Active vs. Passive K-1’s

March Madness is upon us and another one of my tax season “milestones” has passed.  I wish I could say that I watched a bunch of the games this year, but I haven’t.  I have been checking in on the scores though.  While the first day of games seemed to go in line with the seedings, the games that followed didn’t follow suit.  A #1 (Villanova), a #2 (Louisville) and a #3 seed (Florida State) have already lost on the first weekend!  Hopefully the upsets keep coming…. unless it’s the teams I picked in my bracket!

If you are business owner or investor, your company’s tax return was probably filed a few days ago unless it was extended.  For those of you who didn’t extend the return to September, you should have received your Schedule K-1.

Some of the biggest tax issues and confusions I consistently see each year are due to the receipt of the K-1.  I could spend days talking about what each line item means.  This week, however, I wanted to focus on the Material Participation Test.  This test affects each recipient of a K-1 as it determines if you have active or passive income/loss.  Each year you need to go through the following tests and pass just one of them:

  • You participate in the business for more than 500 hours.
  • Your participation in the activity constitutes substantially all of the participation of all individuals and employees.
  • You participate in the business for more than 100 hours and no other individual or employee participates more hours than you.
  • The activity is a Significant Participation Activity and you participate for more than 100 hours and your annual participation in all significant activities is more than 500 hours.
  • You materially participated in the activity for any 5 years during the 10 immediately preceding years.
  • If you are engaged in personal service activity, the test is that you must have materially participated for any 3 years preceding the current year.
  • Based on all facts and circumstances, you participated on a regular, continuous, and substantial basis during the year.

I’m sure reading through these tests makes your head spin!  Sometimes the answer is simple and sometimes there is a great deal of “gray” to consider.

Once you figure out your status, now what do you do?  Well, now the real fun begins!  There is another set of tests that you will need to consider before reporting the K-1 on your taxes.

  • Regardless of your status, if you have net income on your K-1 it is taxable.
  • If you are passive and you have a loss, there are many additional tests that need to be passed to see if you can even deduct the loss. If you meet these tests, then the loss is typically only deducted to the extent you have passive income.
  • If you are active and have a loss, then you must pass additional tests as well. However, if you pass these tests you can generally deduct it without having other sources of active income.

As you can see, the IRS will happily let you report income regardless of your status.  But, if you have a loss, things can get quite complicated.  I could spend days talking about the passive and active loss tests, so I strongly suggest talking with your tax advisor in more detail about them.

If you received a K-1 and do not have a tax advisor, please feel free to forward me your questions.  Since the 4/15 filing deadline is approaching quickly I would happy to answer them for you!