way or the other whether
your corporation's  owner-employees per-
form enough of the company's services to
meet this test. Thus, in some cases, you
may have to take your best shot at gues-
sing whether to answer "YES"  or "NO" to
this question,  in which case the answer
you finally  arrive at as  to PSC status
may well be wrong.
@H\09

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

@H\10
"Net active income" is simply  all tax-
able income OTHER THAN portfolio income
and expenses or passive activity income
and losses.   "Portfolio income and ex-
penses" include the following items  of
income (less all allocable expenses):

 . Gross income from interest, divi-
   dends, 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  considered to "materi-
ally participate" in an activity if:

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

  . His participation constitutes sub-
    stantially ALL participation in that
    activity by anyone for the year; or

  . He participates more than 100 hours
    in the activity and no other indi-
    vidual participates more than he.

(IRS regulations go on ad infinitum....)
@H\13

A  "publicly traded partnership"  is any
partnership whose  capital interests are
traded on an established securities mar-
ket (such as a stock  exchange) or which
are readily tradable on a secondary mar-
ket (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 phase-
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 satisfied  without regular,  con-
tinuous  and substantial  involvement in
operations,  provided that  you partici-
pate  in a  significant way,  such as by
making management decisions or by arran-
ging 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 pro-
perties made after 1989.

@END