Private-Equity Active Investor Tax Breaks

November 19, 2008 | By: Robert A. Green, CPA

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 some time and effort (as little as 100 hours per year). 

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 between 100 and 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)].

Many Active Investors in green energy projects may not need to devote a significant amount of time and effort and they may qualify under the second and third bullet points above, in connection with the 100-hour standard. 

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. 

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