Defining Passive Activity Between Spouses – Beyond the Bedroom: What Is Material Participation?

Defining Passive Activity Between Spouses – Beyond the Bedroom

What Is Material Participation? Ha!

One would imagine this is the script for a low-budget B-rated film by the title, but it is not. But if it got you reading all the better because you may want to know about my friends, a professionally successful and happily married couple who jointly own rental real estate that generated losses for tax years 2010, 2011, and 2012, and their subsequent misunderstanding of material participation as it pertains to passive activity loss limitations, outside the bedroom.

Besides the rental real estate, they also own, as 50/50 shareholders, a corporation successfully elected to be treated as an S corporation. The wife materially participates in the corporation and the husband does not. It is essentially her business that he happens to co-own. It generated net income allocated and passed through 50/50 to each shareholder. Neither spouse is a ‘real estate professional’ for income tax purposes so those exceptions do not apply.

This summarizes my friend’s situation when the IRS conducted an examination. 

Because the husband does not materially participate in the “wife’s business,” his income from her company was incorrectly considered passive by the overpriced tax attorney who prepared, signed, and filed their 2010, 2011, and 2012 tax returns. They were wrongly advised in writing that they could offset all of the rental loss incurred from the real estate holdings against the husband’s purported passive income from the S corporation by a POMPOUS ARROGANT MORON WITH A LAW DEGREE, the worst type of pond scum on the planet.

Unfortunately, the bag of wind that screwed up the tax returns (hailed from a ‘prestigious’ local law school) failed to fully comprehend [IRC Sec. 469(h)(5)] where it states explicitly that when spouses jointly own a business where one spouse materially participates and the other does not, both are treated as non-passive meaning the gains in the S-corporation cannot offset other passive losses generated by rental real estate which by default is customarily treated as passive activity.

Guess what else? This tax attorney still asserts he is correct and refused to turn over the file in a timely fashion. I won’t be surprised to learn further that he probably failed to carry errors and omissions insurance. Doubtless to say his license will be reprimanded.

Nevertheless, my friends have no basis to defend themselves for tax years 2010, 2011, and 2012. They will have to file amended tax returns for 2013 for the IRS and the Colorado Department of Revenue and pay a whole bunch in interest and penalties because they trusted this jerk. I should be able to get the accuracy-related penalties thrown out as I have copies of the misinformation provided by the blowhard practitioner. It shows you that competent and incompetent people are everywhere, regardless of designation.

So what does it mean to materially participate for purposes of passive activity?

According to Chapter 4 of the IRS’ Audit Technique Guide on Passive Activity Losses referencing Material Participation a taxpayer is considered to material participate if the taxpayer meets one of the following 7 tests:

  • The taxpayer works 500 hours or more during the year in the activity.
  • The taxpayer does substantially all the work in the activity.
  • The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.
  • The activity is a significant participation activity (SPA), and the sum of SPAs in which the taxpayer works 100-500 hours exceeds 500 hours for the year.
  • The taxpayer materially participated in the activity in 5 of the prior 10 years.
  • The activity is a personal service activity and the taxpayer materially participated in that activity in any three prior years.
  • Based on all of the facts and circumstances, the taxpayer participates in the activity regularly, continuously, and substantially during such year.  However, this test only applies if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.

In this file, even though the husband did NOT materially participate in the wife’s business, his investment in the business is still considered non-passive simply because he was married to the person who materially participated. Or said differently the IRS thinks of him as essentially ‘faking it’ for income tax purposes.

If you would like more information on defining passive activity between spouses, please contact me anytime.