Who the Passive Activity Rules Apply To

Section 469 applies to individuals, estates, trusts, closely held C corporations, and personal service corporations. Even though S corporations themselves are pass-through entities, the passive loss limitations apply at the shareholder level, not the entity level. Thus, each shareholder must determine material participation and grouping for their own return and apply the limitations and carryovers accordingly. § 469(a)–(b); 26 CFR § 1.469-1T(b)

Key Definitions: Passive Activity, Former Passive Activity, and Disallowed Losses

A passive activity is any trade or business in which you do not materially participate, plus any rental activity (unless you qualify under special real estate professional rules). Disallowed passive activity losses and credits are carried forward to future years, and become allowed when offset against passive income, under special allowances, or upon a fully taxable disposition of your entire interest in the passive activity. If an activity is passive in a prior year but not passive in the current year, it becomes a former passive activity; prior-year suspended losses may be allowed to the extent of current income from that activity. § 469(c), (d), (f), (g); 26 CFR § 1.469-1T(a), (f)

Ordering With Other Loss Limits (Basis and At-Risk)

Before the passive loss rules apply, losses are first limited by basis and at-risk rules. Only losses allowable under basis and at-risk are then subject to the passive loss limitation. This ordering matters for S corporation shareholders, whose deductible losses are first constrained by their stock and debt basis (and at risk in the activity), with any disallowed portion carrying forward at each stage. 26 CFR § 1.469-2T(d)(6); 2024 Instructions for Schedule E

Grouping Activities: Creating an Appropriate Economic Unit

The grouping rules allow you to treat multiple trade or business and rental activities as a single activity if they constitute an appropriate economic unit based on facts and circumstances (similarities of businesses, common control/ownership, geographic location, interdependencies). Grouping affects whether you materially participate at the aggregated level and how losses and credits are computed. Important limitations: you generally cannot group rental activities with non-rental trade or business activities unless the rental use is insubstantial or certain ownership conditions are met; you cannot group real-property rentals with personal-property rentals; and certain limited partner/limited entrepreneur interests have grouping restrictions. You must disclose original groupings and maintain consistency across years unless regrouping is required due to clearly inappropriate prior grouping or material changes. 26 CFR § 1.469-4(c)–(e)

• Grouping rental activity with non-rental: only if the combined activity is an appropriate economic unit and one is insubstantial to the other or specific proportional ownership tests are met; examples in the regulation illustrate the limitations. 26 CFR § 1.469-4(d)(1)

• Grouping limitations for real vs. personal property rentals and limited partners/limited entrepreneurs are explicitly prohibited except as narrowly allowed. 26 CFR § 1.469-4(d)(2)–(3)

• Disclosure and consistency requirements apply; the IRS may regroup if a taxpayer’s grouping undermines the underlying purposes of section 469. 26 CFR § 1.469-4(e), (f)

Material Participation: Tests for Individuals

Shareholders determine material participation using the seven tests in the temporary regulation. Common thresholds include more than 500 hours, substantially all participation, more than 100 hours and not less than any other person, aggregate >500 hours in significant participation activities, and historic material participation in prior years. The facts-and-circumstances test (regular, continuous, and substantial) is available with specific limitations, and certain management activities performed by others can disqualify material participation under that test. Spousal participation counts in determining material participation. The extent of participation may be proven by reasonable records (not necessarily contemporaneous logs) such as appointment books or summaries. 26 CFR § 1.469-5T(a)–(b), (f)

• Significant participation activity: trade or business with >100 hours, not meeting another test, and aggregate >500 hours across such activities can confer material participation. 26 CFR § 1.469-5T(c)

• Spousal participation is counted for the material participation determination of an individual. § 469(h)(5); 26 CFR § 1.469-5T(f)(3)

Special Notes for Limited Partners and S Corp Context

Limited partners are generally not treated as materially participating except under specific tests (e.g., the >500-hour test, certain personal service activity tests), and the regulatory definition of limited partnership interest applies based on the partnership agreement or state law limiting liability. S corporation shareholders apply the individual material participation tests; the entity’s activities pass through, and each shareholder determines their own participation level. The S corporation itself does not determine the shareholder’s material participation, but the K-1 and attached statements identify activity types and passive/active categorization for the shareholder to apply the rules accurately. 26 CFR § 1.469-5T(e); 2024 Shareholder’s Instructions for Schedule K‑1 (Form 1120‑S)

Rental Activities and Real Estate Professionals

Rental activities are passive regardless of participation unless the shareholder qualifies as a real estate professional and materially participates in the rental activity. To qualify, more than half of personal services must be performed in real property trades or businesses and more than 750 hours must be performed in such businesses, with material participation required at the activity level. Each rental is a separate activity unless an election to treat all interests in rental real estate as one activity is made (and properly disclosed). § 469(c)(2), (c)(7); 26 CFR § 1.469-4(h)

Passive Activity Credits and Loss Carryovers

Disallowed passive activity credits and losses carry forward and are allocated ratably among loss activities. Within activities, disallowed deductions are identified by ratable allocation across deductions (with exceptions for separately identified items). Credits are limited by regular tax liability allocable to passive activities; the passive activity credit is the amount by which credits from passive activities exceed the allocable regular tax liability, and disallowed credits carry forward for future use against passive income or on disposition. § 469(d)(2); 26 CFR § 1.469-3T(a)–(d)

