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Seeking Nonpassive Characterization of Income? Comply with the IRS’s Requirements.

Mar 9, 2023

Tax Controversy & Dispute Resolution Spotlight

Current Issue

Taxpayers often seek to have their business activities characterized as nonpassive.  Nonpassive income is not subject to the 3.8% net investment income tax.[1]  Additionally, nonpassive losses may be used to offset other income.[2]  Passive activities involve the conduct of any trade or business in which the taxpayer does not materially participate or other designated categories, such as rental activity and working interests in oil and gas property.[3]  Therefore, taxpayers can characterize their activities as nonpassive by demonstrating material participation.  Taxpayers must be careful of filing requirements depending on which test they utilize to establish material participation.  Treasury regulations provide seven tests for demonstrating material participation.[4] Two of these tests are discussed in further detail below.

Material Participation

500-Hour Test

Generally, material participation is found where the taxpayer’s involvement in the activity is regular, continuous, and substantial.[5]  Taxpayers show that their involvement is regular, continuous, and substantial by proving their participation in any reasonable manner based on all the facts and circumstances.[6]  Taxpayers often assert material participation by showing their participation in the activity exceeded 500 hours during the tax year.  Taxpayers may elect to group activities together to meet this standard.

Taxpayers may group activities where they constitute an appropriate economic unit for measurement of gain or loss based on facts and circumstances, such as common control, common ownership, location, and interdependence.[7]  When taxpayers choose to group activities, a written statement must be filed with the original income tax return for the first taxable year in which the activities are grouped.  A written statement must be filed for every subsequent year that a taxpayer adds a new activity to the existing grouping.  This statement requires a written disclosure of the grouped activities’ names, EINS, and addresses.  It also requires a written declaration that activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of IRC Sec. 469.[8]

Significant Participation Activities

Where taxpayers lack the requisite 500 hours in an activity or group of activities, material participation may still be found where the activity is a significant participation activity in which the taxpayer’s participation exceeds 100 hours and the taxpayer’s aggregate participation in all significant participation activities during the year exceeds 500 hours.[9]  An activity may be considered a significant participation activity only where material participation would not otherwise be found.[10]   Significant participation activities do not require grouping.  

In the case of Gurpreet Padda v. Commissioner, TC Memo 2020-154, the taxpayer was a physician owning his medical practice.  In addition, he was an investor in five restaurants and one brewery.  The taxpayer treated the losses from the restaurants and brewery as nonpassive and used them to offset income from the medical practice.  The IRS argued against this treatment, claiming that the taxpayer failed to file a written grouping statement with his return.  The Tax Court allowed the treatment, finding that the restaurants and brewery were significant participation activities; therefore, no grouping was required.

Best Practices

Taxpayers who seek the tax benefits of nonpassive income/loss characterization should keep complete, accurate and contemporaneous records of the hours worked in each activity.  Based on these records, taxpayers may determine which test (whether the 500 hour test, significant participation activity test, or one of the other five tests not discussed in this article) is most appropriate for showing material participation.  Taxpayers’ records may include appointment books, calendars, and narrative summary notes, or any other reasonable record.  Not all hours will count toward the 500-hour test or the test for significant participation activity.  For example, hours spent in travel do not count toward activity participation.  Taxpayers using the 500-hour test who wish to group various activities must timely elect to group their activities and be careful to include all required information in the written grouping disclosures.

[1] IRC Sec. 1411(c)(2)(A)

[2] IRC Sec. 469(a)(1)(A)

[3] IRC Sec. 469(c)

[4] (1) Taxpayer works more than 500 hours in the activity;  (2) Taxpayer does substantially all of the work in the activity; (3) Taxpayer works more than 100 hours in the activity and no one else works more than the taxpayer; (4) The activity is a significant participation activity (SPA) and the taxpayer’s total time in all SPAs exceeds 500 hours; (5) Taxpayer materially participates in the activity in any five of the prior ten years; (6) Taxpayer materially participates in a personal service activity for any three prior years; or (7) Based on all facts and circumstances, taxpayer participates in the activity on a regular, continuous and substantial basis during the year. Treas. Reg. 1.469-5T(a)(1)-(7).

[5] IRC Sec. 469(h)(1)

[6] Treas. Reg. 1.469-5T(a)(7)

[7] Treas. Reg. 1.469-4(c)(2)

[8] Rev. Proc. 2010-13

[9] Treas. Reg. 1.469-5T(a)(4)

[10] Treas. Reg. 1.469-5T(c)(1)(ii) and see TAM202229036

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Kristen De Noia

Kristen De Noia is a Senior Tax Manager with tax compliance and planning experience focusing on personal and fiduciary income taxation, gift taxation and trusts and estates including high net worth families and closely held business owners.

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