Case study: changing level of participation in an S corporation for Tax Planning purposes.

• Author: Ellentuck, Albert B.

IF A SHAREHOLDER MATERIALLY PARTICIpates in the operations of an S corporation, the passthrough of nonseparately stated (ordinary) income or loss is nonpassive. The income or loss passed through is passive if the shareholder does not materially participate. Congress gave the IRS broad powers to determine whether income or loss from an activity is active or passive (Sec. 469(1)).

A shareholder materially participates in an S corporation if the shareholder or the shareholder's spouse is involved in the corporation's trade or business on a regular, continuous, and substantial basis (Secs. 469(h)(1) and (h)(5)). Temporary regulations expand the definition of material participation by providing six objective tests and one subjective test for determining whether a taxpayer materially participates in an activity. This column discusses three tests that practitioners are likely to encounter when dealing with S corporation shareholders.

The first test states that a shareholder who participates in the activity for more than 500 hours during the tax year will be deemed to materially participate.

The second and third tests apply to a shareholder who no longer meets the 500-hour requirement. These state that the taxpayer materially participates in an activity if the individual materially participated:

1. For any five tax years during the ten immediately preceding tax years; or

2. In a personal service activity for any three tax years preceding the tax year (Temp. Regs. Sec. 1.469-5T(a)).

The years of participation do not have to be consecutive. A personal service activity for these purposes is an activity in the field of health (including veterinarians under Rev. Rul. 91-30), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.

The two tests based on previous participation are designed to prohibit a taxpayer from converting nonpassive income to passive income by cutting back on the hours worked in the business.

Under the five-out-of-ten-year test, an S corporation shareholder who materially participates in the business for at least five years and then retires will continue to receive nonpassive income or loss from the corporation through the sixth tax year following retirement (Regs. Sec. 1.469-5(k), Example (5)). If the shareholder materially participated in a personal service activity for three years, the nonseparately...