Passive Activity (Again)

[JohnH]

This shouldn't be so hard to figure out - maybe it's just been a bizarre week. The situation's a little more complicated than I'm presenting here, but I want to get the first step right.

High-income taxpayer purchases stock for $40,000 and receives a 10% shareholder interest in a restaurant. It's an LLC which elects to file as an S-Corp. He has no material participation - never sets foot in the place except as a customer.

His K-1 shows a year 1 loss of $5,000, year 2 loss of $2,000, and year 3 loss of $1,000. He sells the entire interest for $50,000 cash to an unrelated party in year 3 on the front page of the 1040.

My 8582 is showing $7,000 in prior year unallowed losses plus CY $1,000 loss in year 3, for a total of $8,000 in losses on schedule E, which offsets against ordinary (nonpassive) income in year 3.

On Schedule D the basis is reduced to $32,000, showing a gain of $18,000 which is taxed at favorable LTCG rates. Is that correct?

[Snaggletooth]

I think so

Although the formula for SCorp basis must be applied piecemeal every year, I don't think at any point he was in danger of having losses disallowed for lack of basis, so we'll just apply the formula as is:

Original Investment: $40,000
+ Subsequent Investments: $0
+ Profits taxed: $0
- Dividends/Withdrawals $0
- Losses deducted: $8,000

There are minor other factors, but essentially the formula gives him a basis of $32,000.
Taxable Capital Gains on sale is $18,000. Depreciation recapture was not mentioned.

[JohnH]

Thank you Ron. There was a little bit of recapture but I left it out, along with some other extraneous stuff, to keep things simple. I'm always struggling to wrap my brain around the concept of writing off the accumulated losses against ordinary income and on the same return taxing the writeoff as capital gains via the basis reduction.

[Nashville]

Loss Restrictions

John H - your post has its roots in (at least) three restrictions on deductible losses.

1. First is the matter of reducing the shareholder's basis below zero. Is not a problem for your situation because of abundant original investment. However, what if your shareholder had paid $4000 instead of $40,000? Hmmmmm....
2. Second is the matter of a passive investment. Not sure a shareholder may be designated as "passive" by his own definition, but perhaps by the eternal test of "facts and circumstances." Absent a true passive shareholder, the prior year losses are deductible and cannot defer the gain.
3. Third is the matter of "rental" income. This is in the sense that it is not "ordinary" income but instead becomes subject to the phaseout which occurs between $75K and $150K. Even if the shareholder is active, if the S corp pass-through is "rental" in nature, this phaseout occurs.

My question, if it doesn't gaggle the mind, would be: Is the order of these loss restrictions prioritized? This is important because a loss restriction converts preferential capital gains to ordinary income in the long run.

To better paint the picture:

1. Is the original investment LESS than the losses which accumulate?
2. Is the investor "passive" instead of participatory?
3. Is the nature of the income "rent" with a shareholder in the phaseout range?

If more than one of the above is true, we as preparers should know which of the restrictions to apply first, and when.

Does anyone know??

[outwest]

The three hurdles...

As I learned it, you have to clear three hurdles in sequence to get the loss deduction;

First, the basis hurdle...

Second, the at risk hurdle.

Finally, the passive activity hurdle.


The special rental deduction is actually a limited exception around the passive activity hurdle.

At risk may be less than basis if, for instance, the money was non-recourse borrowing. If you lose, you don't personally have to pay the loan so nothing is at risk.

[Snaggletooth]

Outwest

Thanks to Outwest for this. This is a very difficult question. You would not likely get an answer for specific situations like this in TTB since it is limited to 600-700 pages, although I suspect that if the authors were confronted with this they would be able to correctly assess this on a situation-by-situation basis.

[JohnH]

Thanks to both of you for the continued discussion. My client's situation is fairly clear in my view, but I can see how it can turn on a few key issues and quickly become much more complex. I am going to double-check on the rental loss question just to be sure, but I'm fairly certain this wasn't in the mix.

The "at risk" question is pretty easy - he put money in upfront and got money back at the end. No borrowed funds, cosignatures, or other fancy investment stuff. And as for the material participation question, I think it's a slam dunk. He never had any management input beyond tipping the waitperson when he ate there, never participated in any management meetings or decisions, and never even got a financial statement until the business was sold. Why can't I find an investor like this?

I think he's the guy the passive activity rules were written for...