Tuesday, March 5, 2019
The passive loss rules have a substantial impact on farmers and ranchers and investors in farm and ranch land. Until 1987, it was commonplace for non-farm investors to purchase agricultural real estate and run up losses which were used to offset the investor's wage or other income. However, the Congress stepped-in and enacted the passive loss rules in 1986. I.R.C. §469. Those rules reduce the possibility of offsetting passive losses against active income unless the taxpayer materially participates in the activity.
A look at the passive loss rules and material participation – that’s the topic of today’s post.
The Basic Concept
The passive loss rules apply to activities that involve the conduct of a trade or business and the taxpayer does not materially participate in the activity or in rental activity on a basis which is regular, continuous and substantial. If the passive loss rules apply, deductions (losses) from passive trade or business activities, to the extent the deductions exceed income from all passive activities, may not be deducted against other income (non-passive activity gains).
For farmers, the passive loss rules are likely to come into play in situations where the farmer is a passive investor in a separate business venture apart from the farming operation. In that case, the losses from the venture cannot be used to offset the income from the farming operation. The rules also get invoked when a non-farmer loses money in an activity that is a purported farming activity.
Unless an investor or other individual can meet one of two critical tests, the passive loss rules apply. The first of these tests is the test of material participation. If an individual can satisfy the material participation test, then passive losses can be deducted against active income. If, for example, a physician is materially participating in a farming or ranching activity, the losses from the farming or ranching activity can be used as a deduction against the physician's income from the practice of medicine.
Does an agent’s activity count? An investor is treated as materially participating in an activity only if the person “is involved in the operation of the activity on a basis which is regular, continuous, and substantial.” I.R.C. §469(h)(1). In determining whether an individual taxpayer materially participates (or actively participates), the participation of the taxpayer's spouse is taken into account, whether or not they file a joint income tax return. In addition, while the statute refers to material participation by the taxpayer, it does not specifically bar imputation of the services of an agent or specifically embrace the rules of the self-employment tax statute (I.R.C. § 1402), which does bar the ability of a taxpayer to impute the of an agent. However, a Committee Report and the regulations state that activities of an agent are not attributed to an individual taxpayer and the individual must personally perform sufficient services to establish material participation. Indeed, an individual’s own participation is not taken into account if a paid manager participates in the activity and someone else performs services in connection with management of the activity which exceed the amount of service performed by the taxpayer. See, e.g., Robison v. Comm’r, T.C. Memo. 2018-88.
Satisfying material participation. Farm and ranch taxpayers can qualify as materially participating if they materially participated for five or more years in the eight-year period before retirement or disability. In addition, the material participation test is met by surviving spouses who inherit qualified real property from a deceased spouse if the surviving spouse engages in “active management.” C corporations are treated as materially participating in an activity with respect to which one or more shareholders, owning a total of more than 50 percent of the outstanding corporate stock, materially participates. Treas. Reg. §1.469-1T(g)(3)(i)(A). In other words, the corporation must be organized such that at least one shareholder materially participates, and the materially participating shareholders own more than 50 percent of the corporate stock. Estates and trusts, except for grantor trusts are treated as materially participating (or as actively participating) if a fiduciary meets the participation test. See, e.g., Mattie K. Carter Trust v. United States, 256 F. Supp. 2d 536 (N.D. Tex. 2003); Aragona Trust v. Comr., 142 T.C. 165 (2014).
Regulations. In February 1988, the IRS issued temporary regulations specifying the requirements for the material participation test. Treas. Reg. 1.469-5T. These regulations have great relevance, especially for tenants renting agricultural real estate from the local physician, veterinarian or lawyer or any other non-farm investor. The temporary regulations lay out seven tests for material participation.
Under the first test, an individual is considered to be materially participating if the individual participates in the activity for more than 500 hours during the year. Treas. Reg. §1.469-5T(a)(1). This is a substantial amount of time; almost ten hours per week. In fact, this is more time than some tenants put into the operation on an annual basis. As a result, this test is exceedingly difficult for most investors to satisfy.
