Business entities with pass-through taxation do not retain losses within the business entity. Losses are passed through to owners based either on the percentage of ownership or pursuant to a special allocation in a partnership. The losses can generally be used to offset the individuals profits. There are, however, limitations on the ability of individuals to use or employ these losses. The most important limitations regard basis, at-risk limitations, and active and passive loss rules. Losses must clear all three of these hurdles to be used by owners. Each of these limitations is discussed below.
- Note: The use of losses is a significant concern for equity investors. Part of the value that investors attribute to a startup at the 4me of investment takes into consideration the ability to use these losses to offset income from other investments.
What is a Passive Loss?
Business profits and losses in pass-through tax entities are divided into active profits or losses and passive profits or losses for tax purposes. Active losses are business losses incurred in a business in which the equity holder is an active participant in the business activity. The rules for determining active participation are numerous, but they are mostly based on the number of hours and percentage of 4me spent working in the business. Therefore, any losses that pass through to an investor who is not an active participant in the business are considered passive losses. Classification of losses affects the ability to offset other profits (profits from other activities not related to the business) that the investor includes in her personal income. Passive losses can be used to offset passive income; likewise, active losses can be used to offset active income. Active income includes wages, income from substantial involvement in a pass-through business entity, along with several other sources. Unused active losses can generally be carried backward for two years and forward for twenty years to offset active income. Unused passive losses are carried forward as such to offset passive income. The losses can also be claimed to offset gains at the 4me of sale of the equity interest.
- Example: Tina is a passive investor in a partnership. In a given year she earns $3,000 as her share of partnership profits. At the same 4me, Tina is a passive investor in an S corpora4on that loses $2,500 that year. She also owns an interest in and is actively involved in the opera4ons of an LLC. The LLC loses $500 that given year that is allocated to Tina. In this scenario, Tina can offset the $3,000 passive income with the $2,500 passive loss. This leaves $500 of passive income that is taxable. The $500 in losses from her LLC interest is active in nature. She cannot use these active losses to offset the passive income. The active losses can, however, be carried forward to offset future active income.
- Note: Passive income is subject to ordinary income tax, but is exempt from self- employment taxes in partnerships. Uncertainty exists over the taxa4on of LLC income for seemingly passive investors. That is, regarding LLCs that are taxed as pass-through entities, the IRS has taken the stance that any distributions to an LLC member is subject to self-employment tax. This is a notable difference between the two entity forms. The IRS has proposed regulations to change this disparity.
How does the IRS determine what is passive and active income or losses?
The determination of whether income is active or passive is based upon whether the individual materially participates in the venture. There are several considerations that go into the material participation test. A person materially participates in an activity if:
- She participates for more than 500 hours in business activities,
- Her activity constitutes all of the business activity in the tax year,
- She participates 100 hours and her activity is as much as any other business member,
- She participates in all significant participation activities for more than 500 hours per year,
- She materially participates in the business during any 5 of the past 10 years (3 years if a personal service business), or
- She participates on a regular, continuous, and substantial way during the past year.
- Note: This issue arises in the context of partnership-taxed entities and S corporations.
