Determining the deductibility of S corporation passive losses.

Facts

Derek owns stock in two S corporations; he is the sole shareholder of Sunny Corp., and owns half of the shares of Dew Corp. He works full-time at Sunny and draws an annual salary of $75,000. He does not participate in Dew's operations. The two corporations are engaged in different business activities that are conducted at two different locations.

Sunny reports a loss of $25,000, after considering $1,000 of interest income from investing working capital for a short period of time. Dew reports a loss of $40,000. Neither corporation receives any rental income, and the two companies do not share a common location.

Derek does not have any other income in arriving at adjusted gross income (AGI). He believes that his income will be computed as follows:

Salary $75,000 Sunny passthrough items: Interest income 1,000 Ordinary loss (26,000) Dew loss (20,000) Total income $30,000 He asks his tax adviser if he is correct in his assumptions and, if not, if there is anything he can do to decrease his taxes.

Issue

Can Derek offset the S losses from Sunny and Dew against his salary?

Analysis

The passive or active nature of taxable (nonseparately stated) income or loss passed through by an S corporation is dependent on whether the shareholder materially participates in the business's operation. If the shareholder materially participates, the income or loss is active; if he does not, the income or loss is passive (unless the shareholder "significantly" participates in the S corporation's business and in other activities as well). Material participation requires that the shareholder be involved in the activity's operations on a regular continuous and substantial basis. If the corporation is engaged in more than one activity, these rules apply to each activity.

Rental income or loss generally is passive and is passed through as a separately stated item. Interest and other portfolio income earned by an S corporation pass through as portfolio income, regardless of the shareholder's level of participation, and regardless of whether the interest income was used for business purposes. Other separately stated items may be either active or passive, depending on the type of income and on the taxpayer's participation in the activity.

In this case, Sunny's ordinary loss is an active loss and...