WITH TAX ADVANTAGES
This section is now part of Green's
Entrepreneurs Network. Please visit that separate site and we invite
you to apply to join our network. Click
here to read Robert Green's blog article "Traders should think
of themselves as entrepreneurs. Some may want to diversify by operating
more than one business."
Using our Green Active Investors tax breaks, Green & Company focuses
on tax-advantaged private-equity investments in small businesses and new
green (alternative) energy markets.
It’s a home run solution in this difficult credit crisis, recession
economy and high-tax environment.
Picture raising money from friends and family with limited paperwork and
very few strings attached. You’ll compensate your active investors
in the early years primarily with tax losses, rather than cash (or interest
income). Plus, your active investors can provide your business with special
assistance, knowledge, work, contacts and influence so you all can be
more successful sooner rather than later.
The tax magic of Active Investors is accelerated business write-offs and
tax credits. Most of all, active investors won’t be subject to onerous
“passive activity loss” rules, so they enjoy these tax breaks
up front. Your active investors will get the same tax breaks up front
as you. And they also can write off their own home office, travel, business,
entertainment and other expenses.
With tax rates headed higher on upper-income groups and the green energy
revolution taking shape, this convergence of ideas is a winning formula
for new business success.
Green and Company offers everything you need—from new business ideas
and ways to use Green Active Investors in your business; to development
on the business, tax and legal front; to annual accounting and tax compliance
(delivering these tax breaks to active investors). In addition, we offer
tax opinions if needed.
Some larger private equity deals can be a hybrid of active investors
and traditional private equity (passive) investors. In the LLC investment
pool, the entrepreneur owner can own Class A interests, active investors
Class B interests, and passive investors Class C interests. Class A has
voting control, Class B gives active investor tax breaks (with special
allocations), and Class C features more traditional private equity returns.
GreenEnergyActiveInvestors.com is underway!
Click here to learn more about my own hometown project.
To learn more about Green Active Investor tax breaks, click
If you would like to consult with Robert A. Green personally on these
If you have any questions about these services, please e-mail us at email@example.com
or call us.
Read the below article by Robert A. Green:
Diversify your time and money with a tax-advantaged “Active Investment.”
A green technology active investment might give you a 100-percent return
within the first few years with the tax breaks alone. Later success will
be the icing on the cake!
By Robert A. Green, CPA
This year may be a good time to consider another family business activity—either
starting your own new business, expanding one or joining other entrepreneurs
as an Active Investor.
Many traders were emotionally and financially stressed out in 2008 with
the market meltdown and perfect storm of volatility. Even seemingly steady
employment is a risky proposition in this dangerous job market with layoffs
happening fast and furious. Some traders may want to consider diversifying
both their assets and their personal employment.
Now may be the time to start your own business, and you don’t have
to do it alone. Recruit other Active Investors, or join other business
entrepreneurs in their business as an Active Investor yourself. As an
Active Investor all you will risk is a little money (as little as $25,000)
and material time and effort (see the "material participation"
The convergence of a new presidential administration, expanding technology
industries, stronger environmental advocates and more environmentally
aware consumers are adding up to big things for the new green jobs economy.
This may be the perfect time to consider an exciting highly-tax-advantaged
investment in green energy. Join the green energy revolution and receive
a boat load of tax breaks at the same time!
The Powerful Active Investor Tax-Benefit Plan
Active Investors invest a small amount of cash, plus some time and effort
and their own home-based expenses. Spending 500 hours per year is the
key to unlocking these business tax benefits and avoiding the passive
activity loss deferral rules (see material participation rules below).
Converting your home-based expenses to business-use is the “tax
juice”—the added tax write-offs that ensure you make all your
cash investment money back no matter what the economic outcome. In other
words, even if the business fails, you make money after tax benefits.
More Tax Benefits Going Green
Congress should pass accelerated tax benefits with either 100-percent
first-year depreciation (at very high investment levels), or at least
very accelerated depreciation, plus up front tax credits too.
An Active Investment in a green project could lead to a full return of
cash investment based on tax advantages alone in the first three years.
Active Investors and “Trader Tax Status” Have Much
in Common Tax-Wise
Active Investor business tax breaks are similar in many ways to business
tax breaks based on “trader tax status,” but there are a few
Business traders and Active Investors both need to materially participate
in their business activity in order to be allowed ordinary business tax
loss treatment. Business traders generally spend more than four hours
per day, which is generally close to 1,000 hours per year.
