Determining the deductibility of S corporation passive losses.

Facts

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

Sunny reports a loss of $25,000, after considering $1,000 of interest income from investing working capital for a short period of time. Dew reports a loss of $40,000. Neither corporation receives any rental income, and the two companies do not share a common location.

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

  Salary                  $75,000
  Sunny passthrough
   items:
     Interest income        1,000
     Ordinary loss        (26,000)
   Dew loss               (20,000)

   Total income           $30,000

He asks his tax adviser if he is correct in his assumptions and, if not, if there is anything he can do to decrease his taxes.

Issue

Can Derek offset the S losses from Sunny and Dew against his salary?

Analysis

The passive or active nature of taxable (nonseparately stated) income or loss passed through by an S corporation is dependent on whether the shareholder materially participates in the business's operation. If the shareholder materially participates, the income or loss is active; if he does not, the income or loss is passive (unless the shareholder "significantly" participates in the S corporation's business and in other activities as well). 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.

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, regardless of the shareholder's level of participation, and regardless of 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 on the taxpayer's participation in the activity.

In this case, Sunny's ordinary loss is an active loss and can offset Derek's salary, while Dew's ordinary loss 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 ordinary loss    (26,000)
  Dew 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 Dew interest.

Derek's tax adviser might want to suggest that, in future years, he increase his involvement in Dew so that he materially participates in Dew as well as in Sunny. In that case, the losses could then offset other active income and portfolio income.

Conclusion

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

If the shareholder is involved in more than one business or "undertaking," the undertakings may be aggregated or separated into one or more "activities." In May 1992, Prop. Regs. Sec. 1.469-4 was issued, replacing the mechanical rules of Temp. Regs. Sec. 1.469-4T for aggregating or separating activities with a much simpler "facts and circumstances" test. Prop. Regs. Sec. 1.469-4 applies to tax years ending after May 10, 1992, while Temp. Regs. Sec. 1.469-4T applies to tax years ending on or before this date.