Material Participation and Passive Activity Losses

Corporate tax, or corporation or company tax, is a type of fee that is imposed by the federal government on a business’s profits. According to the Federal Tax Cuts and Jobs Act of 2017, the current federal corporate tax rate is 21%; what this means is that after all business expenses have been deducted, a corporation will be required to pay the federal government 21% of its total revenue when filing a federal corporate tax return.

An example of this would be if your corporation made $1 million in revenue after deducting all legitimate business expenses. When you file your business’s federal corporate tax return, you will owe 21% of that $1 million in taxes to the federal government, or $210,000.

The federal corporate tax rate is subject to change. Additionally, states may impose their own separate corporate income tax rates in addition to the federal corporate tax. However, not every state applies a state corporate income tax rate. Those that do generally have rates that vary considerably by jurisdiction, although the standard range for state corporate income tax rates is between one and twelve percent.

To continue the above example, Kentucky has a five percent tax rate. If you live in a state with a separate corporate income tax rate, such as Kentucky, you must deduct federal ($210,000) and state ($50,000) tax amounts from your total revenue. You will owe $260,000 in federal and state taxes, leaving you with $740,000 of your total profits.

Aside from federal and corporate taxes, a corporation may also need to pay taxes specific to certain business divisions. Some of the most common types of corporate taxes that a business may be required to pay include:

• Employment or Payroll Taxes: The percentage deducted from an employee’s paycheck. This may be used to pay off taxes, such as those for social security benefits and Medicare, or unemployment;
• Real Estate Taxes: Some businesses may need to pay these taxes on property that it owns, such as if the corporation owns the building in which it operates;
• Estimated Taxes: A business may need to make installment payments on taxes periodically throughout a given tax year. This is most commonly required when a business expects to owe $500 or more in federal income taxes;
• Franchise Taxes: Some states place a special kind of tax on businesses that want to operate or remain open in their specific state; and
• Excise Taxes: Only applied to certain goods such as alcohol, gasoline, cigarettes, luxury goods, and other items regulated by various tax laws.

What Is Passive Activity Income?

Generally speaking, passive activity income is income produced from a trade or business in which you materially participate during the tax year. The intention behind passive activity restrictions is that a taxpayer who participates in an activity is more likely to engage with a significant non-tax profit motive and will form a sound judgment as to whether the activity has genuine economic significance and value.

The IRS recognizes two passive activities: trade or business activities in which a person does not materially participate during the tax year and rental activities. This includes whether or not the taxpayer materially participates in the rental activities.

Passive activity restrictions generally apply to:

• Individuals;
• Estates;
• Trusts;
• Personal service corporations; and
• Closely held corporations.

On your tax return, you may generally include all income or losses. However, this excludes those related to an active trade or business, as well as portfolio income which includes:

• Interest;
• Dividends;
• Royalties;
• Annuities; and
• Gain or loss from the sale of portfolio assets.

In general, passive activity losses can only offset passive activity income. Additionally, passive activity tax credits can only be used against tax attributable to passive activity income on your tax return.

You cannot claim expenses from a hobby that exceed the overall income you report for a tax year. Taxpayers receive a deduction for a second business or hobby activity when they can prove that they conduct that second activity or hobby for a profit motive.

What Are Material Participation And Passive Activity Losses?

Expenses and losses related to a passive activity are generally only deductible by the taxpayer to the extent of their passive activity income. To reiterate, there are two main types of passive activities:

1. Trade or business activities that the taxpayer does not materially participate in during the tax year; and
2. Rental activities.

Disallowed passive activity expenses and losses are carried forward to offset future passive activity income.In the year that the taxpayer disposes of their interest in the passive activity, any remaining carryover passive activity losses attributable to that activity may be used as a deduction against the taxpayer’s other income.

It is important to note that the taxpayer may avoid the unfavorable treatment for expenses and losses associated with a passive activity if they materially participate.

What Is Material Participation As It Is Associated With Passive Activity Loss Rules?

There are seven ways in which a taxpayer may be considered “materially participating” in an activity:

1. The taxpayer participates in the activity for more than 500 hours over the course of the tax year;
2. The taxpayer is the only participant in that activity during the tax year;
3. The taxpayer participates for more than 100 hours in the activity, and their participation must be more than any other person involved in the activity during the tax year;
4. The activity is a “significant participation activity” for the taxpayer during the tax year, and the taxpayer’s aggregate participation in all “significant participation activity” for that tax year exceeds 500 hours;
5. The taxpayer materially participated in the activity for any five taxable years, which need not be consecutive, during the past ten years;
6. The activity is a personal service activity, and the taxpayer materially participated in it for the past three years before the current tax year; or
7. The taxpayer participates in the activity for more than 100 hours based on all of the facts and circumstances, and the taxpayer participates on a regular, continuous, and substantial basis.

What Is A Rental Activity For The Purposes Of The Passive Activity Loss Rules?

A rental activity generally refers to an activity in which the taxpayer gets paid for letting someone else use their tangible properties. However, it is important to note that there are several exceptions to this general definition.

If the activity meets any one of the following tests, it will not be considered a “rental activity” for the purposes of the passive activity loss rules:

1. The average rental period for customer use is 7 days or less;
2. The average rental period for customer use is 30 days or less, and “significant personal services” are provided with the rental;
3. “Extraordinary personal services” are provided with the rental, regardless of the average period of rental use;
4. The rental is incidental to a non-rental activity of the taxpayer;
5. The taxpayer customarily makes the rental property available during defined business hours for nonexclusive use by various customers; or
6. The taxpayer provides the property for use in a non-rental activity by a partnership, S corporation, or joint venture in which the taxpayer owns an interest.

Do I Need A Lawyer For Help With My Tax Problems?

You should consult with a tax attorney if you have any questions or issues associated with your tax liability.

Your business or tax lawyer can help you understand your legal rights, options, and obligations according to current tax law and your state’s specific tax laws. Additionally, an attorney will also be able to represent you in court, as needed, should any legal issues arise.