Hyden, Miron & Foster, PLLC Law Blog

Friday, September 26, 2014

Passive Income Leads to Active Battles with IRS

Business and investment activities inevitably involve complex tax laws and regulations, none more so than "passive" and "non-passive" activities.  Generally, losses from passive investments cannot be offset against non-passive gains. Taxpayers often try to characterize their activities as non-passive to use losses as freely as possible when filing their tax returns.

Labeling investment activity as “passive” or “non-passive”, however, can be problematic.  Internal Revenue Code Section 469 and IRS regulations there under leave ample room for interpretation by taxpayers.  Passive income generally comes from real estate rental activity, from a limited partnership, or from a business in which the taxpayer does not "materially participate."  The ultimate determination can be highly fact-specific.

There are at least seven factors that courts may consider when determining whether a taxpayer is materially participating in an investment.  Meeting just one of them may be sufficient for an activity to be deemed non-passive.

1. The taxpayer spends more than 500 hours annually working on the activity. 

2. Few other individuals are involved—the taxpayer’s involvement represents virtually all of the work done on an activity.

3. The taxpayer works on the activity for more than 100 hours annually, and no one else works more. 

4. The activity is a "significant participation activity" (SPA) in which the taxpayer works for more than 100 hours during the year, and the taxpayer’s annual work on all SPAs is more than 500 hours.
5. The taxpayer materially participated in the activity for any five of the ten preceding tax years.

6. For a personal service activity, the taxpayer materially participated for any three tax years preceding the current tax year.

7. Based on all the facts and circumstances, the taxpayer participates on regular, continuous, and substantial basis during the year.

While these criteria offer many ways to have income considered non-passive, they can also lead to disagreements with the IRS and a tax deficiency notice.  We believe that careful tax planning and expert legal representation during an IRS audit can help you avoid disputes over this and other aspects of your tax return.  

On occasion, a dispute with the IRS cannot be avoided or resolved amicably and vigorous advocacy in court is the only viable option.  Arkansas taxpayers seeking experienced, effective guidance on tax planning and representation in IRS audits should contact the tax lawyers at Hyden, Miron & Foster, PLLC.  Call (501) 376-8222 for a consultation about such tax issues. 

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