Portfolio trading and investment companies are not subject to “passive
activity loss” rules; rather they are subject to the “trading
rule.” All other types of businesses are subject to passive activity
loss rules. Passive activity loss rules only allow passive activity losses
to offset passive activity gains and not any other type of income (like
earned income, portfolio income and other income).
Under the trading rule, even passive investors in a hedge fund (that has
trader tax status) are allowed business loss treatment on all expenses
other than investment interest expense. Investors in other types of businesses
only overcome the passive activity loss rules if they can demonstrate
“material participation” in that business activity.
Trader tax status and other types of business status share other key terms
in common. For example, the material participation requirement within
the passive activity loss rules states “the taxpayer is involved
in the operations of the activity on a regular, continuous, and substantial
basis.” Business traders must trade on a “frequent, continuous,
regular and substantial” basis too.
But this is where these paths part ways. Trader tax status is not clearly
defined in the tax code, and it’s left to the tax court to interpret.
Conversely, the passive activity loss rules clearly define “material
Material Participation Defined
Per RIA, “An individual is treated as materially participating in
an activity for the taxable year if he satisfies any one of seven tests
set forth in Reg § 1.469-5T(a)”
The five tests that are most likely to apply to active investors include:
• the individual participates in the activity for more than 500
hours during the year;
• the individual's participation in the activity for the taxable
year constitutes substantially all of the participation in such activity
of all individuals for the year (including individuals who are not owners
of interests in the activity);
• the individual participates in the activity for more than 100
hours during the taxable year, and his participation in the activity for
the taxable year is not less than the participation in the activity of
any other individual (including individuals who are not owners of interests
in the activity) for the year;
• the activity is a “significant participation activity”
(i.e., a trade or business activity in which the individual significantly
participates in the activity for more than 100 hours during the taxable
year ( Reg § 1.469-5T(c) )) for the taxable year, and the individual's
aggregate participation in all significant participation activities during
the year exceeds 500 hours;
• based on all the facts and circumstances, the individual participates
in the activity on a regular, continuous, and substantial basis during
the year. An individual does not satisfy the facts and circumstances test
if he participates in an activity for 100 hours or less during the taxable
year [list reprinted from Reg § 1.469-5T(b)(2)(iii)].
Some Active Investors in green energy projects may be able to spend under
500 hours per year and still pass the material participation standards.
See additional information below from our tax attorney on complications
in the material participation standards in connection with active investor
Many green technology projects are not expected to be operated like a
traditional 9 to 5 business. To be successful, this type of project may
simply require assigning many sub-tasks to different Active Investors,
such as technology procurement, sale to a school, installation arrangements
Both partners’ time is counted, even if only one of the spouse’s
names is recorded as the investor.
The “Trading Rule” versus “Passive Activity
Trader tax status (business treatment) gives full ordinary loss deductions,
including home-office, education, start-up expenses, margin interest and
much more. Conversely, investment expenses (under Section 212) are very
limited, only allowed in excess of 2 percent of Adjusted Gross Income
(AGI), and not deductible at all against the Alternative Minimum Tax (AMT).
Passive activity losses are even worse than investment expenses; they
are only deductible against passive activity income. Unless an investor
has many passive activity investments in place, passive investors suffer
loss deferral over many years until they close down a particular investment.
Notice that because of the trading rule, passive activity investors can’t
generate passive activity income with hedge fund investments either. Otherwise,
it would be too easy for passive investors to use up their passive activity
In the mid 1980s, Congress enacted the passive activity loss rules to
kill off the tax-shelter industry, which had proliferated on real estate
and filmmaking syndicates. Perhaps Congress should consider revising passive
activity loss rules now to help spur growth. Bringing back some tax benefits
in connection with real estate might also help a real estate market in
serious price decline. There are even more onerous special passive activity
loss deferral rules just for rental real estate too.
Home-Based Business Expenses (the Tax Juice)
One of the best tax advantages for Active Investors and business traders
is deducting home-office expenses, travel, meals, entertainment and other
fixed or personal-type expenses (converted to business use) without restriction
Home-based expenses can be pure tax savings. Unlike out-of-pocket expenses
for trading or business services, home-based expenses are already fixed
as part of your personal life. By simply converting them to business-purpose,
you generate tax savings without spending more money on the expenses.
