A Shining Example of Why Our Tax Code Must be Simplified

I made a mistake. In my article on June 30 on Tips for Sub S Corporations I took a stance that was backed by a faulty analysis. I want to thank all of my colleagues who wrote to clue me in on my error.

Turns out, you cannot mix apples and oranges, after all when it comes to the ability to write off rental losses against Sub S income. If you go to work every day at your Sub S Corporation business, (in other words if you have material participation), putting in more than 100 hours per year, you cannot write off your rental losses (passive losses) against the income (nonpassive) generated from the Sub S Corporation. Essentially, if you work less than 100 hours, you can. In Publication 925 there is an entire column with seven bullet points devoted to defining material participation and I urge individuals to read it for more information because there are factors other than the hours you put in. Material participation Sub S income is not considered passive, even though it is considered passive for other purposes of the code.

In my 29 years of doing taxes, this particular situation had not come up before. I have a few clients with material participation in their Sub S corporations who own real estate rentals that are profitable, so its never been an issue before.

This year during tax season, a long time client of mine--Ill call him Art--made 3X his normal profit from his sole proprietorship and indicated that the earnings would be the norm for the future.  He lost the deduction for his rental losses because his income exceeded $150,000. His tax bill was enormous. Hed been paying taxes every year on about $85,000 of income and just when he thought hed pulled ahead and could finance putting his four sons through college, he ends up getting hit with a savage tax bill.

It was time for him to incorporate, Sub S, pay himself a reasonable salary and take the remainder of the profit as income that is not subject to the self-employment tax. When I ran the numbers as a Sub S, the rental losses came back into play as a deduction. Good news! At first it didnt make sense because of his material participation, but a colleague happened to walk by right then (someone with as much tax experience as me) and he concurred with my findings, saying Sub S income is passive. You see that its not subject to self-employment tax, right?

Right! So it made sense. No self-employment tax, it must be passive income. Next I check out code section 469 just to be sure and there it was in black and white Sub S Corporations are an exception. Going back and looking at it now, I see its an exception to the passive activity rules, which means the income cannot be netted against other passive losses. But because I was excited about saving money for my client, I saw only what I wanted to see or expected to see.

Later that  week I was in an audit for another client, so I spoke to the auditor about my findings and she agreed. I also called the Tax Law Department of the IRS and spoke to an agent who also agreed! Art went to a tax attorney to set up the Sub S Corporation and the attorney said I was right, that he would enjoy his rental loss deductions as a Sub S owner. A handful of CPAs wrote to me after also agreeing with me after the article hit, but most of the mail I received was from CPAs who disagreed. This set off an alarm: The ones who disagreed with me made a lot of sense.

It was time to reload and check one more time. I did, and found that I was wrong. Of course, there are some exceptions. If you can be classified as a real estate professional, your rental real estate is not considered a passive activity, therefore you can write off your Sub S losses against it. Read IRS Publication 925 for more information on who can be classified as a real estate professional youll be surprised you dont necessarily have to be a licensed realtor.

This situation is scary: Seasoned professionals, even the IRS itself, can become confused about tax law. There are more than 80,000 pages of code, riddled with exceptions, obscure rules and verbiage. One of the most off-putting words found in IRS publications is the word generally. I hate it when I see sentences that start with that--it implies there is an exception somewhere, but it never details what it is.

It is time for serious tax reform. A flat tax, a fair tax, a simplified tax not burdened with cumbersome and complicated rules and regulations and constant change. A tax on everyone: not just on the rich, not just on the poor or on the middle class (who by the way is the group getting squeezed). Any lawmakers out there listening? Im not scared of my business going away because of a simpler tax code; every tax professional has a sideline to take up the slack when tax season is over insurance, financial planning, and accounting to name a few. We can develop our sidelines. In fact, there will still be tax issues payroll taxes, sales tax, the taxes will never end and there will always be a need for tax professionals.

But right now& I better pick up the phone and call Art.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know, available at all major booksellers. Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook.