You want to deduct that loss? Be ready to prove you are non-passive

January 19th, 2012 by Joe Kristan

A Tax Court case yesterday illustrates the problems taxpayers with day jobs face when they want to deduct losses for side activities. A Minnesota entrepreneur named Alfred Iverson, who founded a successful manufacturer of surgical and medical equipment, also had a 14,000 Colorado ranch where he raised Angus and Herford cattle. The ranch generated tax losses in 2005 and 2006, and the couple deducted the losses.
The IRS challenged the losses, saying they are “passive” under the tax law. The taxpayers failed to convince the Tax Court that they spent enough time in farm activity to deduct the losses. From the Tax Court opinion:

Petitioners claim that in each of 2005 and 2006, whether at the ranch in Colorado or from petitioners’ home in Minnesota, Mr. Iversen spent a total of at least 400 hours working on matters relating to Stirrup Ranch, Mrs. Iversen spent at least another 100 to 150 hours working on matters relating to the horses at the ranch, and that they together meet the 500-hour test of section 1.469-5T(a)(1), Temporary Income Tax Regs.

Our analysis of the time and activity petitioners spent in 2005 and 2006 working on matters relating to Stirrup Ranch is made difficult by the lack of meaningful contemporaneous or other records and documentation regarding specifically what petitioners did on a day-to-day basis and how much time they spent on matters relating to Stirrup Ranch. In this case, the lack of records and documentation are not cured by estimates made years after the fact in writing or by testimony.

It’s up to the taxpayers to prove that they spent enough time on an activity for it to be non-passive. The taxpayers didn’t produce enough time sheets or other records to convince the judge.
The passive loss rules could take on much more importance if the “Affordable Healthcare Act,” or “Obamacare,” remains on the books. The law imposes a 3.8% additional tax on “passive” income starting in 2014. Obamacare defines “passive” using the passive loss rules. At a D.C. bar luncheon yestreday, practitioners noted that this could be a big problem for S corporations ($link)

Unless S corporations begin planning for the tax, shareholders “will be short” when it comes time to pay their taxes, especially those who have passive positions in those passthroughs, he said.
Coupled with a potential increase of the income tax back to 39.6 percent for the highest bracket, the Medicare contribution tax could pose significant problems for S corporations, which must maintain a single class of stock requirement, [Brian] O’Connor said. As a result, the S corporations must “distribute the same amount to everyone,” he said, adding, “So that essentially means that more money is going to be coming out of the company.”
If the income tax rates do rise to pre-Bush era levels, the effect will be “dramatic,” O’Connor said.

The moral? Entrepreneurs with loss activities are wise to keep track of their time daily. Absent AHCA repeal, all entrepreneurs will need to become time trackers.
Cite: Iversen, T.C. Memo 2012-19


Material participation basics.
The regulations say you achieve “material participation” in non-real estate activities for a tax year if:
-You participate at least 500 hours; or
-You participate at least 100 hours and at least 500 hours in that and other “100 hour” activities; or
-You participate at least 100 hours and more than anybody else, or
-You are the only participant; or
-You materially participated in five of the past ten years )or in any three years for a service activity).
There is also a “facts and circumstances” test, but don’t count on it.

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