PRIVATE-EQUITY 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 here.

If you would like to consult with Robert A. Green personally on these ideas, sign up here.

If you have any questions about these services, please e-mail us at greenactiveinvestors@greencompany.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" standards below).

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 key differences.

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 participation.”

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 projects.

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 and more.

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 Losses”
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 losses.

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 or limitation.

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 tax advantages.

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.

Bottom Line
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.

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 capacity.

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 more.

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 participation.

(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 Circumstances Test

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 activity.311

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