An Active Investor can deduct home office and other expenses as “unreimbursed
partnership expenses” (UPE) on their Schedule E in the same manner
that proprietary traders report their K-1 income and UPE.
Hard to Get a Bank Loan? Active Investors Can Help
In addition to tax savings, Active Investors can provide many powerful
advantages, including a convenient way to finance your business, when
more traditional sources of lending or investing have dried up.
As you know, banks are not lending much to small businesses now during
this credit crisis and recession. Private-equity firms went overboard
buying public companies using bank debt, which contributed to the credit
crisis and market meltdown. Private equity firms are not investing much
now. Vendor financing and leasing is also very difficult to arrange in
these times, as companies don’t have sufficient cash flow to help
their customers more than in the past.
Therefore, raising money for your venture with Active Investor tax-advantaged
equity can be a smart business decision in this economic environment.
With an Active Investor program, you probably don’t need to spend
much money on legal fees, since you probably don’t need a private
placement memorandum or other investment documents, as is traditional
in private equity and hedge fund deals. You should try to recruit a good
attorney as an Active Investor too, saving even more cash flow.
As an Active Investor, you save on interest costs, which can be a significant
drain on cash flow during a recession economy. In general, small business
loan interest rates are sky high during this credit crisis. It also can
be hard to get a SBA lower-rate loan too.
Think of Active Investors as self-raised private-equity loan with extreme
The Tax Power of Green
President Obama and the Democratically-controlled Congress have promised
to make a good start at converting America from dependency on foreign-oil
to a U.S.-home-grown green energy job economy. In addition, going green
will help fix our environment, which is also reaching the tipping point.
It’s pretty likely that the Democrats will pass significant fiscal
tax benefits. Tax rates are also headed up for upper-income individuals,
which makes tax-advantaged investing even more valuable to them. Upper-income
investors can probably part with a good chunk of change to invest in your
project as well.
An Example for Going Green (with Lots of Tax Breaks)
Here’s an example of how a trader can suggest a green energy project
in his or her local community:
Contact a local elected official, or write a letter to the editor in the
local paper suggesting that a local school or other quasi-government building
add solar-energy panels and/or wind power energy systems to their properties
to both lower energy costs and protect the environment at the same time.
Point out the tax benefit situation. The school or government entity won’t
benefit from income tax breaks related to green energy, because it’s
a non-profit institution that doesn’t pay taxes. That’s a
real shame, considering that Congress has and will continue to pass significant
new tax breaks for businesses using green technologies.
Invite other community residents and businesses to partner with you in
a management company to purchase the green technologies and lease them
back to the school/government for their use.
Mention that you and your co-Active Investors will do much of the work
required to make the project happen in a successful manner. Briefly point
out the Active Investor tax advantages. Say you want to recruit local
professionals (attorneys, accountants, engineers, physicians), local tradespeople
(builders, contractors, plumbers, electricians, masons, and landscapers),
and business managers, public relations and marketing people to partner
on the project. Point out that this project is great public relations
for these local business people. With local involvement as owners, there
is more incentive to keep the projects on budget and with excellent quality.
Recruit school children to promote and sell the green energy project to
the town residents. The biggest impediment to green energy projects is
objection from the local community—the infamous NIMBY (Not in My
Back Yard) objection.
Towns and schools are being charged much higher interest rates in this
environment on new projects, because the bond guarantors are in distress
too. Active Investor equity is the key to success in this regard.
This plan saves interest and energy costs, and it helps the environment
too. It will be a great working lesson for school children—and it’s
their future at stake too.
Wind Farms in Iowa
If local objections are too stiff, consider a green energy project in
a more friendly green-business state.
For example, wind farms are growing fast with great success in Iowa. In
fact, one Iowa factory—who was facing closure after its jobs moved
to Asia—converted to a wind power equipment manufacturer. The equipment
is very heavy and best to ship and assemble on local wind farms.
Iowa wind farms have proliferated along with corn-ethanol farms. Even
with energy prices headed lower, they both are still economical. And again,
Active Investor tax benefits alone can make it a worthwhile investment.
Energy prices are expected to rise again once we recover from the recession.
Green Gold or Black(Oil) Decay?
In his groundbreaking book, Hot, Flat and Crowded, author and New York
Times columnist Thomas Friedman predicts that billions of people around
the globe will join the American-type of energy consumption demand curve,
which will dwarf energy supplies, including new green energy too. He says
it’s imperative that we start making green energy quickly. Without
it, he goes on to say, our environment is a sure loser.
President Obama has stated that green technologies, green jobs and the
green economy and environment can’t wait for the return of higher
oil prices. The green revolution must start immediately ushered in with
consistent fiscal incentives and all the help American citizens can provide.
It’s our future at stake!
Use Active Investors in Any Business.
If you think green energy is just “pie in the sky,” then use
Active Investors in any small business that you like.
The same powerful tax advantages apply no matter what the business is.
Maybe your business won’t have as many accelerated tax breaks and/or
tax credits as going green, but even basic tax breaks together with the
home-based expense tax benefits make Active Investors a winning formula
for any business.
Picture a business model that raises cash equity along with key labor
support, and the pressure is not on you for compensating your equity-workers—you
instead leave that to Uncle Sam—your other partner-in-profit.
Complications in the material participation standards in connection
with active investor projects.
Your (initial) article fleshed out the Material Participation issue and
says that an Active Investor will often qualify under the following prong
of the Reg.: “the individual participates in the activity for more
than 100 hours during the taxable year, and his participation in the activity
for the taxable year is not less than the participation in the activity
of any other individual (including individuals who are not owners of interests
in the activity) for the year;”
Assume, for example, that there are 10 Active Investors who respectively
put in 105, 110, 120, 130, 140, 150, 160, 170, 180, and 190 hours. Wouldn’t
only the 190 hour person be considered to Materially Participate, because
all others put in fewer hours than that person?
Tax Management Portfolio # 549 notes:
Beyond this, it is not entirely clear how a taxpayer is supposed to compare
his participation to that of other individuals. In many cases, the critical
question may be who spends the most time participating. In the only example
provided to illustrate this test, an individual is considered as materially
participating when he spends exactly the same amount of time in the activity
as the only other participant. In addition, IRS audit guidelines suggest
focusing on comparative time spent.
However, the test does not expressly state that hours are the only relevant
comparison; in other contexts, the regulations expressly compare the hours
spent by different individuals. Conceivably, another individual may be
viewed as participating more if his involvement is greater, in light of
the general facts and circumstances -- e.g., if his role is more important
to the business.
Comment: To the extent that time spent is controlling, it appears that
even one extra hour (or minute?) spent by someone else on the activity
is fatal. Still, given the absence of any requirement that a taxpayer's
hours be precisely established through contemporaneous recordkeeping,
Treasury may have meant to be flexible in interpreting this requirement
and, to that end, thought that this flexibility was best left unvoiced.
It is not entirely clear how a taxpayer is expected to know the amount
of time spent by other individuals in participating, especially if they
are not employees or independent contractors.
Further to last year’s comment: Note that you can qualify for material
participation under a different prong of the regulations if you spend
500 hours a year, but as a practical matter, I don’t know that people
will be able to spend that kind of time.
In addition, work done in a taxpayer's capacity as an investor is not
counted in determining the taxpayer's hours of participation in the activity
unless the taxpayer is directly involved in the day-to-day management
or operations of the activity. Thus, for example, a taxpayer who is not
a manager or operator cannot count time spent: (1) studying and reviewing
financial statements or reports on an activity; (2) preparing studies
or analyses of the activity's finances or operations for his own use;
or (3) monitoring the activity's finances or operations in a nonmanagerial
Tax Management Portfolio #549 makes the following additional
comments with regard to the 500 hour category:
A taxpayer presumably should count time spent participating in management
of an activity even if he is not present at the site where the activity
is conducted. For example, if the taxpayer contemplates management decisions
while traveling in an airplane or showering, the time so spent presumably
counts (if bona fide).219 Commuting to the site where the taxpayer works
in an activity, which is not away from home for tax purposes, probably
does not count as time spent participating in the activity since, for
other tax purposes, commuting is regarded as personal rather than business-related.220
Nor should one count time spent at a job site but not working (e.g., a
lunch break other than a business lunch, unless a part of lunch is spent
discussing work-related issues.) Time spent traveling away from home in
order to render services (e.g., taking an airplane to a city in another
state), plausibly counts as time spent participating, although if the
trip is for both business and vacation purposes, then at a minimum, allocation
between the two purposes seems appropriate. It should be noted, however,
that questions of this kind -- although invited by the regulations' focus
on the exact number of hours spent participating -- go well beyond the
level of detail that most taxpayers can expect to encounter or are asked
to reflect in their records.
