Deducting Business Losses

by Kenneth Hoffman in , ,


Even if you own 100% of a business, be it a sole proprietorship, LLC, partnership, or S corporation, you can't deduct losses from the entity unless you can show you materially participate in the business.

That is, you're involved in the activity in managing or working in the business. Showing up once a week to review the books for two hours won't qualify as material participation; participation must be substantial.

There are several ways to show material participation, but most business owners will pass the test using the more than 500 hour rule. In Alfred A. Iversen et ux. (T.C. Memo. 2012-19) the taxpayer was the founder of a large manufacturer of surgical and medical equipment in Minnesota. He also owned a working cattle ranch with 14,000 owned and 28,000 leased acres operated as an LLC. The ranch generated losses and the taxpayer claimed he materially participated in the operation. The IRS claimed the taxpayer did not, and disallowed the losses. The taxpayers lived in Minnesota and flew to the ranch either alone or with guests.

The Court noted participation in an activity may be shown by any reasonable means, including calendars, appointment books, or narrative summaries identifying work performed and the approximate number of hours spent performing the work. Contemporaneous daily time reports, logs, or similar documents are not required if other reasonable means exist of establishing a taxpayer's participation.

Neither of the taxpayers maintained a log, diary, notes or other record of the work performed. The taxpayers claimed they spent 2 to 3 hours a day on telephone calls, emails, and fax communications with the ranch manager. Telephone records introduced did not support that claim. Airplane logs indicated few trips during one of the years at issue and the trips were only for a day. Moreover, a family member went along.

The Court also noted that the fact that the airplane flights were paid for by the taxpayer's corporation, not the ranch, indicated the time spent at the ranch often and primarily related to the affairs of the corporation. In addition, the presence at the ranch of a full-time paid ranch manager for most of 2005 and 2006 disqualifies much of the taxpayer's time working on ranch activities from counting under the facts and circumstances test (an alternate test for material participation). The Court concluded the taxpayer failed to show he materially participated in the activity. 

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