Passive vs. Non-Passive

[RayT]

Client created an LLC and elected to be taxed as an S Corp. He rented his commercial building to the LLC. The LLC, in turn, rents space in the building to professionals who pay a commission to the LLC, based on revenues. The company was started in 2004. For 2004 and 2005, the client filed tax returns as a non-passive business with owner participation because he assisted in managing the start-up process. In 2006 the owner has reduced his time to collecting rent and maintenance equal to approximately 5-hours per month. He no longer participates in the management of the business. The business earns a profit. Question: Can the client switch from non-passive to passive for 2006 and beyond, in order to offset residential real estate rental losses? Comments appreciated.

[erchess]

I'm sorry that no one with more knowledge

than I have has elected to respond. If I were you I would ask BeesKnees and NYEA by private message. There are others you could ask as well. Please ask that they respond here for the education of the group.

I have thought of one possible reason why you may have received no responses. You don't provide a lot of information. So let me take a stab. He obviously reports the rent from the LLC on his personal return on Sch E pg 1. My understanding would be that the limited activity you describe is sufficient to make the Rental activity active. I suspect that he has everything worked out so that the LLC/Scorp does not pass any other income on to him. Am I right?

I am sure that there is a way he could get the passive income he wants but I do not know exactly how. I suspect that any such plan would involve transferring the building to the LLC and might involve revoking the S Election and or changing the terms under which the LLC is paid by the users of the building. I am afraid that whatever the users pay would be considered Rent and would have the character of Rent when passed through to your client by an SCorp. However, if the LLC elected to be taxed as a C-Corp then it could pass on dividends, which would be passive, to the client. The cost of course, would be double taxation and depending on all the facts and circumstances that might or might not be too high a price to pay.

By the way, I hope the client pays himself as an employee for the work he does. When an owner works in the business it is necessary that he or she be paid the going rate for those services that would have to be paid to a non owner.

[RayT]

F/U Passive vs. Non-Passive

This is a follow up to the previous question and, hopefully, offers a better explanation of the situation.

Landlord owns building and rents building to his LLC (single-member LLC). Landlord claims rental income (passive income) on Form 1040 Sch E p.1, Supplemental Income and Loss (from Real Estate, etc.).

LLC receives commissions from professionals using the building. Commissions are paid by professionals in return for use of space, furnishings, utilities, taxes, insurance, phone services, computer facilities, supplies and clinical equipment. Net after expenses is pass-thru to LLC member. Question: Is net income pass-thru passive or non-passive?

[veritas]

My first concern is

the "passive income" from renting to his LLC. Are you using that passive income (if you had any) from the commercial rental to free up other passive losses for 2004 and 2005?

I would say for 2006 since he was not materially participating in the LLC you may use the LLC loss to offset other passive income. The regulations say if he had partcipated 5 out of the last ten years you could not define the losses from the LLC as passive. The regulations don't speak to a business in existence less than 10 years.

[Bees Knees]

Passive activity rules are a year to year rule. You can have an activity be passive in one year and non-passive in the next year.

I question, however, whether the LLC is a rental activity, since it is sharing profits with the tenants. Sharing profits with another business is a partnership, not a rental.

[Davc]

Passive activity rules are a year to year rule. You can have an activity be passive in one year and non-passive in the next year.

I question, however, whether the LLC is a rental activity, since it is sharing profits with the tenants. Sharing profits with another business is a partnership, not a rental.

Also, it sounds like the LLC is providing enough services to preclude treatment as a rental.

[veritas]

The owner of the LLC

is not providing material participation with only 5 hours a month. So it is passive. Since the LLC is passive the self-rental is passive.