Two early Tax Court decisions illustrate the skepticism that courts (as
well as the IRS) can be expected to summon when taxpayers make extravagant
claims regarding the number of hours they have spent participating. In
Toups v. Comr.,221 taxpayers who lived and worked in Baton Rouge, Louisiana,
attempted to show that they had spent a significant number of hours participating
in the activity of holding for short-term rental (not treated as a rental
activity for passive loss purposes) a cottage near Atlanta, Georgia, which
they also used for their own vacations. The court rejected much of their
claimed decision-making involvement under the rule, described above, that
requires disregarding work one performs as an investor.222 In addition,
the court rejected the taxpayers' claim that time they ostensibly had
spent discussing the cottage with neighbors and friends merited inclusion
as serious marketing or promotion activity. The court expressed similar
skepticism regarding the taxpayers' claims that they had worked on the
cottage activity while vacationing there, and that their 16-hour round
trip drive to the cottage (undertaken mainly for vacation purposes) should
count at all. The taxpayers had claimed that it counted as 32 hours of
participation since both of them were in the car.
Similarly, in Goshorn v. Comr.,223 taxpayers residing in Connecticut unsuccessfully
argued that they had participated for more than 500 hours with respect
to a sailboat in Dallas, Texas, that was held for short-term rental and
that they had used as a personal asset when they lived in Texas. The court,
in addition to disregarding time spent on the activity in an investor
capacity, seemed skeptical about the claim that travel time between Connecticut
and Dallas should count, given that the taxpayers had independent business
or personal reasons for making all of these trips. Moreover, the court
criticized the lack of contemporaneous record-keeping, stating that "while
the regulations are somewhat ambivalent concerning the records to be maintained,
they by no means allow the type of post-even ballpark guesstimate that
petitioner used." 224
The 500-hour figure applies without modification in the case of a short
taxable year, an activity that begins late in the taxable year, an activity
in which the taxpayer owns an interest for only part of the taxable year,
or a seasonal activity that is conducted for only part of the year (such
as a winter ski resort). Thus, in such circumstances, taxpayers who want
to establish material participation may need to rely on others from among
the seven tests. Arguably, the fact that a taxpayer would have exceeded
500 hours had the relevant period been a full 12 months is significant
under the general facts and circumstances test for material participation.
The taxpayer's hours of participation need not be proven by contemporaneous
daily time reports, logs, or similar documents. Rather, any reasonable
means of proof may be sufficient. For example, a taxpayer can identify
the services he has performed and the approximate number of hours spent
performing those services based on appointment books, calendars, or narrative
summaries. Courts may be skeptical, however, of self-serving testimony
that is not sufficiently corroborated by contemporaneous records or otherwise.225
Of course, the IRS -- as well as the taxpayer -- may want to prove material
participation in a particular case. Courts may not insist on a high level
of proof from it, however (recognizing that it cannot control what records
are kept) in circumstances where the evidence shows substantial operational
involvement by the taxpayer.226
Note: Despite the absence of a contemporaneous recordkeeping requirement,
prudent taxpayers should keep careful records when it is not overly burdensome
to do so, and especially when such records are expected to be favorable
to the taxpayer's position. Serious ethical considerations may be raised
by failing to keep contemporaneous records where the reason for such failure
was not undue burden but the belief that such records might prove inconsistent
with the taxpayer's reporting position.
Comment: The absence of a requirement to keep specific records (such as
timesheets), although administratively reasonable and even necessary,
gives an extremely odd flavor to the material participation regulations.
It causes them to depend, in many cases, on a specific and precise fact
(i.e., the number of hours the taxpayer has spent participating) that
is in principle readily ascertainable -- absent ambiguities about which
of the taxpayer's hours count -- but with respect to which no one will
have sufficient information to ascertain precisely. It is unclear how
taxpayers, the IRS, or the courts are expected to go beyond guesswork
in deciding close cases where the exact number of hours spent participating
is unclear. However, IRS audit guidelines suggest that one important factor
is whether the taxpayer's activity employs a management service. Moreover,
evidence that the taxpayer is busy in another line of work is treated
as making satisfaction of the standard unlikely.227
There is a different way to qualify for material participation, but it
is unlikely to be practical for us:
g. Test Seven: Regular, Continuous, and Substantial Involvement Under
the Facts and Circumstances
Finally, a taxpayer can establish material participation by reason of
his regular, continuous, and substantial involvement in the activity,
based on all of the facts and circumstances.285 This test is discussed
only briefly in the regulations286 and, thus, continues to acquire its
meaning largely from the legislative history.
