15th Sep 2014
One of the most complex areas of tax law is the issue of passive income and passive losses vs. active income and active losses. There isn’t enough coffee or Red Bull in the world to not fall asleep trying to wade through these things. Today we are looking at just one area to limit the glassy eyed look: What happens when a parent hands over management of the family business to a child? Generally, once the child takes over the business, the child has active income while the retired parent (if they still retain an ownership interest) has passive income. But that is not always the case.
To make it very simple, passive income and passive losses are from activities that the taxpayer does not actively participate (usually applies to real estate) or materially participate in the business. Active income and active losses are everything else. For example, you inherited a 1% interest in a family business. Each year you receive a K-1, occasionally a check, but have nothing else to do with the business. In fact, you aren’t even sure what the business does. This is a passive activity. You didn’t participate materially in any of the income producing activities. Focusing on material participation, if you meet one of several guidelines for assisting in management, you are considered to be materially participating. We are looking at a recent Tax Court case, Wade v. Commissioner, TC Memo 2014-169, involving spending more than 500 hours in the year in the activity and participating in the business on a regular, continuous, and substantial basis.
Dad (Mr. Wade) and his partner started a successful business in 1980 (s-corporation). Sometime between 1994 and 2008, Dad handed over day to day management (as well as 70% of the stock) to his son, Ashley, and moved to Florida. Son had trouble in 2008 due to the economy and Dad stepped back in to establish customer connections, boost employee morale, and smooth things over with the bank. Dad also developed several new products for the company. Son continued to run day to day operations. IRS came in and said, well sure you did all this great stuff, but you still didn’t “run” the company, your son did that.
The tax court said, now wait a minute. Dad smoothed over the customers, the bank, the employees, he even developed new products. This business would have died without him, if that’s not material participation, what is? This is a positive step in that previous cases focused on the fact a person like son was running day to day operations and not on the other aspects of management that in this case Dad took on. Hopefully this is a positive trend.
Why does active v. passive count in the first place? Active losses can only be taken against active income and passive losses against passive income. Passive losses are also limited in how much can be taken at one time and how much can be rolled over to successive years. Passive losses cannot be carried back to previous years. In the Wade case, Dad wanted to carryback losses from 2008 to receive retroactive refunds from 2006 and 2007. This is also why the IRS fought the battle in this case, it doesn’t like handing out money!