Tax Preparer Education About Passive Loss Limitations

February 27, 2012 by  Filed under: Taxes 

A recent case in Tax Court reveals the complexity a tax preparer faces with deducting losses for a taxpayer’s sideline work. The issue in this matter concerns the limitation for deducting losses from passive activities against ordinary income, such as wages.

Loss from an ongoing passive activity is only deductible against gains on other passive activities. Any excess is carried over to future years. The cumulative passive loss is eventually deducted from ordinary income when the taxpayer disposes of the passive activity. Tax professionals who are unfamiliar with the nature of passive losses should update their knowledge of the subject with an online CPE course.

In the Tax Court case, the founder of a successful manufacturing company in Minnesota also has a large cattle ranch in Colorado. The ranch generated losses in 2005 and 2006, which were deducted on the joint tax return of the entrepreneur. The IRS challenged the deduction by determining them as related to a passive activity. Although ranching is not necessarily passive, an absentee ranch owner is passive under the tax rules learned during enrolled agent education.

The taxpayers claimed that management of the ranch occurred from both physical presence in Colorado and from the couple’s home in Minnesota. Time from the combined locations exceeded 500 hours. Although this is enough time to qualify as material participation, no documentation was supplied to the Court describing the taxpayer’s ranching activities.

Illustrating an important lesson for anyone training to become an enrolled agent, the Court disallowed deduction claims based upon estimates made years after the fact. Tax practitioners should therefore caution their clients to maintain contemporaneous substantiation of time spent on a potentially passive activity.

The Affordable Healthcare Act also impacts passive income. Beginning in 2014, an additional tax of 3.8 percent is imposed on income from passive activities. This makes passive losses important to offsetting this tax triggered by passive income.

Even profit from an S corporation is treated as passive income for shareholders not materially participating in the business. This can easily happen to owners of minority interests. S corporations have only one class of stock. Therefore, profit is allocated among all shareholders in proportion to ownership, whether or not the profit is distributed. When the extra tax is assessed on a passive shareholder, increased pro rata distributions for all shareholders are likely.

Taxpayers spending less than full-time on an S corporation should keep time sheets that support their contributions to the businesses. Doing so could substantiate status as a materially active participant. This situation embodies another reason for holders of business interests to consult the expertise of a tax professional with enrolled agent certification.

IRS Circular 230 Disclosure

Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.

Fast Forward Academy is a leading publisher of education for tax preparer and tax professionals. Access to free questions for the online CPE course is available on their website.

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