(1) Effect of the Regulations on the General Standard
The regulations expressly elaborate or modify the standard as set forth
in the legislative history in only two respects. First, they provide that
a taxpayer cannot qualify as materially participating under the facts
and circumstances test if he participates in an activity during the taxable
year for 100 hours or less.287
Second, the requirement of the statute that the taxpayer's involvement
be "in operations," 288 and the suggestion in the legislative
history that an asserted role in management must be scrutinized carefully,289
are given more specific form. Under the regulations, services performed
by an individual in the management of an activity are disregarded under
the facts and circumstances test unless: (1) no other individual is compensated
for performing management services in connection with such activity; and
(2) no other individual performs management services that exceed, by hours,
the amount of such services performed by the taxpayer.290 Beyond this,
the regulations do not expressly require that the taxpayer's involvement
be "in operations."
Comment: Despite expressly disregarding certain management services, the
regulations do not define such services or explain how they are distinguished
from other services. Does any responsibility for making decisions or supervising
other personnel count as management? If it does, a plumber working on
construction with an assistant and deciding where to place a drain may
be engaged in management. This seems to stretch the notion of management
too far, and in any event, the plumber would not just be managing to the
extent that he did any plumbing work himself (although this would not
prevent the plumber's performance of management services, if any, from
affecting the treatment of other persons engaged in management). Nevertheless,
where to draw the line between management and other services is unclear.
The regulations create an additional (undiscussed) issue by attaching
tax consequences to whether other individuals are compensated for the
performance of management services. Does the payment of de minimis compensation
for one individual's performance of management services potentially cause
another individual's performance of management services to be disregarded?
Compensation for performing management services can be de minimis in either
of two ways: the payee receives only a de minimis amount of compensation;
or he receives a larger amount but most of it is for performing operational
services (as in the case of the plumber, who receives a little bit extra
for supervising someone else's work). If de minimis compensation counts,
a tax planning opportunity arises for taxpayers who want their performance
of management services to be disregarded so that they can avoid being
treated as materially participating. The IRS could argue, however, that
an amount that was paid (or characterized as for the performance of management
services) in large part for this purpose was not in fact paid for the
performance of management services and hence should be disregarded as
a sham. This argument would not be inconsistent with the IRS' claim that
the payment of de minimis compensation for management services does count
when it is not tax-motivated, and thus is non-sham, even if not commensurate
to the time spent or the value of the management services performed.
In practice, the regulations may greatly narrow the facts and circumstances
standard. By providing six specific quantitative tests for material participation,
the regulations in effect relegate the general standard to the status
of a residual category, no longer including any case in which the taxpayer
has participated for more than 500 hours. Material participation may be
difficult to show under the facts and circumstances, and probably requires
establishing an unusually important type of involvement by the taxpayer,
preferably accompanied by close to 500 hours of involvement.291 Indeed,
IRS audit guidelines state that, while "[T]axpayers will frequently
argue the facts and circumstance test when they fail the others . . .
due to the stringent limitations, few taxpayers can meet [it]." 292
Given the array of alternative means for establishing material participation
under the regulations, along with the regulatory bar on relying on the
facts and circumstances test if a taxpayer has less than 100 hours of
involvement, the dominant reason for taxpayers to look to this test relates
to the SPA/SIPPA rules. Those rules can be extremely unfavorable in that,
if SPAs qualify as SIPPAs (i.e., the taxpayer spends less than 500 hours
participating in all of them as a group), any net loss from the group
is passive but any net income is recharacterized as nonpassive.293 Thus,
in some circumstances, it can be important for the taxpayer either: (1)
to qualify as materially participating in an activity in which he has
participated for between 100 and 500 hours -- to avoid SIPPA status; or
else (2) to avoid qualifying as materially participating -- so that the
activity will be a SPA, thereby increasing the hours spent participating
in SPAs as a unit and enabling them as a group to avoid SIPPA status.
