Software of the Month Club 1996 May/Software of the Month Club 1996 May.iso/mac/ISO9660/ZIPFILES/SBA962.ZIP/F309.SBE

Text File | 1996-02-15 | 19.8 KB | 555 lines

@Q01
                ┌────────────────────────────────────┐
                │ ARE LOSSES INCURRED BY MY BUSINESS │
                │ LIMITED BY THE PASSIVE LOSS RULES? │
                └────────────────────────────────────┘

As a general rule, tax losses and tax credits generated by a
business may be used to offset other income of the owner(s)
of the business, in the case of a sole proprietorship, part-
nership, of S corporation.  Or, in the case of a C corpora-
tion, such losses or credits may, in many cases, be used to
offset other income of the corporation, such as portfolio
income or active business income.

However, if the losses or credits are considered to be from
"passive activities," there are severe limits on the use of
such losses or credits to offset current income other than
income from "passive activities."

  QUESTION:  Is your business set up as a "C corporation"?
@YN
01\Q02
02\Q11

@Q02

CONCLUSION:  Then you will not be able to offset losses or
credits generated by your corporation against your personal
income.  This is always true in the case of a C corporation,
whether or not the losses or credits it incurs are "passive"
in nature.  Thus the real questions in your case are (1)
Whether your corporation has any "passive" losses or credits
and (2) whether your corporation is considered to be a "per-
sonal service corporation" or a "closely-held C corporation."

(Note:  A "passive" activity, for purposes of the question
below, is a trade or business that is carried on by a corpor-
ation, where the major shareholders do not "materially parti-
cipate" in the activity.  If any one or more shareholders
owning more than 50% of the stock "materially participate"
in the activity, it is not considered a "passive activity.")
(Most rental activities are automatically "passive.")

  QUESTION:  Does your C corporation generate any losses or
             credits that are from "passive activities"?
@YN
01\Q04
02\Q03

@Q03

CONCLUSION:  Then you do not need to be concerned about the
usability of "passive" losses or credits, since your corpor-
ation does not have any such losses or credits.  Therefore,
any losses or credits your corporation generates from a
trade or business should, in general, be allowable as an
offset against income from any other trades or businesses
it carries on, or against "portfolio income" such as taxable
interest or dividend income.

@STOP

@Q04

TENTATIVE CONCLUSION:  Then your C corporation may be limi-
ted, under the passive activity loss rules, in its ability
to currently utilize such losses or credits, IF it is ei-
ther:  (a) a "personal service corporation"; or (b) a
"closely-held C corporation."

For a C corporation to be a "personal service corporation,"
the corporation's principal activity must consist of the per-
formance of personal services.  Personal services would cov-
er a wide range of activities, including professional ser-
vices such as law, medicine, dentistry, accounting, architec-
tural and engineering services, actuarial sciences, and the
like. It would also cover areas such as consulting services,
the incorporated professional athlete or entertainer, and
miscellaneous other service businesses, such as an incorpor-
ated salesperson.

  QUESTION:  Does your corporation perform personal
             services as its principal activity?
@YN
01\Q08
02\Q05

@Q05

CONCLUSION:  Your company is not a "personal service corpor-
ation" for purposes of the passive loss rules, and thus is
not fully subject to the passive activity loss limitations.

However, your company may be a "closely held C corporation"
that is partially subject to the passive loss rules, depen-
ding on its stock ownership.  (See below)

 QUESTION:  Did 5 or fewer individuals (directly or indirec-
            tly) own more than 50% (in value) of the stock
            of the corporation during the last half of the
            tax year?

@YN
01\Q06
02\Q07

@Q06

FURTHER CONCLUSION:  While your corporation is not consid-
ered a "personal service corporation," and thus is not fully
subject to the passive loss restrictions, it is considered
to be a "closely held C corporation," and thus is partially
subject to the passive loss rules.  That is, it may offset
passive activity losses against its "net active income,"
but not against its "portfolio income."

@STOP

@Q07

FURTHER CONCLUSION:  Your C corporation is not a "personal
service corporation" (within the meaning of the passive loss
rules), and is also not considered a "closely held C corpor-
ation."  This means, if the above conclusions are both cor-
rect, that your corporation is not subject to ANY of the
passive loss restrictions.  Thus, losses incurred by your
corporation on passive activity investments should be fully
available to offset against either portfolio income or other
income ("net active income") of the corporation, without
restriction.

