This was originally published on PAOO on August 30th, 2010.
In Action On Decision 2010-002 the IRS acquiesced in a Court of Claims decision (Thompson v. US 104 AFTR 2d 2009-5381) holding that a membership interest in a LLC was not presumptively passive. Since the LLC is really the entity of choice, if you want a flow through this can be of significance. The passive activity loss rules were probably the most novel element of the Tax Reform Act of 1986. They created a new taxonomy of business undertakings based on each individual taxpayers participation in the business.
The income or loss created by passive activities are aggregated and, in general, the losses are only allowed to the extent of the income. It is erroneous to think of the process as an offset, because the various types of income and losses retain their character. So if you have a capital gain from one passive activity and an ordinary loss from another activity, the ordinary loss will be allowed, while the capital gain will retain its character as a capital gain. Losses without accompanying gains languish suspended from year to year until they are released by the total disposition of the activity giving rise to them. It all gets tracked by Form 8582. If you have been involved in passive activities it could be a worthwhile exercise to review your 8582's from year to year. You will have two sets, one for the regular tax and another for the alternative minimum tax. If you have switched tax preparers, there is a decent chance something got lost in transition. It can happen even from preparers switching software.
The cleanest way out of the morass of passive activity concerns is "material participation". The regulations give an individual seven ways to establish material participation :
(1) The individual participates in the activity for more than 500 hours during such year.
(2) The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;
(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;
(4) The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;
(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;
(6) The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or
(7) Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.
The regulations go on to state that if the taxpayers interest in the activity is as a limited partner qualification for material participation can only come from items 1, 5, and 6 above. Thus a limited partner who does more than any other individual in the activity will not be considered to be materially participating if that amounts to less than 500 hours. In the Thompson case the service had argued that an LLC membership interest was the same as a limited partnership interest for purposes of this regulation. The Court of Claims did not agree and the service has thrown in the towel on this issue.
This decision should further bolster the LLC as the entity of choice where a flow though is desired. Taxpayers should bear in mind though that if they are posting negative numbers from an activity, the IRS will likely attack any reconstruction of their time as a ballpark guesstimate (This has become a term of art apparently).