The second test involves situations where an individual's participation is less than 500 hours, but constitutes “substantially all of the participation” in the activity by all individuals during the year. Treas. Reg. §1.469-5T(a)(2). In other words, if the investor puts in less than 500 hours annually in the farming or ranching operation, but substantially all of the involvement comes from the investor, the material participation test will be satisfied. However, the investor cannot meet this test if there is a tenant involved, because a tenant will probably put more time in than the investor. Consequently, this test also tends to be difficult to meet.
Under the third test, an individual is considered to be materially participating if the individual puts more than 100 hours per year into the activity and the individual's participation is not less than that of any other individual. Again, if there is a tenant, this test is nearly impossible to meet because of the likelihood that the tenant will put more hours into the activity than the investor. Treas. Reg. §1.469-5T(a)(3).
The fourth test involves “significant participation.” An individual is treated as materially participating in significant participation activities if the individual's aggregate participation activities for the year exceed 500 hours. Treas. Reg. §1.469-5T(a)(4). A “significant participation activity” is a trade or business activity in which the individual participates for more than 100 hours for the taxable year. This is an aggregate test. For example, let us assume that an investor owns a farm, two fast food restaurants, and a convenience store. This rule permits an aggregation of all of those together, provided the investor puts in more than 100 hours in each activity. If the investor spends more than 100 hours in each activity, then each activity can be aggregated to see if the 500-hour test has been met. Thus, if an investor puts more than 100 hours into a farm activity, more than 100 hours into, for example, convenience store, and more than 100 hours into each of several restaurants, the total hours may exceed 500.
Under the fifth test the individual is treated as materially participating if the individual materially participated in the activity for any five of the ten taxable years immediately preceding the taxable year. Treas. Reg. §1.469-5T(a)(5). The idea behind this rule is that substantial involvement over a lengthy period indicates that the activity was probably the individual's principal livelihood. This is a very useful test for a retired farmer who has had several years of involvement.
The sixth test is for individuals involved in personal service activities. An individual is treated as materially participating in a personal service activity for a taxable year if the taxpayer materially participated in the activity for any three taxable years preceding the taxable year in question. This is a test solely for personal service activities. Treas. Reg. §1.469-5T(a)(6). Thus, it is a rule that can be used by taxpayer’s engaged in accounting, law practice, medicine and other professional services.
The seventh and final test is a “facts and circumstances” test. Treas. Reg. §1.469-5T(a)(7). This is the rule under which most farm investors try to qualify, and it requires that the taxpayer participate in the activity during the tax year on a basis that is regular, continuous and substantial. What a taxpayer does for any other purpose (such as material participation for Social Security purposes), does not count for purposes of the material participation test of I.R.C. §469. Treas. Reg. §1.469-5T(b)(2)(i). In addition, the facts and circumstances test cannot be satisfied unless the taxpayer participates more than 100 hours in the activity during the year as a threshold requirement. Treas. Reg. §1.469-5T(b)(2)(iii). Also, as noted above, if the taxpayer is represented by a paid manager, the taxpayer’s own record of involvement does not count. Treas. Reg. §1.469-5T(b)(2)(ii)(A). Thus, the involvement of a paid farm manager eliminates the possibility of the investor counting his or her own hours of participation.
Active participation. Farm landlords receiving crop share rent will likely have difficulty in satisfying any of the tests for material participation. However, if a taxpayer fails to meet the material participation test, there is a fallback test of active participation if the taxpayer owns at least 10 percent of the value of the interests in the rental activity and is not a corporation. I.R.C. §469(i). Active participation requires less than the material participation test, and allows the taxpayer to deduct up to $25,000 each year in losses from a rental real estate activity.
The IRS position is that a crop-share lease is a joint venture and not a rental real estate activity. Treas. Reg. § 1.469-1T(e)(3)(viii), Example (8). Thus, according to the IRS, a crop-share landlord will not qualify under the active participation test.
The active participation test is unavailable to taxpayers with adjusted gross income in excess of $150,000. As adjusted income exceeds $100,000, the $25,000 amount is phased-out over a $50,000 adjusted gross income (determined without regard to passive activity losses) range.
The passive loss rules are important in agriculture. While they operate to bar passive losses from offsetting passive income, material (or active) participation can suffice to allow full deductibility of losses. In the next post, we will dig deeper into the passive loss rules.