@STOP

@Q08

SERVICES MUST BE "SUBSTANTIALLY PERFORMED" BY SHAREHOLDER-
EMPLOYEES:  To be considered a "personal service corpor-
ation," the personal services performed by the corporation
must be "substantially performed" by employees who own stock
in the corporation.  To determine whether the services to
customers, clients, etc. are "substantially" performed by
employee-owners, the Income Tax Regulations say that more
than 20% of the corporation's compensation expense attribut-
able to its service activities have to be attributable to
personal services performed by its employee-owners.  If it
is clear that over 20% of the cost of performing services
(of the types described in the previous question) are attri-
butable to services performed by owners, you should answer
"Y" ("YES") to the following question.  If it is clear that
less than 20% of such compensation costs are attributable to
services rendered by employee-owners, then answer "N" ("NO").

QUESTION:  Are the services rendered by the corporation "sub-
stantially" performed by employee-owners of the corporation?
@YN
01\Q09
02\Q05

@Q09

STOCK OWNERSHIP REQUIREMENT:  A corporation cannot be treat-
ed as a "PSC" for tax purposes unless employees own more
than 10% of its stock (by value), directly or indirectly.

  QUESTION:  Do employee-owners own (directly or indirectly)
             more than 10% of the stock of your corporation,
             by value?

@YN
01\Q10
02\Q05

@Q10

CONCLUSION:  It appears from your responses that your C cor-
poration may be a "personal service corporation" under the
definitions used in the passive activity loss rules and for
determining whether a C corporation is restricted in its
choice of a fiscal tax year.

If so, this means that if your corporation has losses from
"passive activities," it may not generally offset those
losses against its "net active income" (business income,
generally) or against its "portfolio income" (income from
dividends, interest, annuities, certain royalties, etc.).

However, such losses (or credits) can be used to offset oth-
er passive income of your corporation.  Also, when you fin-
ally dispose of a passive activity (by selling off such a
business, for instance), the corporation should than be al-
lowed to deduct any "suspended" passive losses related to
that activity which it had accumulated over the years, but
had not been able to utilize because of the passive loss li-
mitations.

@STOP

@Q11

"Passive" losses or credits of unincorporated businesses,
or of S corporations, generally cannot  be used to offset
income of the owners of the business to whom such business
losses are allocated, unless there is passive income against
which such losses can be offset.

Note:  A "passive" activity,  is a trade or business that
is carried on by a business, where you, as sole proprietor,
partner, or S corporation shareholder, do not "materially
participate" in such activity.  However, if you, individual-
ly, are considered to "materially participate" in the activ-
ity in question, it is not a passive activity with regard to
YOU (even if it is for some of your fellow partners or S
corporation shareholders).  (Note also that most rental acti-
vities are automatically considered to be "passive" in nature,
regardless of your "material participation."  However, AFTER
1993, REAL ESTATE PROFESSIONALS CAN "materially participate.")
QUESTION: Does the unincorporated business in question gener-
          ate any losses or credits from "passive activities"?
@YN
01\Q13
02\Q12

@Q12

CONCLUSION:   Then this consulting  session may not be rele-
vant to your situation.   Since your business is not genera-
ting any "passive" losses or credits,  you are not subject
to the  restrictions on utilization of passive losses.

(Unless you HAD passive losses in prior years which have
been suspended and carried over.  In that case,  you will
not generally be able to deduct those "suspended" prior year
passive losses until you generate passive income against
which the suspended losses can be offset, or until you dis-
pose of the activity, by sale or in certain other ways, and
are allowed to  offset the  accumulated  suspended losses
against non-passive income in the year of the disposition.)

@STOP

@Q13

There are special, especially strict, rules on deducting
passive losses from certain "publicly-traded partnerships."
(Most such partnerships are limited partnerships,  whose
units trade much like common stocks of corporations.)

  QUESTION:  Is the business in question a publicly-
             traded partnership?

@YN
01\Q14
02\Q15

@Q14

CONCLUSION:  Then your ability to deduct any passive losses
from such a publicly traded partnership will be EXTREMELY
limited.   As a practical matter, so long as you own your
interest in such partnership,  you will not be able to uti-
lize any passive losses from it against other income, EVEN
AGAINST OTHER PASSIVE INCOME, with one very limited excep-
tion: You may only carry such losses forward as "suspended
losses"; then, if the same partnership later generates net
passive income, only then may you offset the suspended los-
ses against the passive income of that same partnership.

