Passive Activity Restrictions

The idea behind the passive activity restrictions is that a taxpayer who "materially participates" in an activity is more likely than a "passive investor" to engage in the activity with a significant non-tax profit motive, and form a sound judgment as to whether the activity has genuine economic significance and value. Generally you are in a passive activity if you have a trade or business activity in which you do not materially participate during the tax year, or a rental activity.

Passive Activities - According to the Internal Revenue Service there are two kinds of passive activities. Trade or business activities in which you do not materially participate during the tax year, and rental activities (whether or not the taxpayer materially participates) except for the $25,000 exclusion.

The passive activity rules apply to -

  • Individuals
  • Estates
  • Trusts (other than grantor trusts)
  • Personal service corporations (those whose principal activity is the performance of personal services that are substantially performed by employee-owners)
  • Closely held corporations (those that are subject to the corporate income tax and in which more than 50 percent of the value of the stock is owned by five or fewer individuals)

IRS's Position on Application of Passive Loss Rules to Trusts

The passive loss rules, IRC Sec. 469, disallow the current deduction of losses and credits from businesses in which a given owner does not materially participate. The IRS has never issued any guidance on how the passive loss rules apply to a business held by a trust. It's clear that the trust itself is "the taxpayer" to which Sec. 469 applies. The issue has been the person(s) associated with the business to which the material participation requirement applies. The IRS position is that it's the trustee (fiduciaries), and that any participation by employees of the business or the beneficiaries does not apply to the trust. This position was rejected by a Federal District Court in The Mattie K. Carter Trust v. U.S. [256 F. Supp. 2d 536, 2003] The court's position regarding the 15,000 acre Cater Cattle Ranch was that the determination be made considering the participation of all the fiduciaries, employees, and agents of the trust. However, the IRS has reiterated its position in Technical Advise Memorandum (TAM) 200733023. In the TAM the taxpayer claimed that its "Special Trustees" qualified as fiduciaries, however, in rejecting this argument the IRS noted that although these individuals were involved in the operation and management of the business, but had no discretionary power to act on behalf of the trust to commit it to any course of action or control.

Editorial Comment: A significant proportion of timberland is titled to trusts. Not all are subject to the passive loss rules since their activities don't rise to the level of a business. However, in the many cases where a business exists the IRS's position needs to carefully considered in the language used to establish a trust, and how an existing trust is managed.

If your timber ownership is subject to the passive loss rules, you must determine which of the three following classifications applies to you and your forest property. This determination must be made each tax year.

Timber held as part of a trade or business in which you materially participate

Timber held as part of a trade or business in which you do not materially participate (this is a passive activity)

Timber held for the production of income (an investment), but which is not part of a trade or business

The rules for deducting operating costs and carrying charges will depend on how your ownership fits one of these categories. The passive loss rules may restrict the extent to which operating losses can be offset against income from other sources. All income and losses fall into one of three categories.

Active- Active income is income from a trade or business in which you materially participate. This category includes wages, salaries, bonuses, etc. and profits (losses) from businesses, trades, or other "for profit" activities in which you materially participate.

Portfolio- interest; annuities; dividends; royalties (unless earned in the ordinary course of a trade or business); dividends on C corporation stock; dividends on S corporation stock; and gain or loss on the sale of property generating portfolio income. In portfolio activities, the investor only receives income from the activity and does not share in the expenses related to the activity.

Passive- income (losses) from limited partnership interests, regardless whether you materially participate; business or trade activities in which you do not materially participate; and rental activities except for a $25,000 exclusion.

In general, you are allowed to deduct passive activity losses only from passive activity income. Passive activity losses cannot offset active or portfolio income. They can, however, be carried over to future years and applied against passive income. Tax credits, such as the reforestation investment tax credit can off-set only tax payable on passive income.

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