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You can only deduct losses from an S corporation, partnership or LLC if you “materially participate” in the business. If you don’t, your losses are generally “passive” and can only be used to offset income from other passive activities. Any excess passive loss is suspended and must be carried forward to future years.
Material participation is determined based on the time you spend in a business activity. For most business owners, the issue rarely arises — you probably spend more than 40 hours working on your enterprise. However, there are situations when the IRS questions participation.
To materially participate, you must spend time on an activity on a regular, continuous and substantial basis.
You must also generally meet one of the tests for material participation. For example, a taxpayer must:
There are other situations in which you can qualify for material participation. For example, you can qualify if the business is a personal service activity (such as medicine or law). There are also situations, such as rental businesses, where it is more difficult to claim material participation. In those trades or businesses, you must work more hours and meet additional tests.
Proving Your Involvement
In some cases, a taxpayer does materially participate, but can’t prove it to the IRS. That’s where good recordkeeping comes in. A good, contemporaneous diary or log can forestall an IRS challenge. Log visits to customers or vendors and trips to sites and banks, as well as time spent doing Internet research. Indicate the time spent. If you’re audited, it will generally occur several years from now. Without good records, you’ll have trouble remembering everything you did.
Passive activity losses are a complicated area of the tax code. Consult with Doeren Mayhew’s tax advisors for more information on your situation.
This publication is distributed for informational purposes only, with the understanding that Doeren Mayhew is not rendering legal, accounting, or other professional opinions on specific facts for matters, and, accordingly, assumes no liability whatsoever in connection with its use. Should the reader have any questions regarding any of the news articles, it is recommended that a Doeren Mayhew representative be contacted.
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