It is quite common for “high net worth” individuals (e.g., physicians, landowners, developers, and those with significant investment portfolios) to invest in side businesses or enterprises. The investment decision might be prompted by a specific hobby or interest – say, in classic automobiles – or it may be rooted in a desire to help a fledgling entrepreneur. Often, particularly in the early years, these side businesses generate losses instead of actual income. The IRS has a vested interest in limiting the ability of an investor to reduce his or her taxable income by what it labels as “passive” losses. What sort of participation in the business is required to characterize the loss as “active” rather than “passive?”
Generally speaking, the Internal Revenue Service requires “material participation” in the business in order for losses to be considered active and not passive. Investors are sometimes surprised that having a financial interest in a business – even when it is a significant one – is insufficient to meet the Tax Code’s material participation criteria. According to the IRS, an individual materially participates in a business activity when his or her participation is on a “regular, continuous and substantial basis” [see the recent case of Escalante, T.C. Summ. 2015–47].
In most cases, the IRS uses a seven-part test to determine if an investor’s participation is material. The taxpayer need not meet all parts in the test; the IRS gauges participation on an overall score. It assesses whether:
In many cases, material participation is easier to establish where the issue isn’t merely an afterthought. It is important to give careful attention to the detail at the time the investment is made. For example, the investment might designate the number of hours each month that the investor is to devote to the business. It might designate not only a time frame for participation, but specify the actual duties that are contemplated. The investor should also give attention to documenting his or her time spent on the side business after the investment is made. It will do little good to craft an investment agreement that calls for material participation if the agreement is then ignored.
Paul Romano & Kenny Sumner have more than 20 years of combined experience in business law. They have helped investors and business owners structure transactions that not only meet business needs, but they also take appropriate advantage of tax and other issues. The business law attorneys at Romano & Sumner have drafted countless contracts and agreements. They know the pitfalls and can help you avoid them.
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