Trade or Business Activities

A trade or business activity is an activity (other than a rental activity or an activity treated as incidental to an activity of holding property for investment) that:

1. Involves the conduct of a trade or business (within the meaning of section 162),
2. Is conducted in anticipation of starting a trade or business, or
3. Involves research or experimental expenditures deductible under section 174 (or that would be if the corporation chose to deduct rather than capitalize them).

Reporting Income, Deductions, Losses, and Credits From the Activities

Trade or business activities with material participation.   If the corporation materially participated in a trade or business activity, the activity is not a passive activity. Report the income, deductions, losses, and credits from the activity on the form or schedule normally used.

Trade or business activities without material participation.   In general, use Worksheets 1 and 2 on page 7 to determine the amount to enter in Part I of Form 8810 for each trade or business activity in which the corporation did not materially participate. If, however, the corporation held the activity through a PTP or the activity is a significant participation activity, special rules apply. See Publicly Traded Partnerships (PTPs) on page 10. See Pub. 925 for how to report income or losses from significant participation passive activities.

In general, if the corporation has credits from passive activities, use Worksheet 5 on page 11 to figure the amount to enter in Part II of Form 8810. However, if the corporation held the activity through a PTP, special rules apply. See Credits From PTPs on page 12 for how to report credits from these activities.

Material Participation

Personal service corporations and closely held corporations materially or significantly participate in an activity if one or more individuals, each of whom would materially or significantly participate in the activity if the corporation's activity were the individual's activity, directly or indirectly own more than 50% (by value) of the corporation's outstanding stock. For this purpose, an individual's participation in all activities other than activities of the corporation is disregarded.

A closely held corporation also materially participates in an activity if the corporation satisfies the qualifying business requirements of section 465(c)(7)(C) (without regard to (iv) for the excluded business exception from the at-risk limitations).

These requirements are met if:

1. During the entire 12-month period ending on the last day of the tax year, substantially all the services of at least one full-time employee of the corporation were in the active management of the activity;
2. During the same period, substantially all the services of at least three full-time nonowner employees were directly related to the activity; and
3. The deductions attributable to the activity and allowed solely under sections 162 and 404 exceed 15% of the gross income from the activity for the tax year.

Participation.   For purposes of the material participation tests listed below, participation generally includes any work the individual did (without regard to the capacity in which the individual did it) in connection with an activity in which the corporation owned an interest at the time the individual did the work.

Work is not treated as participation, however, if the work is not work that an owner of that type of activity would customarily do, and if one of the individual's main reasons for doing the work is to avoid the disallowance of losses or credits from the activity under the passive loss and credit rules.

Proof of participation.   Participation in an activity can be proved by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if participation can be established by other reasonable means. Reasonable means for this purpose may include, but are not limited to, the identification of services performed over a period of time and the approximate number of hours spent performing the services during that period, based on appointment books, calendars, or narrative summaries.

Tests for investors.   Work done as an investor in an activity is not treated as participation unless the individual was directly involved in the day-to-day management or operations of the activity. For purposes of this test, work done as an investor includes:

1. Studying and reviewing financial statements or reports on operations of the activity.
2. Preparing or compiling summaries or analyses of the finances or operations of the activity for the individual's own use.
3. Monitoring the finances or operations of the activity in a nonmanagerial capacity.

If the individual is married for the tax year, the individual's participation in an activity includes any participation in the activity during the tax year by that individual's spouse, whether or not the spouse owned any interest in the activity and whether or not the individual and spouse file a joint return for the tax year.

Tests for individuals.   An individual would materially participate in an activity of the corporation if one or more of the following tests are satisfied.

1. The individual participated in the activity for more than 500 hours.
2. The individual's participation in the activity for the tax year was substantially all of the participation in the activity of all individuals (including individuals who did not own any interest in the corporation or the activity) for the year.
3. The individual participated in the activity for more than 100 hours during the tax year, and that individual participated at least as much as any other individual (including individuals who did not own any interest in the corporation or the activity) for the year.
4. The activity is a significant participation activity for the individual for the tax year, and the individual participated in all significant participation activities during the year for more than 500 hours. For this purpose, an individual's participation in all activities other than activities of the corporation is disregarded.

   A significant participation activity is any trade or business activity in which the individual participated for more than 100 hours during the year and in which the individual did not materially participate under any of the material participation tests (other than this fourth test). For more information regarding significant participation, see Pub. 925.

5. The individual materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
6. The activity is a personal service activity in which the individual materially participated for any 3 (whether or not consecutive) preceding tax years.

   An activity is a personal service activity if it involves the performance of personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting in any other trade or business in which capital is not a material income-producing factor.

