You have an interest in a business that lost money, but when you get your final tax return you are surprised to see you still owe taxes. What happened? Well your business or businesses may have been subject to the passive activity loss rules, with losses being carried forward to future years instead of taking advantage of them now. In general, you can only use losses from activities in which you are “passive” against income from other passive activities.
Whether it’s restaurants, real estate or most other types of businesses, you must satisfy one of the following seven requirements for it to NOT be considered a passive activity:
- You spend more than 500 hours participating in EACH business during the year.
- You are the only one who substantially participates, which is not likely in the restaurant business but may be in real estate.
- You spend more than 100 hours participating and no one else spends more hours than you.
- You spend more than 100 hours participating and aggregate participation by the individual for all significant participation activities exceeds 500 hours for the year.
- You met participation requirements for any five of the ten prior tax years.
- The activity is a personal service activity and you materially participated for any three prior tax years. This does not apply to restaurants or real estate.
- Facts and circumstances determine if you participate more than 100 hours on a regular and substantial basis.
If you have multiple businesses or restaurants, each of your businesses may not qualify individually, but they may qualify as active income if you elect to group them as a single activity for tax purposes. The tests above are then applied to your cumulative time participating in all the businesses combined. Grouping is allowed if they constitute an appropriate economic unit, with some considering factors including similarities in types of business and extent of common control.
Let’s say you have multiple franchise locations that all end up being reported in a partnership but someone else manages them for you. These would be classified as passive activities on your tax return. However, if you have ten restaurants that you actively own and manage, they may qualify as active activities that you materially participate in if they are grouped into a single activity on your tax return. Of course, always consult your tax advisor for the pros and cons of doing so.
So you may owe tax now, but know that you will have those losses to take advantage of in the future when you have more income.
Feel free to contact your Henry+Horne tax adviser with any questions.
Christina Henning, CPA