Taking a loss on any business hurts, no question—but at least you get that immediate tax deduction, right? Not necessarily. And the “not necessarily” is more true when you incur that business loss on your second or third business.
Here’s the culprit: When you operate a business, you have to materially participate to deduct the losses. As you create more businesses, you can, and often do, reduce your chances of passing the material participation tests.
The material participation tests generally require that you spend a certain number of hours working in the business. Your primary business likely takes most of your time, meaning you have less or perhaps little time to devote to the second or third business. This article gives you several tactics that help you avoid the mistakes that can cost you loss deductions for your second and third businesses.
Multiple Businesses, Multiple Traps
Rev. Rul. 81-90 notes that you must file a separate small business Schedule C for each of your sole proprietorship businesses which includes home based businesses, and 1 member LLC’s. If you fail to file separate Schedule Cs for your small home based business, small business, or proprietorship businesses, you trigger possible penalties for negligence or intentional disregard of rules and regulations.
The failure to file separate Schedule Cs for separate proprietorship’s also triggers possible penalties for your tax preparer.
The Passive Loss Trap
If you don’t pass one of the material participation tests for a business activity and that activity shows a tax loss, the tax code makes that loss a “passive loss,” and this means you can
- deduct the passive loss only against your passive income,
- carry forward any unused passive losses to future years, and
- claim the unused passive losses when you dispose of the entire business activity.
Special passive loss rules apply to rental properties. We don’t discuss the special rental property rules in this article because the focus of this article is on a second or third business. We’re also not talking hobbies, as they face a set of their own ugly rules.
Now to the businesses at hand: you need to “materially participate” in a business to deduct the business losses against your total income from all sources.
Proving Material Participation in a Second Business Activity
The IRS has seven tests for business material participation. In six of the seven tests, the IRS looks at the time you spend on the business activity. For the taxable year, you need to satisfy only one of the seven tests below to prove you materially participated in the business activity.
- You participated for more than 500 hours.
- Your participation represents substantially all participation in the business.
- You participated for more than 100 hours, and your participation is equal to or greater than the participation of any other individual.
- The business activity is a significant participation activity, and your aggregate participation in all significant participation activities exceeded 500 hours.
- You materially participated in the business activity for any five (whether consecutive or not) of the 10 immediately preceding taxable years.
- The business activity is defined by tax law as a “personal service activity” in which you materially participated for any three taxable years (whether consecutive or not) prior to this year.
- Based on all the facts and circumstances, you participated in the business activity on a regular, continuous, and substantial basis during the year
“Participation” includes any time you spend working in connection with the business, except:
- You can’t count time you spend as an investor (for example, reviewing financial statements or operations reports) unless you’re directly involved in the business’s day-to-day management or operations.
- You can’t count time you spend doing work that isn’t customarily done by the owner if one of your main reasons for doing the work is to avoid the passive loss rules.
Your spouse’s time counts too. You can count the time your spouse spends on the business as time you spend, even if he or she doesn’t have an ownership interest in the business.
What the IRS regulations say. You may establish your participation in a business by “any reasonable means.” You aren’t required to have contemporaneous daily time logs if you can use your appointment books, calendars, or other narrative summaries to identify services performed over a period of time, including the approximate number of hours spent on those services.
The real world. If there is going to be anything near a close call on the time needed for material participation, you need to keep a daily time log. Taxpayers without a daily time log consistently lose both to the IRS and in court.
Although we’ve given you the basics, this is not an all inclusive article. Should you have questions, or need business tax preparation, business entity creation, business insurance, or business compliance assistance please contact us online, or call our office at 855-743-5765. Make sure to join our newsletter for more tips on reducing taxes, and increasing your wealth.
 IRC Section 469.
 Rev. Rul. 81-90.
 Reg. Section 1.469-5T(a).
 Reg. Section 1.469-5T(f)(2).
 Reg. Section 1.469-5T(f)(3).
 Reg. Section 1.469-5T(f)(4).