When you own more than one business, you need to consider the grouping rules that apply for passive-loss purposes.
Should one of your businesses lose money, you may not deduct the losses from that business during the current tax year unless you
- materially participate in the business or, if grouped, materially participate in the group; or
- do not materially participate but have passive income from other sources against which to deduct your passive business losses.
Example. Sam Warren, MD, operates a medical practice and starts a new physical therapy business (his second business) in which he will not materially participate. The physical therapy business is going to lose money during its first years of operation. If Dr. Warren wants to deduct the losses from his physical therapy business, he has one choice: group that business with his medical practice.
Dr. Warren knows that he will have tax losses in his physical therapy business during its start-up years. Because he will not materially participate in the physical therapy business, the tax code deems his losses passive. He may deduct his passive losses
- against his passive income from other sources (excess passive losses are carried forward); and
- in total, when he sells or otherwise disposes of his entire interest in the passive activity.
This is ugly.
First, Dr. Warren has no other passive income. The medical practice, his only other business or activity, is an active business that produces active income.
Second, he does not plan on selling the physical therapy business anytime soon, so he would not realize any benefit from the accumulation of his carried-forward passive losses.
His solution: the group.
If Dr. Warren’s physical therapy business loses $175,000 as he projects, he can write off that $175,000 because the grouping makes him a material participant.
Without the grouping, he does not materially participate in the physical therapy business. Without material participation, his $175,000 loss is a passive-loss deductible against only passive income, of which he has none.
The medical practice income is active income, not passive income.
When he makes the grouping election, the law combines the two businesses for material participation purposes. Let’s say he works 2,000 hours a year in his medical practice. With grouping, he now works 2,000 hours a year in the combined activity, and that makes the loss from the physical therapy business deductible.
If you have multiple activities and want to discuss grouping, please reach out to me.