(2) High Threshold of Involvement Under the Facts and Circumstances Test
Under the statute and legislative history, the threshold for establishing
material participation based on all of the facts and circumstances is
a high one. The statute uses the terms "regular, continuous, and
substantial" to distinguish the material participation standard,
for purposes of the passive loss rules, from standards existing under
prior law (e.g., § 464, under which active participation by investors
is relevant to the timing of certain deductions incurred in the farming
business). The legislative history and the regulations confirm that prior
law standards defining material participation for purposes of Code provisions
such as § 1402(a) (relating to the self-employment tax) and §
2032A (relating to the valuation of farm property for estate tax purposes)
are both inapplicable and, in general, more easily satisfied.294
Further evidence that the passive loss material participation standard
is an exacting one is provided by comparing it to the lower active participation
standard that governs the application of the $ 25,000 rule for rental
real estate activities. While active participation can be established
through significant and bona fide participation in management decisions,295
material participation under the facts and circumstances test requires
Material participation also can be contrasted with the requirements for
being engaged in carrying on a trade or business. As Groetzinger, above,
explains, "continuity and regularity" are required in order
for a taxpayer to be involved in a trade or business.296 For passive loss
purposes, however, not only must these two factors exist with respect
to the individual (i.e., not just for the activity as a whole), but substantiality
of involvement must be shown.
Each of the three critical aspects of the definition of material participation
for passive loss purposes (i.e., regularity, continuity, and substantiality)
has some separate relevance that merits elaboration.
(3) Regularity of Involvement
Regularity of involvement implies having a significant ongoing business
role, rather than merely a sporadic one. A taxpayer is not regularly involved
in an activity simply by reason of participating on one or two exceptional
occasions, or for only a small amount of time. Similarly, with respect
to the existence of a trade or business, courts have considered the amount
of time spent on an enterprise by the taxpayer,297 and whether business
is transacted on multiple occasions.298
(4) Continuity of Involvement
The word "continuous" is somewhat redundant of "regular,"
and is possibly included in the statute in part for emphasis and rhetorical
effect. Nonetheless, it clearly emphasizes the importance of having a
definite and ongoing business role that leads to more than sporadic participation
in the activity.
The requirement of continuous involvement clearly is not meant to be applied
in an overly literalistic fashion. For example, sleeping at night, going
on vacation for a month, or even taking a sabbatical for six months, is
not inconsistent with continuous involvement.299 Similarly, cases (such
as Groetzinger) in the trade or business area have spoken of "continuity"
without using the term in such a literalistic sense.
Requirements such as regularity and continuity of involvement have been
interpreted in the trade or business area as requiring the consideration
not merely of the amount of time spent on an activity, but also of whether
a taxpayer's personal skill and efforts are a material factor in the success
of the business. Courts and commentators both have viewed reliance on
personal skill and effort as critical to establishing the existence of
a business, rather than an investment activity.300 This factor likewise
may be critical with respect to the facts and circumstances test for material
(5) Substantiality of Involvement
The requirement that a taxpayer's involvement in an activity be substantial
imparts a quantitative element. It suggests that the more time the taxpayer
spends on the activity -- i.e., the closer to 500 hours -- the more likely
a finding of material participation.
The substantiality requirement may also suggest that the degree of reliance
by the activity on the taxpayer's personal skill and effort should be
significant and meaningful, rather than trivial. For example, to the extent
that participation in management is relevant,301 substantiality may depend
in part on the extent to which one's involvement, and the use of one's
know-how, are important to the business. Management activities are more
likely to be substantial if the success of the activity depends in large
part upon the taxpayer's exercise of business judgment.302 This, in turn,
may be more likely in the case of a taxpayer who has substantial experience
in a particular type of activity and who is involved in many such activities.
