Most privately-held businesses have incurred some sort of loss during the COVID-19 pandemic. The federal income tax passive activity loss (PAL) rules can restrict an owner’s ability to currently deduct tax loss that’s been thrown off by passive activities. Here’s an overview of how the PAL rule applies to members or owners of limited liability companies (LLCs).

 

LLC Focus

An LLC that is owned by an individual is in typically treated as a sole proprietorship for federal income tax purposes. A loss from single-member LLCs is potentially subject to PAL rules.

An LLC that has several members or owners is typically treated as a partnership for federal income tax purposes. A loss passed through to individual members of such LLCs are also potentially subject to the PAL rules.

 

Basics of PAL 

In some cases, you can deduct PALs only to the extent of the passive income from other sources, such as positive income from gains from assets used in passive activities or other passive activities.

Unfortunately, many individuals have little to no passive income, so most of their PALs are suspended and carried over to later tax years.

You can deduct suspended PALs when you sell the activities that produced the PALs or when you have passive income. But these events might not happen.

In some cases, when an LLC member “materially participates” in an LLC’s tax-loss activity for the year, that activity is classified as nonpassive. That means it’s exempt from the PAL rules for that year. In turn, you can currently deduct losses from a certain activity unless some other federal income tax rule prevents another favorable outcome.

For some individuals, meeting the material participation standard can be the key to deducting a loss from a business activity for federal income tax purposes. Most individual owners must pass at least one of the seven tests to meet the standard. Individual owners of multi-member LLCs that are treated as a partnership for federal income tax purposes have to apply the material participation tests at the member or owner level rather than at the LLC level. (See “7 Material Participation Tests” at right.)

 

Limited Partners’ Unfavorable Rule 

If an individual LLC member is classified as a limited partner for PAL purposes, they have to pass the first, fifth, or sixth test to establish material participation. The other four tests are not available to LLC members who are classified as a limited partner for PAL purposes.

Any individual members of multi-member LLCs that are classified as a partnership for federal income tax purposes may be classified as a limited partner for PAL purposes; and others are classified as general partners.

 

Capacity as an Investor

Time spent in the capacity as an investor does not count for the purposes of passing the material participation tests except if the individual is directly involved in any day-to-day operations or management of the activity. With this restriction, work done in the capacity as an investor includes:

  • Reviewing and studying reports or financial statements on any operations of the activity,
  • Compiling or preparing analyses or summaries of the operations or finances of the activity for an individual’s own use, and
  • Monitor the operations or finances of the activity in a non-managerial capacity.

 Self-Rentals’ Unfavorable Exception 

IRS regulations established another unfavorable exception: the self-rental income recharacterization rule. Under this particular exception, an individual’s net rental income can be recharacterized as nonpassive if collected from a business in which the individual materially participates (in other words, a nonpassive business owned by an individual).

This rule is targeted to prevent individuals from generating passive net rental income by renting property to any businesses in which they materially participate and then using the passive losses from other sources to fix that passive net rental income. But, the opposite isn’t the case: When the self-rental activity generates a net loss, it remains a passive loss.

 

The 7 Material Participation Tests

The IRS has given the following seven tests to determine if you meet the material participation standard in respect to a particular business activity:

  1. More than 500 hours test. This test is passed if the individual participates in the activity for more than 500 hours during the year.
  2. Substantially-all test. This test is passed if the individual’s participation in the activity during the calendar year is substantially all the participation by all individuals (this is including those who aren’t owners of interests in the activity) during that year.
  3. More than 100 hours test. This test is passed if the individual participates in the activity for more than 100 hours during the calendar year, and no other individual (including nonowners) participates more during that year.
  4. Significant participation activity (SPA) test. This is passed if the activity is a SPA in which the individual participates for 100 hours or more during the calendar year, and the individual’s total participation in all SPAs during the year is greater than 500 hours.
  5. Prior-year material participation test. This is passed for the year if the individual materially participated in the activity for any five of the 10 immediately preceding years.
  6. Personal service activity test. This is passed for the year if the activity is an activity related to personal service, and the individual materially participates in the activity for any three preceding years.
  7. Facts and circumstances test. This is passed if consideration of relevant facts and circumstances show that the individual materially participates in the activity on a continuous, regular, and substantial basis. The individual must participate for more than 100 hours to be eligible for this test. In addition, an individual’s hours performed in the management of an activity don’t count for purposes of this test unless 1) no other person who performs management services for the activity receives compensation for such services, and 2) no other person who performs management services for the activity spends more time on such services than the individual.

If you pass one or more of these seven tests for the tax year, you meet the material participation standard for that particular activity for that year, which means that activity is nonpassive for you for that year. If so, you’re exempt from the PAL rules for that activity for that year.

 

Need Help?

If you own an interest in an LLC that incurs losses, the PAL rules can be a big deal. We can help determine whether you meet the material participation standard. If so, you may be allowed to deduct your losses in the current tax year — if not, or if you’re affected by an unfavorable exception, your losses may be suspended under the PAL rules and carried over to future tax years.

Hoberman & Lesser’s NYC accountants serve a broad cross section of businesses, ranging from publicly held companies, to private sector businesses, to individual entrepreneurs throughout New York, New Jersey, and Connecticut, and across the United States. To schedule a complimentary and confidential consultation with a member of our team, please contact us.