7. Based on all the facts and circumstances, the individual participated in the activity on a regular, continuous, and substantial basis during the tax year.

   The individual did not materially participate in the activity under this seventh test, however, if the individual participated in the activity for 100 hours or less during the tax year. Participation in managing the activity does not count in determining whether the individual materially participated under the test if:

   1. Any person (except that individual) received compensation for performing services in the management of the activity or
   2. Any person in the activity spent more hours during the tax year than that individual spent performing services in the management of the activity (regardless of whether the individual was compensated for the management services).

Special rules for limited partners.   Generally, a limited partner cannot materially participate in an activity. However, the corporation is considered to materially participate in an activity in which it holds a limited partner interest if one or more individuals, each of whom would materially participate in the activity under test 1, 5, or 6 for the tax year if the corporation's activity were the individual's activity, directly or indirectly, own more than 50% (by value) of the corporation's outstanding stock.

The corporation is not treated as a limited partner, however, if the corporation was a general partner in the partnership at all times during the partnership's tax year ending with or within the corporation's tax year (or, if shorter, during the portion of the partnership's tax year in which the corporation directly or indirectly owned a limited partner interest).

A limited partner's share of an electing large partnership's taxable income or loss and credits (including general business credits) from all trade or business and rental activities is treated as income or loss from the conduct of a single passive trade or business activity.

Consolidated groups.   See Regulations section 1.469-1(h)(4) for rules for determining whether a consolidated group materially or significantly participates.

Grouping of Activities

Generally, one or more trade or business activities or rental activities may be treated as a single activity if the activities make up an appropriate economic unit for the measurement of gain or loss under the passive activity rules. Whether activities make up an appropriate economic unit depends on all the relevant facts and circumstances. The factors given the greatest weight in determining whether activities make up an appropriate economic unit are:

1. Similarities and differences in types of trades or businesses,
2. The extent of common control,
3. The extent of common ownership,
4. Geographical location, and
5. Reliance between or among the activities.

Example.   The corporation has a significant ownership interest in a bakery and a movie theater in Baltimore and in a bakery and a movie theater in Philadelphia. Depending on all the relevant facts and circumstances, there may be more than one reasonable method for grouping the activities. For instance, the following groupings may or may not be permissible:

• A single activity,
• A movie theater activity and a bakery activity,
• A Baltimore activity and a Philadelphia activity, or
• Four separate activities.

Once the corporation chooses a grouping under these rules, it must continue using that grouping in later tax years unless a material change in the facts and circumstances makes it clearly inappropriate.

The IRS may regroup the activities if the grouping fails to reflect one or more appropriate economic units and one of the primary purposes of the grouping is to avoid the passive activity limitations.

Limitation on grouping certain activities.   The following activities may not be grouped together.

1. A rental activity with a trade or business activity unless the activities being grouped together make up an appropriate economic unit and
   1. The rental activity is insubstantial relative to the trade or business activity or vice versa or
   2. Each owner of the trade or business activity has the same proportionate ownership interest in the rental activity. If so, the portion of the rental activity involving the rental of property used in the trade or business activity may be grouped with the trade or business activity.
2. An activity involving the rental of real property with an activity involving the rental of personal property (except personal property provided in connection with the real property or vice versa).
3. Any activity with another activity in a different type of business and in which the corporation holds an interest as a limited partner or as a limited entrepreneur (as defined in section 464(e)(2)) if that other activity engages in holding, producing, or distributing motion picture films or videotapes; farming; leasing section 1245 property; or exploring for or exploiting oil and gas resources or geothermal deposits.

Activities conducted through partnerships and other C corporations subject to section 469.   Once a partnership or corporation determines its activities under these rules, a partner or shareholder may use these rules to group those activities with:

• Each other,
• Activities conducted directly by the partner or shareholder, or
• Activities conducted through other partnerships and corporations.

A partner or shareholder may not treat as separate activities those activities grouped together by the partnership or corporation.

Partial disposition of an activity.   The corporation may treat the disposition of substantially all of an activity as a separate activity if it can prove with reasonable certainty:

1. The prior year unallowed losses and credits, if any, allocable to the part of the activity disposed of and
2. The net income or loss and any credits for the year of disposition allocable to the disposed part of the activity.

Passive Activity Income and Deductions

Take into account only passive activity income and passive activity deductions to figure the corporation's overall gain or overall loss from all passive activities or any passive activity. In figuring the passive activity loss, a closely held corporation subtracts both passive activity income and net active income from its passive activity deductions. See the instructions for line 2 on page 8 for the definition of net active income.

