Convert C corporation to S corporation at retirement for passive income.

• Author: Brown, Robert R.

Losses generated from a passive activity are deductible by an individual only to the extent of income from passive activities. Losses that, because of this rule, are not currently deductible are suspended and carried over to future years for possible deduction later. Suspended losses may be carried over for an unlimited number of years.

A passive activity is any activity in which the taxpayer does not materially participate. The general rule for material participation is that the taxpayer's involvement in the operations must be regular, continuous and substantial. Like many other areas in the Code, there is a facts and circumstances test to determine material participation in an activity. However, the regulations under Sec. 469 rely on a number of objective tests to determine if material participation exists. Specifically, Temp. Regs. Sec. 1.469-5T(a) states that a taxpayer will be considered as materially participating if (1) the individual participates in the activity for more than 500 hours during the year; (2) the individual's participation in the activity constitutes substantially all of the participation in the activity of all individuals for the year; (3) the individual participates in the activity for more than 100 hours during the year, which is not less than the participation of any other individual; (4) the activity is a significant participation activity (as defined in Temp. Regs. Sec. 1.469-5T(c)) and the individual's aggregate participation in all significant participation activities exceeds 500 hours; (5) the activity is a personal service activity (as defined in Temp. Regs. Sec. 1.469-5T(d)); or (6) the individual materially participated in the activity for any five tax years during the 10 tax years that immediately precede the current year.

An issue arises when an individual who is a shareholder in a closely held corporation ceases all day-to-day functions and management of the company, does not dispose of his investment in the company (his stock) and continues to receive income. If the income received is noncompensatory in nature (e.g., not regular wage income or deferred compensation), a determination must be made as to whether the...