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:: Passive Activity Loss ATG - Exhibit 4.1: Material Participation
Exhibit 4.1:
Material
Participation
ISSUE: Are
losses
limited, as taxpayer
is not materially
participating?
OR
Is
taxpayer materially
participating in the
activity; therefore,
income
is non-passive and
cannot be used on
FORM 8582 to offset
passive losses?
ACTIVITY:
If the return
reflects several
related businesses,
particularly for
income issues, the
examiner should
consider whether
they should be
grouped as a single
activity under Reg.
§ 1.469-4. The
grouping rules are
also a position the
taxpayer may raise
in loss situations.
The time for the
taxpayer to group is
when the first
return with the
entity was filed.
To
determine material
participation in an
activity, the
taxpayer must meet
ONE of the
following:
1.____ Does
taxpayer and/or
spouse work more
than 500 hours a
year in the
business?
2.____ Does
taxpayer do most of
the work? Even
if taxpayer does not
meet 500 hour test,
but his
participation is the
only activity in the
business, he
materially
participates.
Example: sole
proprietor with no
employees.
3.____ Does
taxpayer work more
than l00 hours and
no one
(including
non-owners or
employees) works
more hours?
Example: If
owner puts in l75
hours a year and an
employee works 190
hours a year,
taxpayer would not
meet material
participation test.
4.____ Does
taxpayer have
several passive
activities in which
he participates
between 100-500
hours each, and the
total time is more
than 500 hours?
The following
activities should
not be included in
the above test:
rental activities:
activities involving
portfolio or
investment income,
and activities in
which the taxpayer
does most of the
work.
5.____ Did
taxpayer materially
participate in
activity for any 5
out of l0
preceding
years (need not
be consecutive)?
Example:
taxpayer who retired
and his children now
run business, but he
stills owns part of
partnership.
6.____ Did
taxpayer materially
participate in a
personal
service
activity for
any
3 prior
years (need
not be
consecutive)?
Personal service
activity includes
fields of health,
law, engineering,
architecture,
accounting,
actuarial science,
performing arts and
consulting.
7.____ Do the
facts and
circumstances
indicate taxpayer is
materially
participating?
Test does not apply
unless taxpayer
worked more than 100
hours a year.
Furthermore, it does
not apply if:
-
any person,
other than the
taxpayer,
received
compensation for
managing the
activity; or,
-
if any person
spent more hours
than taxpayer
managing the
activity.
REMINDER: Limited
partners under IRC §
469(h)(2) are
generally passive.
The exceptions to
the limited partner
rule are tests 1, 5
and 6 above. If
taxpayer holds both
a general and
limited partner
interest, he will
have all seven tests
available.
If
the answer to
any of the
above questions is
YES the
taxpayer meets the
material
participation
standard. Losses or
income should not be
reflected on Form
8582, and the
taxpayer may
generally deduct in
full the amount of
the loss in the
current year. If
the taxpayer
materially
participated, losses
or income are
reflected on the
return as
non-passive.
If
the answer is NO
to all seven tests,
the material
participation
standard is not met,
and losses are
passive. Taxpayer
will be allowed
losses only to the
extent of passive
income.
CONCLUSION:
Under IRC § 469, it
has been determined
that the taxpayer is
/is not materially
participating.
Reminder: If
the taxpayer does
not materially
participate, credits
arising from the
business are
generally passive.
In the absence of
passive income, a
passive activity
credit is
nondeductible in the
current year.
Examples:
investment credit,
rehabilitation
credit, work
opportunity,
disabled access,
credit for employer
social security and
medicare taxes on
employee tips, etc.
See Instructions for
Form 8582-CR for a
list.
ADJUSTMENT:
Generally, the
adjustment is the
full amount of the
loss disallowed,
unless the taxpayer
has remaining
passive income which
has not been used to
trigger other
passive losses.
Passive income is
net income from a
rental or from a
business in which
the taxpayer does
not materially
participate.
Losses belong on
Form 8582 line 3b
(2b for years prior
to 2002). As a
practical matter,
there is often no
need to compute Form
8582 if there is no
remaining passive
income.
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