Losses passed through from partnerships and S corporations are reported on Schedule E, page 2, but cannot be deducted unless they exceed the partner or shareholder’s basis in the trade or business, and the losses are both at risk and generated from a nonpassive activity. Is your ownership in a partnership or S corporation nonpassive?

Nonpassive activities include the following:

• Trade or business activity in which a taxpayer materially participates;
• Working interest in oil or gas property where the taxpayer’s ownership does not limit liability;
• Rental of a home when personal use is more than the greater of 14 days or 10% of the number of days rented at fair rental value; and
• Rental real estate activities in which the taxpayer materially participates as a real estate professional.

A taxpayer materially participates in a trade or business activity if they can meet any one of the following seven tests:

1. The taxpayer participated in the activity for more than 500 hours;
2. The taxpayer is the only one who substantially participated in the activity (including the participation of those who did not own any interest in the activity);
3. The taxpayer participated more than 100 hours and no one else participated more than the taxpayer (including employees);
4. The taxpayer participated in the “significant participation activity” (more than 100 hours) and the total of all significant participation activities exceeded 500 hours;
5. The taxpayer materially participated in the activity for any 5 of the 10 immediately preceding tax years;
6. The taxpayer materially participated in an activity which is classified as a personal service activity for any 3 preceding tax years; or
7. Based on the facts and circumstances, the taxpayer participated in the activity on a regular, continuous and substantial basis during the year.

Participation generally includes any work done in connection with the activity except for work not generally performed by owners and work performed in the capacity of an investor. A taxpayer must be able to prove participation through collaborating records. If material participation does not exist, then the losses passed through from the partnership or S Corporation are considered passive and are only deductible when offset against other passive income.

If you invest in pass-through entities, contact Flexible Accounting Services of the Triangle and let us help you determine how to properly report your pass-through income and losses.