Contemporaneous Recordkeeping Key to Avoiding Loss Limitations

Taxpayers who run up tax losses in a business must be prepared to prove that one of the material participation tests was passed to avoid having the losses characterized as a passive activity loss (PAL) that cannot be currently deducted. Adequate contemporaneous records that detail the taxpayer's tasks and time spent in the activity are crucial in attempting to sidestep the PAL rules. Records created after-the-fact are better than nothing, but they are much less believable than contemporaneous records. If losses are disallowed by the IRS, interest and penalties may be added to the unpaid taxes.

In general, an individual taxpayer can meet the material participation standard by passing one of the following seven tests outlined in the regulations:

In attempting to pass the material participation tests, taxpayers can prove their participation levels by any reasonable means. This can include identifying the types of work performed and the approximate number of hours spent performing such work with contemporaneous appointment books, calendars, narrative summaries, and the like. Several court decisions have said that, while the regulations permit flexibility regarding what it takes to prove material participation, courts are not required to accept after-the-fact "ballpark guesstimates" or a taxpayer's unverified, undocumented, and presumably self-serving testimony.

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. The information contained in this newsletter was not intended or written to be used and cannot be used for the purpose of (1) avoiding tax-related penalties prescribed by the Internal Revenue Code or (2) promoting or marketing any tax-related matter addressed herein. © 2015