@STOP

@Q15

In general, such "passive" losses will not be currently de-
ductible for you, unless you have other "passive income"
which they can be used to offset.  However, there is a lim-
ited exception for passive losses from certain real estate
rental activities, for some individuals who have adjusted
gross incomes of less than $100,000 (phasing out at income
levels between $100,000 and $150,000, or in the case of low
income housing projects, between $200,000 and $250,000). Un-
der this exception, an individual who is deemed to "actively
participate" (this is not the same as "material participa-
tion") in the rental activity is allowed to offset up to
$25,000 a year of passive rental losses against other tax-
able income (or the "credit equivalent" of such deductions,
in the case of low-income housing credits.

  QUESTION:   Does the "passive activity" in question
              consist of rental real estate?

@YN
01\Q17
02\Q16

@Q16

CONCLUSION:  Then it appears that your passive losses from
your sole proprietorship, partnership or S corporation busi-
ness may not be currently deductible, unless you have other
"passive income" against which such losses can be offset
(other than "passive income" from "publicly-traded partner-
ships").

@STOP

@Q17

To qualify for the right to offset such rental real estate
losses against non-passive income, you must "actively parti-
cipate" in the management of the property.  Part of the def-
inition of "active participation" is that you must own at
least 10% of the property in question, either directly, or
as a 10% or more partner in a partnership.

(An ownership interest as a limited partner is not counted
towards the 10% ownership requirement.)

(Note that there is NO "active participation" test required
for investors in low-income housing activities that qualify
under special provisions of the tax code.)

  QUESTION:   Do you meet the "active participation" re-
              quirements described above (if applicable)?

@YN
01\Q18
02\Q16

@Q18

CONCLUSION: Then, in any year in which your "adjusted gross
income" is less than $150,000 ($250,000 in the case of cer-
tain low-income housing), you may be able to offset all or
some  portion of your net rental losses against other, non-
passive income, on your individual income tax return.  The
maximum such passive loss that you may deduct in one year
is limited to the lesser of:

   . $25,000; or

   . $25,000, reduced by half the amount your adjusted
     gross income exceeds $100,000 ($200,000 in the case
     of low-income housing, if acquired before 1990).

Thus, for each dollar of adjusted gross income you have
above $100,000 (or $200,000, for low-income housing ac-
quired before 1990), the maximum $25,000 loss allowable
for the year is reduced by 50 cents.

             ┌─────────────────────────────────────┐
             │ EXAMPLE OF PHASE-OUT OF THE $25,000 │
             │ LIMIT ON PASSIVE LOSSES FOR "ACTIVE │
             │ PARTICIPATION" RENTAL  REAL ESTATE: │
             │ =================================== │
             │ Say your adjusted  gross income for │
             │ the year before passive losses, IRA │
             │ deduction, taxable Social Security, │
             │ and the exclusion  for savings bond │
             │ interest used for  higher education │
             │ expenses, is $115,000, and you have │
             │ a $27,500 rental loss from property │
             │ in which you "actively participate" │
             │ in management.  Your allowable loss │
             │ for the year would be $25,000, less │
             │ $7,500  (one-half of $115,000 minus │
             │ $100,000), or a net deduction equal │
             │ to $17,500.  The remaining,  unused │
             │ loss of $10,000 would be  suspended │
             │ and carried  forward  indefinitely, │
             │ until, if ever, it can be used.     │
             └─────────────────────────────────────┘


@STOP

@HELP

@H\01

A "C corporation" is  a technical term,
but, fortunately,  is a relatively easy
one to understand.  A C corporation is,
quite  simply,  any corporation  (other
than a  not-for-profit  one) OTHER THAN
an "S corporation" (formerly known as a
Subchapter S corporation). Thus, unless
your corporation  is one that  has made
an election to be taxed as an S corpor-
ation,  it is an C corporation.  There-
fore,  answer this  question "N" ("NO")
only if your  company is an  S corpora-
tion, or is not a corporation at all.

