To prevent avoidance of the passive activity rules through use of corporations, the law imposes restrictions on income and loss offsets in closely held C corporations and personal service corporations.
Unless the material participation tests discussed in this section are met, the activities of a personal service corporation or a closely held corporation are considered passive activities, subject to the restrictions on loss deductions and tax credits. For purposes of these passive activity rules, a closely held C corporation is a corporation in which more than 50% in value of the stock is owned by five or fewer persons during the last half of the tax year.
A personal service corporation is a C corporation the principal activity of which is the performance of personal services by the employee-owners. Personal services are services in the fields of health, law, engineering, architecture, accounting, actuarial sciences, performing arts, or consulting. An employee-owner is any employee who on any day in the tax year owns any stock in the corporation. If an individual owns any stock in a corporation which in turn owns stock in another corporation, the individual is deemed to own a proportionate part of the stock in the other corporation. Further, more than 10% of the corporation’s stock by value must be owned by owner-employees for the corporation to be a personal service corporation.
Personal service corporations and closely held corporations use Form 8810 to figure the amount of the passive activity loss or credit that is allowed on the corporation’s tax return for the year.
A personal service corporation or closely held corporation is treated as materially participating in an activity during a tax year only if either:
A stockholder is treated as materially participating or significantly participating in the activity of a corporation if he or she satisfies one of the seven tests for material participation (10.6). For purposes of applying the significant participation test (Test 4), an activity of a personal service or closely held corporation will be treated as a significant participation activity for a tax year only if:
Even if a closely held corporation does not meet the material participation tests above, it still qualifies for a slight break from the passive loss restrictions. On Form 8810, a closely held corporation may use passive activity deductions to offset not only passive activity gross income but also net active income. Generally, net active income is taxable income from business operations, disregarding passive activity income and expenses, and also disregarding portfolio income and expenses (10.8). Passive activity losses cannot offset portfolio income.
If a corporation stops being closely held, its passive losses and credits from prior years are not allowable against portfolio income but continue to be allowable only against passive income and net active income.
Tax liability on net active income may be offset by passive activity credits.
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