Chpt 11 Income tax Guide

Tax Shelters Problem

Ways to avoid taxes, offset income against deduction from other sources. Taxpayers
intentionally invested in activities that were designated to produce losses
(partnerships)
At risk limitation: amount loss is amount invested (the amount of cash and the
adjusted basis of property contributed to the activity by the taxpayer; amounts
borrowed for use in the activity for which the taxpayer is personally liable or has
pledged as security property not used in the activity). Applies to individual and
closely held corporation (S corporation and partnerships). The amount can be
increase each year by the taxpayers share of income and is decreased by the
taxpayer share of deductible income.
Passive Loss: Passive losses offset passive income. Requires taxpayers to segregate
income and losses in: active, portfolio and passive.
Active income: Wages, salary, commissions, bonuses, and other payments for
services rendered by the taxpayer; profit from a trade or business in which the
taxpayer is a material participant; gain on the sale or other disposition of assets
used in an active trade or business; income from intangible property if the
taxpayers personal efforts significantly contributed to the creation of the property.
Portfolio income: Interest, dividends, annuities, and royalties not derived in the
ordinary course of a trade or business; gain or loss from the disposition of property
that produces portfolio income or is held for investment purposes.
Passive: Any trade or business or income-producing activity in which the taxpayer
does not materially participate; subject to certain exceptions, all rental activities,
whether the taxpayer materially participates or not.
General impact: Losses or expenses generated by passive activities can be
deducted to the extent of income from all of the taxpayers passive activities. Any
excess may be carry forward to future years to offset passive income generated in
those years. When taxpayer disposes of his interest in the activity, all current
suspended losses related to the activities may offset active and portfolio income.
Carryover of suspended losses: taxpayers are able to deduct passive losses from
other passive activities and then allocated the net losses among the activities that
had losses.
Suspended losses are carryover indefinably and are offset in the future first against
any passive income, and passive income from other activites.
Passive credits: can be utilize only against regular tax attributable to passive
income. Passive credit arise from comparing the tax on all income (including passive
income) with tax on income excluding passive income

Carryover of passive Credits: carry forward indefinitely like suspended passive

losses. When activity is dispose of in taxable transaction and loss is recognized the
passive credit is lost forever. Credit are allowed on disposition only when there is
sufficient tax on passive income to absorb them.

Passive activity Changes to Active

If passive becomes active activity, suspended losses are allowed to the extent of
income from the now active business. The suspended loss can be carry over to the
next years. They activity must continue to be the same activity.
Taxpayers subject to passive Loss Rules
Applies to individuals, estates, trusts, personal service corporation, and closely held
C Corporation (flows through the owners).
Personal Service Corporation: to prevent taxpayers from sheltering personal
services income by creating personal service corporation and acquiring passive
activities at the corporate level. To determine if it is a personal service corporation is
based on: the principal activity is the performance of personal services; such
services are substantially performed by employee owners. Treated as a personal
service corporation if more than 10 percent of the stock value is held by employee
owners.
Closely Held C Corporation: if at any time during he taxable year more than 50% if
the value of its outstanging stock is owned directly or indirectly by five or fewer
individuals. C corp. may use passive losses to offset active income but not portfolio
income
Working with the definition of Passive Activities: Any trade or business or incomeproducing activity in which the taxpayer does not materially participate; and,
subject to certain exceptions pertaining to real estate (discussed later), all rental
activities.
Identification of Activity: Taxpayers who are involved in complex business operations
need to determine whether a given segment of their overall business operations
constitutes a separate activity or is to be treated as part of a single activity.
In general, a taxpayer can treat one or more trade or business activities or rental
activities as a single activity if those activities form an appropriate economic unit for
measuring gain or loss.
Regrouping of activities: taxpayers can group activities appropriately; if not it me be
regrouped, the IRS can regroup when taxpayers grouping fail to reflect one or more
appropriate economic units; and , one primary purpose is to avoid passive loss
limitation.
Special grouping rules for rental activities: a rental activity may be grouped with a
trade or business activity only if one activity is insubstantial in relation to the other;

