Being a Passive Business Owner

By Jason Watson, CPA
Posted Monday, October 23, 2023

This is aimed at business owners where they no longer materially participate in the business activity, and as such they are now considered passive investors. Seems easy right, but why would you care? For two big reasons- first, if you have other non-deductible passive losses due to income limitations, such as those from a rental property, you can now have your passive income absorb these passive losses. This allows you to enjoy your tax benefits now rather than delaying the pleasure to future years. Yay!

Second, you might be able to only draw distributions from your business rather than earned income (i.e., reasonable shareholder salary) + distributions. This saves you several thousands of dollars in avoided Social Security and Medicare taxes. Every $10,000 in owner salary is about $1,500 in payroll taxes. Yay again!

The world is always trending towards harmony, so here are the passive business owner downsides. It is difficult to claim passive business owner given the material participation tests. The hardest one to overcome is #5. Here is a blurb from our Real Estate Professional webpage which is applicable to all business owners, not just real estate related-

5. You materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.

IRS Audit Techniques Guide (ATG): An activity is non-passive if the taxpayer would have been treated as materially participating in any 5 of the previous 10 years (whether or not consecutive). This test usually applies when a taxpayer “retires from material participation” but maintains an ownership interest in the activity. Yikes (emphasis added).

IRS Examination Techniques: Even if the taxpayer performs no services for a business currently, the examiner should inquire about involvement in prior years and review the returns to see if income or losses were treated as non-passive.

In other words, you need to look back for 10 years and if 5 of those years had material participation by you in the business activity (as defined by the IRS and Treasury Regs), then the IRS will disallow your passive claim. Could you start a brand-new business without the history? Perhaps, but this might be viewed as an end-around especially if the new business magically looks, walks, talks and smells like the old. Transitioning from material participation to passive is certainly tough!