Disposition Rules: Releasing Suspended Losses

Disposing of your entire interest in a passive activity in a fully taxable transaction generally frees up suspended losses against other passive income and then, to the extent they remain, as nonpassive losses in the year of disposition. Related-party dispositions are limited, and installment sale dispositions proportionately release losses over the period payments are recognized. § 469(g)

Net Investment Income Tax (NIIT) Interactions: When Passive Matters for the 3.8% Tax

The NIIT applies to net investment income, which includes income from trades or businesses that are passive activities with respect to the taxpayer. If you do not materially participate in an S corporation’s trade or business, your share of that income is generally included in net investment income and may be subject to the 3.8% tax (to the extent your modified AGI exceeds the thresholds). Conversely, trade or business income in which you materially participate is generally excluded from NIIT (except certain portfolio items), though capital gains may be included unless excluded by the trade or business test. The regulation also addresses recharacterization rules and how passive-to-nonpassive recharacterizations affect NIIT categorization. 26 CFR § 1.1411-5(a)–(b)

• Recharacterization coordination: If income or gain is recharacterized as not from a passive activity under section 469 recharacterization rules (e.g., certain rentals to nonpassive activities), the NIIT classification follows that recharacterization solely for the recharacterized items. 26 CFR § 1.1411-5(b)(2)

• Amounts treated as portfolio income (e.g., dividends/interest not derived in ordinary course) remain NIIT investment income, even if recharacterized to not-from-passive under the passive rules. 26 CFR § 1.1411-5(b)(2)(iii)

Common S Corp Scenarios and How the Rules Apply

• Operating S corp business, shareholder works full-time: Likely materially participating (>500 hours or other test). Activity is nonpassive; losses may be currently deductible subject to basis/at-risk limits; NIIT generally does not apply to operating income (but portfolio items like interest/dividends are still NIIT). 26 CFR § 1.469-5T(a); 26 CFR § 1.1411-5

• Shareholder-investor with limited involvement: Likely passive; losses are suspended and carried forward; income is NIIT investment income if thresholds are met. § 469(d), (b); 26 CFR § 1.1411-5

• Rental real estate owned via S corp: Passive unless real estate professional tests are met and shareholder materially participates in the rental activity; NIIT applies to passive rental income. § 469(c)(2), (c)(7); 26 CFR § 1.1411-5

Reporting: What Shareholders Should Expect

S corporation Schedule K‑1 reports your share of income, deductions, credits, and other items and notes whether items are from passive activities, as well as boxes for items affecting basis. Losses and deductions may be limited by basis, at-risk, and passive activity limitations; suspended amounts carry forward and are tracked at the shareholder level. Your return should reflect consistent treatment of K‑1 items with the S corporation’s reporting, or you must file Form 8082 to flag any inconsistent treatment. 2024 Shareholder’s Instructions for Schedule K‑1 (Form 1120‑S)

• Passive activity limitations for K‑1 losses: You may need Form 8582 to compute allowable passive losses and carryovers; ensure grouping and material participation determinations are documented. 2024 Instructions for Schedule E

• Basis and loss limitations: Use Form 7203 to compute stock and debt basis and apply basis limits before at-risk and passive limits; K‑1 box references guide which items increase or decrease basis. 2024 Shareholder’s Instructions for Schedule K‑1 (Form 1120‑S)

Recordkeeping: Proving Participation and Supporting Groupings

Maintain reliable records of time, nature of services, and the periods worked. While contemporaneous daily logs are not required, documentation by appointment books, calendars, or narrative summaries is acceptable. Grouping disclosures must be consistent and maintained across years, with regrouping only when a material change makes the original grouping clearly inappropriate. 26 CFR § 1.469-5T(f)(4); 26 CFR § 1.469-4(e)

Best Practices to Minimize NIIT and Passive Loss Suspension

• Aggregate activities as allowed to meet material participation (when appropriate) and document why the grouping constitutes an appropriate economic unit. 26 CFR § 1.469-4(c)

• Maximize participation where feasible (e.g., >500 hours or significant participation aggregation), and track hours objectively. 26 CFR § 1.469-5T(a)–(c)

• For rentals, consider real estate professional status and elect to treat all interests as one activity to simplify material participation testing, if you meet the requirements. § 469(c)(7); 26 CFR § 1.469-4(h)

Conclusion

For S corporation shareholders, passive activity rules, grouping, and material participation determinations drive both the timing of deductions and the NIIT exposure. Proper grouping can help you meet material participation, but grouping must reflect an appropriate economic unit and comply with the limitations (especially for rentals). Documenting participation and maintaining consistent groupings, applying basis and at-risk rules before passive limits, and understanding the NIIT interactions will keep your return consistent with IRS expectations and reduce the risk of suspended losses and NIIT surprises. § 469; 26 CFR § 1.469-4; 26 CFR § 1.469-5T; 26 CFR § 1.1411-5; 2024 Shareholder’s Instructions for Schedule K‑1 (Form 1120‑S); 2024 Instructions for Schedule E