Unraveling Conflicting Tax Rule for Active vs Passive Business Owners
February 26, 2020
Few topics in the office cause more arguments than the tax definition of active versus passive. The answer affects your income taxes vastly more than one would ever guess. And, not in just one area of tax but often involving a multitude of seemingly unrelated areas. At times, both parties in our office scuffles will have written evidence to support each of their opposing views. Taxes have many shades of gray.
It is commonly accepted wisdom that tax rules are complicated. This belief is well supported by the conflicting tax rules that apply to business owners, depending on their participation in the business. Let me try to make some sense of these conflicting rules.
Business owners may be active in their business. This means they are hands-on and are involved in day-to-day activities. Other business owners may be mere investors, adding their capital but not their labor. The following are various rules that take into account whether owners do or do not work in their businesses.
Qualified business income deduction
The 20% deduction for qualified business income (QBI) applies to owners of pass-through entities. There is no requirement that they do or do not participate in the daily operations of the business in order to claim this personal deduction based on their share of business income. If they participate (e.g., they are an S corporation shareholder who receives a salary), this factors into the QBI determination. For example, salary to an S corporation shareholder is not an item allowed in determining QBI, but the salary does count as wages for purposes of W-2 wages used in the formula for the QBI deduction.
Net investment income deduction
The 3.8% net investment income (NII) tax depends entirely on an owner’s participation in the business. Only income from a business in which the taxpayer does not materially participate is treated as investment income and potentially subject to the NII tax. The determination of material participation is made using the passive activity loss rules (below).
Passive activity loss rules
Under the passive activity loss rules, losses from a business activity in which an owner does not materially participate, and has no passive income, are not currently deductible (sorry for the double negative but it’s the best way to explain this limitation). Suspended losses can be carried forward and used to offset passive activity income in the future.
The determination of whether an owner is passive or active is based on 7 tests. An owner is treated as materially participating (i.e., active) and is exempt from the passive activity loss rules if he or she meets any of these tests:
1. The owner participated in the activity for more than 500 hours.
2. The owner’s participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
3. The owner participated in the activity for more than 100 hours during the tax year, and he or she participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
4. The activity is a significant participation activity, and the owner participated in all significant participation activities for more than 500 hours (i.e., participation for more than 500 hours during the year and in which the owner didn’t materially participate under any of the material participation tests).
5. The owner materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
6. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
7. Based on all the facts and circumstances, the owner participated in the activity on a regular, continuous, and substantial basis during the year.
Note: When it comes to rental real estate activities and the passive activity loss rules, an owner’s participation doesn’t entitle him or her to claim losses. Owners of rental real estate activities can escape the passive activity loss rules only by demonstrating that they are real estate professionals (part of the definition of a real estate professional is based on material participation).
Sole proprietors pay self-employment tax on their net self-employment income. This is so whether they run their business or are totally in the background, relying on a full-time manager to handle the business.
General partners are subject to self-employment tax on their distributive share of self-employment income, plus any guaranteed payments. In contrast, limited partners are exempt from self-employment tax (other than for any guaranteed payments they receive for personal services rendered for the partnership).
Members in limited liability companies may or may not be subject to self-employment tax. There is no firm IRS guidance on this matter. However, tax professionals have argued that where members are mere investors (i.e., they act like limited partners), they should be treated like limited partners who are exempt from self-employment tax on their distributive shares.
Whether you sweat each day in your endeavors or are an investor who watches the books determines the tax rules that apply to you. Discuss your status with your CPA or other tax advisor.
Credit given to: Barbara Weltman
Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.
Today's author - Mark Bradstreet