Substantiality of involvement may also be more likely when a taxpayer
is regularly present at the place or places where the principal operations
of the activity are conducted. For example, in the case of a horse breeding
operation, a taxpayer who lives at or near the site where the horses are
kept is more likely to be materially participating.303 In contrast, an
individual who works as an employee or professional is relatively unlikely
to materially participate in an activity located hundreds of miles from
where he lives and works, especially if he does not visit the site of
the activity frequently.304 In addition, substantiality of involvement
in an activity is more likely if conducting that activity is the taxpayer's
principal business (although this factor is not conclusive and taxpayers
can materially participate in more than one activity and in more than
one type of business).305 Substantiality of involvement in anything other
than the taxpayer's primary business is relatively unlikely if he works
full-time in that business as an employee or on a self-employed basis,
or if he works full-time in a professional service business such as law,
accounting, or medicine.306
Note: Making it even harder for taxpayers in professional service businesses
to qualify as materially participating in other businesses in which they
invest, the legislative history states that, when a taxpayer who provides
legal, tax, or accounting services to the general public as an independent
contractor (or an employee thereof) provides these services to an activity
(such as research and development partnership in which he has invested),
the taxpayer is materially participating only in the activity of providing
such services to the general public, not in the activities of the partnership
in which he has invested.307 The regulations seemingly contradict this,
however, by requiring only that work performed by an owner of an interest
in an activity be "in connection with" the activity.308 Thus,
for purposes of the facts and circumstances test, the language in the
legislative history may go at most to the weight attached to performing
such services, rather than to whether they count at all.
Even absent the application of the 5-out-of-10 years test described above,
in most cases a taxpayer's participation is not expected to change significantly
from year to year.309 Thus, the outcome with regard to material participation
in one year may be probative with respect to subsequent taxable years,
although any such inference can be rebutted through evidence showing that
the taxpayer's involvement has in fact changed.
(6) Further Illustrations of Material Participation Under the Facts and
In the case of a farming activity, an individual who does not perform
physical work, but who is treated as having self-employment income with
respect to the activity under § 1402, generally is treated as materially
participating.310 However, the overlap between the passive loss and §
1402 standards is only an empirical one (i.e., many individuals who qualify
under the latter also qualify under the former), rather than a rule of
law. The two standards remain distinguishable, and material participation
is no different for farmers than for participants in any other type of
In the case of a condominium hotel, as with any other type of activity,
a taxpayer can possibly materially participate, under the facts and circumstances
standard, while not living nearby and being inexperienced in the business.
Material participation under such circumstances generally would be expected,
however, to involve making frequent visits to the hotel to conduct on-site
inspections, meeting with on-site management, and otherwise participating
in integral functions of the business.312 It also may be useful, under
such circumstances, for the taxpayer to be personally assessed his owner
association charges, to be assessed separately and personally the property
taxes against his room or rooms, to appeal personally such assessments
when he thinks them incorrect, and to pay personally any debt service
on his unit when due. Again, however, these factors do not provide a safe
harbor or other special rule for condominium hotels.313
Two further examples from the legislative history may help to give the
flavor of the facts and circumstances standard for establishing material
participation, and in particular the need for hands-on involvement, rather
than amorphous management oversight or the sporadic performance of limited
tasks that require no special expertise. First, in the case of a general
partnership engaged in the business of producing movies, the services
that may be necessary to the business include the following: writing screenplays;
reading and selecting screenplays; actively negotiating with agents who
represent writers, actors, or directors; directing, editing, scoring,
or acting in the films; actively negotiating with third parties regarding
financing and distribution; and actively supervising production (for example,
selecting and negotiating for the purchase and use of movie sets). The
legislative history, while anticipating that individuals who make significant
contributions regarding services of this kind generally will qualify as
materially participating, nevertheless states that merely approving a
financing target, accepting a recommendation regarding the selection of
the screenplay, cast, locations, and director, or appointing others to
perform the above functions, not only falls short of establishing material
participation, but generally does not even constitute involvement in operations.314
Second, in the case of an investor in a barge that transports grain along
the Mississippi River, being physically present on the barge and rendering
substantial services in transporting the grain (not merely traveling as
a passenger) is one way of establishing material participation. Another
way of materially participating, if the taxpayer does not accompany the
barge, is to work on a regular basis at finding new customers for the
barge service and to negotiate with customers regarding the terms on which
the service is provided.315
Comment: By focusing on the practicalities of daily operation of a business
and rejecting certain types of claimed involvement in management, the
legislative history makes it easier for taxpayers with a clear primary
business to "beat the rules" by creating passive income from
other businesses, rather than by creating nonpassive loss from such other
businesses. Given the unavoidability of erring in one direction or the
other, this follows logically from the passive loss rules' primary purpose
of eliminating the classic tax shelter that individuals (such as salaried
professionals) used before enactment of the 1986 TRA to avoid tax on the
income they derived from rendering personal services.316