Non-passive? Prove it!

June 6th, 2013 by Joe Kristan

20130104-1The Obamacare Net Investment Income Tax will make owners of “passive” businesses pay 3.8% additional tax on income from their businesses, as long as their income is high enough for the tax to apply in the first place.

Taxpayers with only profitable businesses haven’t had to worry about whether they were “passive” before.  It only mattered if you had losses.  Now it matters a great deal, and a case this week out of Tax Court helps illustrate some of the challenges these taxpayers will face.

The Net Investment Income Tax piggybacks on the Section 469 “passive loss” rules in determining whether the tax applies.  There are a number of ways you can be non-passive (see summary below), but they generally involve showing that you have spent enough time working in the activity to be “non-passive.”

A retired soccer coach in California kept busy buying and renting residential property; when the IRS came looking at their tax return, he owned eight properties with his wife.  As his business was real estate rental, he had to meet a higher standard to avoid the passive loss rules.  Rental losses are automatically passive unless you both spend 750 hours on real estate activities and spend more time on that than on non-real estate activities.  As he was retired, the 750 hour test was the issue.

It’s up to the taxpayer to prove that they are non-passive, and proof was the problem.  The Tax Court explains the rules (my emphasis)

    Ideally, a taxpayer who claims to be described in section 469(c)(7) would maintain a contemporaneous log or record showing with particularity the amount of time devoted to the rental real estate activity on an event-by-event basis. See sec. 1.469-5T(f)(4), Temporary Income Tax Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988). Ideally, the log would be detailed enough to allow for someone who reviewed it to make an informed judgment as to the accuracy of the information reported. The creation and availability of a detailed log is important, especially if that reviewing “someone” is an Internal Revenue Service employee considering the log in connection with an examination of the taxpayer’s return on which rental real estate losses are deducted. Apparently, petitioners were not aware of the importance of keeping such a log and, as noted, neither kept a log during either year in issue.

     Recognizing that many taxpayers might not be aware of the importance of keeping a contemporaneous log of time devoted to the taxpayer’s rental real estate activity, the Commissioner’s regulations provide a second-best alternative. Section 1.469-5T(f)(4), Temporary Income Tax Regs., supra, provides:

(4) Methods of proof. The extent of an individual’s participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.

The retired coach didn’t keep a log, so he tried the “second-best alternative,” using logs put together for the trial.  It wasn’t enough:

Simply put, the logs do not allow for a review of activity related to the rental properties on an event-by-event basis to the extent necessary to establish that the 750-hour test has been satisfied.

The moral: If you want to prove that you are non-passive, and it’s not obvious otherwise (e.g., a full-time job), you should keep a daily calendar of your time spent.  I know that for some of you, tracking hours is why you got out of lawyering or public accounting in the first place, but there it is.  If you are an owner, just getting a W-2 won’t prove you are active if you live in Florida and your business is in Iowa.


Bonus observation: The Tax Court seems to no longer give weight to the IRS position that you need to hit 750 hours to materially participate in a given real estate activity.  From the opinion:

Keeping that definition in mind, and because petitioners elected to treat the rental properties as a single activity, we are satisfied that they materially participated in the rental property activity during each year in issue, and respondent does not seem to suggest otherwise.

The judge said they “materially participated” even though in one year they only documented 379.5 hours.  It would have been enough in a non-real estate activity, but not enough for the stiffer real estate standard.  The election they refer to is the election to treat all rental real estate operations as a single activity.


Cite: Hofinga, T.C. Summ. Op. 2013-43.

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.