Self-Charged Interest

Certain self-charged interest income or expense may be treated as passive activity gross income or passive activity deductions if the loan proceeds are used in a passive activity. Generally, self-charged interest income and expense result from loans between the corporation and a partnership in which the corporation had a direct or indirect ownership interest. It also may result from loans between one partnership and another if each owner in the borrowing entity has the same proportional ownership interest in the lending entity. The corporation may elect not to apply these rules to self-charged interest income. See Regulations section 1.469-7 for details.

Passive Activity Income

Passive activity income includes all income from passive activities, including (with certain exceptions described in Temporary Regulations section 1.469-2T(c)(2) and Regulations section 1.469-2(c)(2)) gain from the disposition of an interest in a passive activity or property used in a passive activity at the time of the disposition.

Passive activity income does not include the following:

• Income from an activity that is not a passive activity.
• Portfolio income, including interest, dividends, annuities, and royalties not derived in the ordinary course of a trade or business, and gain or loss from the disposition of property that produces portfolio income or is held for investment (see section 163(d)(5)). See Temporary Regulations section 1.469-2T(c)(3). See Self-Charged Interest above for an exception.
• Personal service income, including commissions and income from trade or business activities in which the corporation materially participated for the tax year. See Temporary Regulations section 1.469-2T(c)(4).
• Income from positive section 481 adjustments allocated to activities other than passive activities. See Temporary Regulations section 1.469-2T(c)(5).
• Income or gain from investments of working capital.
• Income from an oil or gas property if the corporation treated any loss from a working interest in the property for any tax year beginning after 1986 as a nonpassive loss under the rule excluding working interests in oil and gas wells from passive activities. See Regulations section 1.469-2(c)(6).
• Any income treated as income not from passive activity under Temporary Regulations section 1.469-2T(f) and Regulations section 1.469-2(f). See Recharacterization of Passive Income below.
• Overall gain from any interest in a PTP.
• State, local, and foreign income tax refunds.
• Any reimbursement of a casualty or theft loss included in income as recovery of all or part of a prior year loss deduction, if the deduction for the loss was not treated as a passive activity deduction.
• Cancellation of debt income to the extent that at the time the debt was discharged the debt was not properly allocable under Temporary Regulations section 1.163-8T to passive activities.

Recharacterization of Passive Income

Certain income from passive activities may be recharacterized and excluded from passive activity income. The amount of income recharacterized equals the net income from the sources described below. If during the tax year the corporation received net income from any of these sources (either directly or through a partnership), see Pub. 925 for details on reporting net income or loss from these sources.

Income from the following sources may be subject to the net income recharacterization rules:

• Significant participation passive activities. A significant participation passive activity is any trade or business activity (defined on page 3) in which the corporation is treated as having participated for more than 100 hours during the tax year but did not materially participate.
• Rental of property when less than 30% of the unadjusted basis of the property is subject to depreciation.
• Passive equity-financed lending activities.
• Rental of property incidental to a development activity.
• Rental of property to a nonpassive activity.
• Acquisition of an interest in a pass-through entity that licenses intangible property.

Passive Activity Deductions

Passive activity deductions include all deductions from activities that are passive activities for the current tax year and all deductions from passive activities that were disallowed under the PAL rules in prior tax years and carried forward to the current tax year under section 469(b). See Regulations section 1.469-1(f)(4).

Passive activity deductions include losses from dispositions of property used in a passive activity at the time of the disposition and losses from a disposition of less than an entire interest in a passive activity. See Dispositions below for the treatment of losses upon certain dispositions of an entire interest in an activity.

Passive activity deductions do not include the following:

• Deductions for expenses (other than interest expense) that are clearly and directly allocable to portfolio income.
• Dividends-received deductions for dividends not included in passive activity gross income.
• Interest expense, other than interest expense properly allocable under Temporary Regulations section 1.163-8T to passive activities or self-charged interest treated as a passive activity deduction (see Self-Charged Interest on this page). For example, capitalized interest expense is not a passive activity deduction.
• Losses from dispositions of property that produce portfolio income or property held for investment.
• State, local, and foreign income taxes.
• Charitable contribution deductions.
• Net operating loss deductions, percentage depletion carryovers under section 613A(d), and capital loss carrybacks and carryovers.
• Deductions and losses that would have been allowed for tax years beginning before 1987, but for basis or at-risk limitations.
• Net negative section 481 adjustments allocated to activities other than passive activities. See Temporary Regulations section 1.469-2T(d)(7).
• Deductions for losses from fire, storm, shipwreck, or other casualty, or from theft, if losses similar in cause and severity do not recur regularly in the activity.

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