“Passive activity income does not include the following: Income from an activity that is not a passive activity” – unknown

Recently a client came to us with a problem – the Internal Revenue Service was denying his taking a loss from a family business.

Why?

Because they deemed his loss as a passive activity.

Losses from passive activities – investments – are treated differently than losses from activities that are active – your every day job or full time business.

Aside from Real Estate professionals – which are subject to a completely different set of rules – the Internal Revenue Code and the regulations supporting the Internal Revenue Code are what govern the determination of passive versus active participation.

Under the Internal Revenue Code, the nature and quantity of a taxpayers participation in a trade or business activity will determine whether the taxpayer’s activity qualifies as passive or non-passive. Passive activity is generally defined as activity involving the conduct of trade or business in which the taxpayer does not materially participate. Material participation exists if the taxpayer’s activity satisfies any one of the following seven tests:

1. The taxpayer worked more than 500 hours during the taxable year;
2. The taxpayer performed substantially all of the work in the activity;
3. The taxpayer worked more than 100 hours and no other individual worked more than the TP in the activity;
4. The activity was “significant participation activity” and totaled more than 500 total hours;
5. The taxpayer, notwithstanding this test, materially participated in the activity for any five out of the ten prior taxable years;
6. The activity was a “personal service activity” performed in any three of the prior the taxable years; or
7. Based on all of the facts and circumstances the taxpayer participates in the activity on a regular, continuous, and substantial basis during the taxable year. However, this test only applies if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.

With a little planning, and some guidance on record-keeping, that full loss could be available to reduce that taxable, ordinary income – the income taxed at the highest marginal rate. Without that guidance, the client will have to be satisfied with netting against capital gains and a paltry $3,000 against ordinary income. Of course, earning a positive return is still the best approach in business (as in life), but making the most of your losses is the next best thing.

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Today, Tuesday, October 28, 2014, is the publishing of the results of the July 2014  New York State Bar Exam. We offer up good wishes to all those that took the exam and hope you passed. For those that are not so blessed, take this post as encouragement to redouble your efforts and take the exam again. The only true failure is to not try.

I would like to offer a special congratulation to our own Ariel Cabral, who has surmounted the insurmountable, and passed the New York Bar.