Determining deductibility of passive losses.

Facts: Derek owns stock in two S corporations--he is the sole shareholder of Sunny Corp. and owns half the shares of Dew Corp. He works full-time at Sunny at a $75,000 annual salary. He does not participate in Dew's operations. The two corporations are engaged in different business activities at different locations.

Sunny reports a loss of $25,000, after considering $1,000 of interest income from investing working capital for a short time. Dew reports a loss of $40,000. Neither corporation receives rental income.

Derek does not have any other income items in arriving at adjusted gross income (AGI) on his return. He believes his 2004 income will be computed as follows:

Salary                            $75,000

Sunny Corp. pass through items:
Interest income                     1,000
Ordinary loss                     (26,000)
Dew Corp. loss                    (20,000)
Total income                      $30,000

He asks his tax adviser if his assumptions are correct and, if not, is there anything he can do to decrease his taxes. Issue, Can Derek offset the Sunny and Dew losses against his salary?

Analysis

The passive or active nature of nonseparately stated income or loss passed through by an S corporation depends on whether the shareholder materially participates in the business's operations. If the shareholder materially participates, the income or loss is active; if he or she does not materially participate, the income or loss is passive. Under Sec. 469(h)(1), material participation requires that the shareholder be involved in the activity's operations on a regular, continuous and substantial basis. If the corporation is engaged in more than one activity, these rules apply to each activity.

According to Sec. 469(c)(2), rental income or loss generally is passive and is passed through as a separately stated item. Interest and other portfolio income earned by an S corporation pass through as portfolio income, under Sec. 469(e)(1)(A) and Temp. Regs. Sec. 1.469-2T(c)(3), regardless of whether the shareholder materially participates in the S corporation's activities, or whether the interest income was used for business purposes. Other separately stated items may be either active or passive, depending on the type of income and the taxpayer's participation in the activity.

Here, the ordinary loss from Sunny is active and can offset Derek's salary, while the ordinary loss from Dew is passive and can only offset income from other passive activities.

Derek's AGI is computed as follows:

Salary                      $75,000
Interest income               1,000
Sunny Corp. ordinary loss   (26,000)
Dew Corp. loss                    0
AGI                         $50,000

The Dew loss carries over until there is other passive income to apply against it or until Derek disposes of his entire interest in that corporation.

Conclusion

The passive or active nature of nonseparately stated income from an S corporation is determined by the level of shareholder involvement in the business's operation. If the shareholder materially participates in the S corporation's operation, the corporation's nonseparately stated income is active. Thus, Derek can offset the active losses from Sunny against his salary. Because he does not materially participate in Dew's operations, however, the losses are passive and cannot offset his salary. Even if an S corporation's nonseparately stated income or loss is active, the corporation can pass through separately stated passive (e.g., rental income) or portfolio income items.

The tax adviser might want to suggest that, in future years, Derek increase his involvement in Dew, so that he materially participates in it as well as in Sunny. If he can participate on a regular, continuous and substantial basis, the losses could offset other active income and portfolio income.

Editor's note: This case study has been adapted from PPC Tax Planning Guide--S Corporations, 17th Edition, by Andrew R. Biebl, Gregory B. McKeen and George M. Carefoot, published by Practitioners Publishing Company, Ft. Worth, TX, 2003 ([phone]; www.ppcnet.com).

Editor:

Albert B. Ellentuck, Esq.

Of Counsel

King & Nordlinger, L.L.P.

Arlington, VA