Not all income is treated equally under the U.S. tax code. Nonpassive income gets taxed differently from portfolio income, which gets taxed differently from passive income. For example, losses from a nonpassive business are typically fully deductible, while losses from a passive business can be limited. This limitation, called the passive activity loss (PAL) limitation, may make you view your business investments in a different light.
What is Nonpassive Income? What is Passive Income?
Nonpassive income is income you earn from a trade or business in which you materially participate. Simple examples are wages, salaries, tips, commissions, and bonuses. Passive income, on the other hand, is any trade or business income earned from activities that you do not materially participate in. If you are simply an investor in the business and perform no day-to-day or managerial activities, that income would be considered passive.
What are Passive Activity Losses?
Passive activity losses (PALs) are generated when a taxpayer has more losses than they have income from a passive activity. An activity will typically be considered passive to you if one of the following statements is true:
- You don’t materially participate in the business over the course of the year.
- You have a rental business (but you are not considered a real estate professional).
What is Material Participation?
The crux of the PAL limitation comes down to material participation. If you are found to materially participate in the business, the income or losses from that business activity will not be subject to the PAL limitations, and you can deduct your business losses against any other income that you have – interest, dividends, wages, etc. You will be shown to materially participate in your business if you satisfy one or more of the following seven steps:
- You participated in the activity for at least 500 hours during the year.
- You alone performed most of the work in the business for that year.
- You participated in the activity for at least 100 hours, and you participated more than any other individual.
- Your activity is a Significant Participation Activity (SPA), and you participated in multiple SPAs that totaled at least 500 hours.
- You materially participated in the activity for any five of the last 10 years.
- The activity is a personal service activity, and you materially participated in at least one of the last three years.
- You participated in the activity on a regular, continuous, and substantial basis, taking into account all facts and circumstances.
When are Passive Activity Losses Deductible?
The general rule is that PALs are not deductible against active income. In other words, you can only offset passive losses against passive income. Consider the following example:
Jody works 40 hours per week as a computer programmer. This year, she and four of her friends decided to open a franchise of a well-known sandwich shop. One of her friends performs the day-to-day management of the business. The only asset Jody brings to the business is capital.
Jody’s salary from her job as a computer programmer is considered nonpassive income. Her share of the sandwich shop’s earnings is passive income because she does not materially participate in the activity. Under the PAL rules, her share of the losses from the sandwich shop cannot offset her computer programmer salary.
Luckily, disallowed PALs can be carried forward and used to offset future years’ income.
Passive Activity Losses are Only Part of the Puzzle
Small business owners have more to worry about than just their PAL limitations. Their losses may also be limited by:
- Their tax basis in the activity;
- Their at-risk limitations; or,
- A new dollar limitation introduced by the TCJA that limits the amount of business losses you can offset with another business’s income.
Each of these limitations could affect your tax planning for 2018 and beyond. If you’d like to discuss the PAL limitations (or any of these other business limitations) in more detail, contact your Spire Group professionals for help.