and taxpayers generally may not treat an activity involving the rental of real
property and an activity involving the rental of personal property as a single activity.
Material Participation: taxpayer actively participated in a no rental trade or business
activity, any loss from that activity is treated as an active loss that can offset active
income or portfolio income.
Material participant is one who has a significant nontax economic profit motive for
taking on activities and selects them for their economic value. S 469 requires a
taxpayer to participate on a regular, continuous, and substantial basis to be a
material participant.
Seven Test divided in three categories: Test based on current participation; test
based on prior participation and test based on facts and circumstances. Material
participation is achieved by meeting any one of these tests.
Participation Defined: work done in activities that one owes. It should be done
constantly. It does not include work if it is of a type not usually done by owners and
if one of its principal purposes is to avoid the passive losses or credit limitations.
Reviewing reports in a non-managerial capacity is not counted in applying the
material participation test. Participation of owners spouse counts as participation by
the owner.
Limited Partners: limited partner is not considered a material participant unless
qualifies under test 1, 5, or 6. A general partner may qualify as a material
participant by meeting any of the seven tests.
Rental Actives defined: all treated as passive activity; subject to passive activity loss
even if the taxpayer is material participant involved. Exception to the rule is based
on the presumption that a person who rents property for is required to provide
significant service to the customerinvolved in service business.
Interaction of at-risk and Passive loss limits: the determination of whether a loss is
suspended under the passive loss rules is made after application of the at-risk rules,
as well as other provisions relating to the measurement of taxable income.
Special Passive activities Rules for Real Estate Activities: allow real estate rental
losses to offset active or portfolio income.
Material Participations in a Real Property Rental Trade or Business: taxpayers must
meet: more than half of the personal services that the taxpayer performs in trades
or businesses are performed in real property trades or businesses in which the
taxpayer materially participates; the taxpayer performs more than 750 hours of
services in these real property trades or businesses as a material participant. Hours
working for spouse does not count toward 750 hours; service provided for
employees not count, unless the employee performing services owns more than a
5% interest in the employer.
Real Estate Rental Activities: real estate professionals can deduct up to 25,000 of
losses from real estate rental activities against active and portfolio income. must
meet: Actively participate in the real estate rental activity; own 10 percent or more

(in value) of all interests in the activity during the entire taxable year (or shorter
period during which the taxpayer held an interest in the activity).
The difference between active participation and material participation is that the
former can be satisfied without regular, continuous, and substantial involvement in
operations. It can be involved in management decision such as approving new
tenants, deciding on rental terms, and approving capital expenditure.
Disposition of Passive interest
Disposition of a passive Activity at death: transfer because of taxpayer death,
suspended losses are allowed (to the decendant) to the extendt they exceed the
amount, if any, of the allowed step-up basis (increase because of fair value), if not
losses are lost.
Disposition of a Passive activity by a Gift: the suspended losses are added to the
bases of the property. Suspended losses become nondeductible to both the donor
and the done. Grater depreciation deduction result because of the increase on the
propertys basis. Not materialize if it is given to charity organization
Installment sale of a Passive Activity: installment sale of a taxpayers entire interest
in a passive activity triggers recognition of the suspended sale. Losses are allowed
as payment received each year.
Investment interest Limitation
Limited imposed: investment interest interest paid on debt borrowed for the
purposed of purchasing or continuing to hold investment property\. It is limited to
the lesser of the investment interest paid or net investment income.
Investment income and expenses: serves as the ceiling on the deductible of
investment interest, excess of investment income over investment expenses.
Investment income includes gross income from interest, annuities, and royalties in
the ordinary course of he trade or businessnot passive activity included.
Computation of Allowable deduction: the amount invested interest disallowed is
carried over to future years. No limits in the length of the carryover period.