@H\02
An individual is  considered to "materi-
ally participate" in an activity if:

  . She participates in the activity
    more than 500 hours in the year; or

  . Her participation constitutes sub-
    stantially ALL participation in that
    activity by anyone for the year; or

  . She participates more than 100 hours
    in the activity and no other indi-
    vidual participates more than she.

(IRS regulations go on for many pages...)
@H\04

Businesses that  sell some form of prop-
erty,  rather than purely services,  are
not considered to be engaged in perform-
ing services.   Although such activities
as wholesale or retail sales of goods or
sales of insurance, real estate, or fin-
ancial services or products have a large
service component,  they are not consid-
ered to be  performance of personal ser-
vices, for purposes of this definition.

@H\05

Don't think you can get around the "five
or fewer persons owning  over 50% of the
value of the  stock" rule by putting 10%
of the stock in the  hands of each of 10
related people.  The "attribution" rules
of the tax law lump  all related parties
together and treat them as one person.

@H\06
"Net active income" is simply  all tax-
able income OTHER THAN portfolio income
and expenses or passive activity income
and losses.   "Portfolio income and ex-
penses" include the following items  of
income (less all allocable expenses):

 . Gross income from interest, divi-
   dends, annuities, or royalties not
   derived in the ordinary course of a
   trade or business (less expenses);

 . Gain or loss not derived in the
   ordinary course of business from
   disposition of assets (non-passive).
@H\08
The Regulations contain a number of very
technical  rules explaining this test as
to whether services  are "substantially"
performed by owner-employees,  which are
much too complex and detailed to explain
here, so in some cases it may not be to-
tally clear one way or the other whether
your corporation's  owner-employees per-
form enough of the company's services to
meet this test. Thus, in some cases, you
may have to take your best shot at gues-
sing whether to answer "YES"  or "NO" to
this question,  in which case the answer
you finally  arrive at as  to PSC status
may well be wrong.
@H\09

If the total combined ownership of stock
in the corporation by employees, includ-
ing shares they are deemed to own (stock
owned by  their children,  related enti-
ties and so forth),  is more than 10% of
the corporation's  stock (by value), you
should answer "Y" ("YES")  to this ques-
tion.  Otherwise, answer "N" ("NO").

@H\10
"Net active income" is simply  all tax-
able income OTHER THAN portfolio income
and expenses or passive activity income
and losses.   "Portfolio income and ex-
penses" include the following items  of
income (less all allocable expenses):

 . Gross income from interest, divi-
   dends, annuities, or royalties not
   derived in the ordinary course of a
   trade or business (less expenses);

 . Gain or loss not derived in the
   ordinary course of business from
   disposition of assets (non-passive).
@H\11
An individual is  considered to "materi-
ally participate" in an activity if:
  . She participates in the activity
    more than 500 hours in the year; or
  . Her participation constitutes sub-
    stantially ALL participation in that
    activity by anyone for the year; or
  . She participates more than 100 hours
    in the activity and no other indi-
    vidual participates more than she.
  . For rental real estate (after 1993),
    she must perform over 750 hours a
    year in real estate trade(s) & more
    than half her total services must
    be in real estate trades/businesses.
@H\13

A  "publicly traded partnership"  is any
partnership whose  capital interests are
traded on an established securities mar-
ket (such as a stock  exchange) or which
are readily tradable on a secondary mar-
ket (or its substantial equivalent).

@H\15

Note that  "rental real estate" does not
include very transient rentals,  such as
operation of hotels or motels. Thus, the
income from any such  operations are not
automatically treated as passive.

Also, note that for  low-income property
acquired after 1989,  there is no phase-
out of the $25,000  deduction (or credit
equivalent) if  adjusted gross income is
over $200,000.   That limit was  removed
by the 1989 Revenue Reconciliation Act.

@H\17

"Active participation"  is  a much  less
stringent participation requirement than
the "material  participation" rule  that
applies to non-real estate activities.

The  "active participation"  requirement
can be satisfied  without regular,  con-
tinuous  and substantial  involvement in
operations,  provided that  you partici-
pate  in a  significant way,  such as by
making management decisions or by arran-
ging for others to provide services. For
example, approving rental agreements may
constitute "active participation."
@H\18

Special rules apply to allowance of low-
income housing credits under the passive
loss rules for acquisitions of such pro-
perties made after 1989.

@END