South-Western Federal Taxation, 2009 Edition
Comprehensive Volume
ISBN: 0324660529
Chapter 11
Investor Losses
Active income. Active income includes wages, salary, commissions, bonuses, profits from a trade or business in which the taxpayer is a material participant, gain on the sale or other disposition of assets used in an active trade or business, and income from intangible property if the tax-payer’s personal efforts significantly contributed to the creation of the property. The passive activity loss rules require classification of income and losses into three categories with active income being one of them.
At-risk limitation. Generally, a taxpayer can deduct losses related to a trade or business, S corporation, partnership, or investment asset only to the extent of the at-risk amount.
Closely held corporation. A corporation where stock ownership is not widely dispersed. Rather, a few shareholders are in control of corporate policy and are in a position to benefit personally from that policy.
Extraordinary personal services. These are services provided by individuals where the customers’ use of the property is incidental to their receipt of the services. For example, a patient’s use of a hospital bed is incidental to his or her receipt of medical services. This is one of the six exceptions to determine whether an activity is a passive rental activity. § 469.
Investment income. Consisting of virtually the same elements as portfolio income, a measure by which to justify a deduction for interest on investment indebtedness.
Investment interest. Payment for the use of funds used to acquire assets that produce investment income. The deduction for investment interest is limited to net investment income for the tax year.
Material participation. If an individual taxpayer materially participates in a nonrental trade or business activity, any loss from that activity is treated as an active loss that can be offset against active income. Material participation is achieved by meeting any one of seven tests provided in the Regulations. § 469(h).
Net investment income. The excess of investment income over investment expenses. Investment expenses are those deductible expenses directly connected with the production of investment income. Investment expenses do not include investment interest. The deduction for investment interest for the tax year is limited to net investment income. § 163(d).
Passive loss. Any loss from (1) activities in which the taxpayer does not materially participate or (2) rental activities (subject to certain exceptions). Net passive losses cannot be used to offset income from nonpassive sources. Rather, they are suspended until the taxpayer either generates net passive income (and a deduction of such losses is allowed) or disposes of the underlying property (at which time the loss deductions are allowed in full). One relief provision allows landlords who actively participate in the rental activities to deduct up to $25,000 of passive losses annually. However, a phaseout of the $25,000 amount commences when the landlord’s AGI exceeds $100,000. Another relief provision applies for material participation in a real estate trade or business.
Personal service corporation (PSC). A corporation whose principal activity is the performance of personal services (e.g., health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting) and where such services are substantially performed by the employee-owners. The 35 percent statutory income tax rate applies to PSCs.
Portfolio income. Income from interest, dividends, rentals, royalties, capital gains, or other investment sources. Net passive losses cannot be used to offset net portfolio income.
Rental activity. Any activity where payments are received principally for the use of tangible property is a rental activity. Temporary Regulations provide that in certain circumstances activities involving rentals of real and personal property are not to be treated as rental activities. The Temporary Regulations list six exceptions.
Significant participation activity. There are seven tests to determine whether an individual has achieved material participation in an activity, one of which is based on more than 500 hours of participation in significant participation activities. A significant participation activity is one in which the individual’s participation exceeds 100 hours during the year. Temp.Reg. § 1.469–5T.
Tax shelters. The typical tax shelter generated large losses in the early years of the activity. Investors would offset these losses against other types of income and, therefore, avoid paying income taxes on this income. These tax shelter investments could then be sold after a few years and produce capital gain income, which is taxed at a lower rate than ordinary income. The passive activity loss rules and the at-risk rules now limit tax shelter deductions.