More than 100 but Less than 500
When a farmer or taxpayer owns an S corporation that incurs a loss, the farmer must show that they have materially participated in the companies operations in order to deduct the loss. The slam dunk test is that the owner works for more than 500 hours. If the owner works for less than 100 hours, then it is very difficult to meet any material participation test. If the owner works more than 100 hours but less than 500 hours, then they are in the dreaded “GRAY” zone.
In an US Tax Court case decided today (Charles and Betty Wade), the Tax Court agreed with the taxpayer that he materially participated in the company’s operations even though he did not work 500 hours. The company had been very successful in the plastics industry and dad semi-retired to Florida and turned day-to-day operations over to his son. Although semi-retired, he continued to spend at least 100 hours on company business.
With the great recession of 2007-2008, the company started to lose money and he became more and more involved and actually spent substantial time on R & D and developed a new product for the company in 2008 plus made several trips to the company to reassure the workers they still had a job.
During 2008, the company lost over $3 million and the taxpayer carried the loss back and got a refund of about a $1 million. The IRS audited the amended returns and denied the loss claiming the taxpayer was not materially active in the company. The taxpayers claimed that they met one of two tests (1) he worked at least 500 hours in the business; or (2) he participated in the companies’ activities on a regular, continuous, and substantial basis during 2008. As you can see, the 500 hour test is very objective while the second test is extremely subjective. The Tax Court decided to rule on the second test and agreed with the taxpayers. Based on his 237 phone calls with the plant during the year, his development of a new product, etc. the Court agreed he materially participated in the business.
Most cases involving passive/material participation involve the more objective tests. It is nice to see that a subjective test went in the taxpayer’s favor. If you are involved with a farm S corporation, partnership or LLC and work in the operation more than 100 hours or less than 500 hours, make sure to document how you meet this test. If you do, you will be able to keep you tax savings.
Paul Neiffer is a certified public accountant and business advisor specializing in income taxation, accounting services, and succession planning for farmers and agribusiness processors. Paul is a principal with CliftonLarsonAllen in Walla Walla, Washington, as well as a regular speaker at national conferences and contributor at agweb.com. Raised on a farm in central Washington, he has been immersed in the ag industry his entire life, including the last 30 years professionally. Paul and his wife purchase an 180 acre ranch in 2016 and enjoy keeping it full of animals.
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