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Passive vs Non-passive K-1 Income/loss: Confusion reigns!

Brian’s question:

What does it mean when the k-1 income/loss is listed as ‘passive’ instead of ‘non-passive’?

Linda says:

In the post on whether to add back passive/non-passive losses, I focused on what to do with each. But your question is more basic. What is the difference? Good question.

This is one of those topics that you don’t need to know a lot about, but just enough. So I’ll give you the (fairly) simple explanation of what it is and then tell you what difference it makes to you. I also cover this distinction in the 17th of the free 20-video series on K-1s and pass-through entities. Each video is under three minutes, another resource to clear up your confusion.

Definition

Passive income/losses are those in which the taxpayer does not materially participate. Pre-1984 we called these ‘paper’ losses. And in 1984 President Ronald Reagan successfully changed the tax law so taxpayers with paper (passive) losses cannot take them against non-passive income. Non-passive includes earned and portfolio income.

Which is better

It is generally an advantage, then, for losses to be listed as non-passive because they can ‘shelter’ taxes from wages, capital gains and other non-passive sources. Sometimes it is an advantage for income to be passive because it can ‘allow’ passive losses to be taken.

What does it tell me about the borrower’s involvement in the activity?

You may be thinking I am diving too deep. Perhaps you just want me to tell you if you should use the numbers, or not. But for those of you lending to businesses, farms or real estate developers, understanding a bit more about the difference will help you understand your business borrower and the guarantors.

If the taxpayer meets any ONE of the following tests, they are considered to materially participate in the activity and the income/loss is reported as non-passive.

  1. ____ Does taxpayer and/or spouse work more than 500 hours a year in the business?
  2. ____ Does taxpayer do most of the work? Even if taxpayer does not meet 500 hour test, but his participation is the only activity in the business, he materially participates. Example: sole proprietor with no employees.
  3. ____ Does taxpayer work more than l00 hours and no one (including non-owners or employees) works more hours? Example: If owner puts in l75 hours a year and an employee works 190 hours a year, taxpayer would not meet material participation test.
  4. ____ Does taxpayer have several passive activities in which he participates between 100-500 hours each, and the total time is more than 500 hours? The following activities should not be included in the above test: rental activities: activities involving portfolio or investment income, and activities in which the taxpayer does most of the work.
  5. ____ Did taxpayer materially participate in activity for any 5 out of l0 preceding years (need not be consecutive)? Example: taxpayer who retired and his children now run business, but he stills owns part of partnership.
  6. ____ Did taxpayer materially participate in a personal service activity for any 3 prior years (need not be consecutive)? Personal service activity includes fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting.
  7. ____ Do the facts and circumstances indicate taxpayer is materially participating? Test does not apply unless taxpayer worked more than 100 hours a year. Furthermore, it does not apply if:
    1. any person, other than the taxpayer, received compensation for managing the activity; or
    2. if any person spent more hours than taxpayer managing the activity.

Practical application:

Income/loss listed on the passive side on a 1040 Schedule E are not activities in which the borrower is materially participating. These are more like investments. Thus the borrower is less likely to have guaranteed debts and probably less likely to have a high % ownership. If listed on the non-passive side, this is an activity the borrower is active in, is more likely to have guaranteed debts, and is more likely to have a high % ownership.

If you are inclined to skip some of the k-1s, and your guidelines will tell you if you can, I would not be inclined to skip over the k-1s for organizations listed as non-passive.

More resources on pass-through entities

Six of the 22 online training modules on tax return analysis for lenders at www.LendersOnlineTraining.com focus on the pass-through entities; three on 1065 and three on 1120S. If you prefer the flexibility of online credit training, take a look.

About the Author
Linda Keith CPA is an expert in credit risk readiness and credit analysis. She trains banks and credit unions throughout the United States, both in-house and in open-enrollment sessions, on Tax Return and Financial Statement Analysis. She is in the trenches with lenders, analysts and underwriters helping them say "yes" to good loans. Creator of the Tax Return Analysis Virtual Classroom at www.LendersOnlineTraining.com, she speaks at banking associations on risk management, lending and director finance topics.