Passive — Instruction 1120-S — Instructions for Form

In general, section 469 limits the amount of losses, deductions, and credits that shareholders can claim from “passive activities.” The passive activity limitations don’t apply to the corporation. Instead, they apply to each shareholder’s share of any income or loss and credit attributable to a passive activity. Because the treatment of each shareholder’s share of corporate income or loss and credit depends on the nature of the activity that generated it, the corporation must report income or loss and credits separately for each activity.

The following instructions and the instructions for Schedules K and K-1, later, explain the applicable passive activity limitation rules and specify the type of information the corporation must provide to its shareholders for each activity. If the corporation had more than one activity, it must report information for each activity on an attachment to Schedules K and K-1.

Generally, passive activities include (a) activities that involve the conduct of a trade or business if the shareholder doesn’t materially participate in the activity and (b) all rental activities (defined later) regardless of the shareholder’s participation. For

Activities Covered by the At-Risk Rules If the S corporation is involved in one of the following activities as a trade or business or for the production of income, the shareholder may be subject to the at-risk rules.

Holding, producing, or distributing motion picture films or video tapes.
Farming.
Leasing section 1245 property, including personal property and certain other tangible property that is depreciable or amortizable.
Exploring for or exploiting oil and gas.
Exploring for or exploiting geothermal deposits (for wells started after September 1978).
Any other activity not included in (1) through (5) that is carried on as a trade or business or for the production of income.

Aggregation of Activities Activities described in (6) under Activities Covered by the At-Risk Rules, earlier, that constitute a trade or business are treated as one activity if:

You actively participate in the management of the trade or business, or
The trade or business is carried on by a partnership or S corporation and 65% or more of its losses for the tax year are allocable to persons who actively participate in the management of the trade or business.

Similar rules apply to activities described in (1) through (5) of that earlier discussion. For more information, see Pub. 925. If you aggregate your activities under these rules for section 465 purposes, check the appropriate box in item J.

At-Risk Activity Reporting Requirements If the corporate items of income, loss, or deduction reported on Schedule K-1 are from more than one activity covered by the at-risk rules, the corporation must report information separately for each activity.

The following information must be provided on an attachment to Schedule K-1 for each activity.

A statement that the information is a breakdown of the items of income, loss, or deduction by at-risk activity.

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exceptions, see Activities That Are Not Passive Activities, later. The level of each shareholder’s participation in an activity must be determined by the shareholder.

The passive activity rules provide that losses and credits from passive activities can generally be applied only against income and tax (respectively) from passive activities. Thus, passive losses can’t be applied against income from salaries, wages, professional fees, or a business in which the shareholder materially participates or against “portfolio income” (defined later). Passive credits can’t be applied against the tax related to any of these types of income.

Special rules require that net income from certain activities that would otherwise be treated as passive income must be recharacterized as nonpassive income for purposes of the passive activity limitations. See Recharacterization of Passive Income, later.

To allow each shareholder to correctly apply the passive activity limitations, the corporation must report income or loss and credits separately by activity for each of the following.

Trade or business activities.
Rental real estate activities.
Rental activities other than rental real estate.
Portfolio income.

Activities That Are Not Passive Activities The following aren’t passive activities.

Trade or business activities in which the shareholder materially participated for the tax year.
Any rental real estate activity in which the shareholder materially participated if the shareholder met both of the following conditions for the tax year.

a. More than half of the personal services the shareholder performed in trades or businesses were performed in real property trades or businesses in which the shareholder materially participated.

b. The shareholder performed more than 750 hours of services in real property trades or businesses in which the shareholder materially participated.

For purposes of this rule, each interest in rental real estate is a separate activity unless the shareholder elects to treat all interests in rental real estate as one activity.

If the shareholder is married filing jointly, either the shareholder or the shareholder’s spouse must separately meet both of the above conditions, without taking into account services performed by the other spouse.

A real property trade or business is any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. Services the shareholder performed as an employee aren’t treated as performed in a real property trade or business unless the shareholder owned more than 5% of the stock in the employer.

The rental of a dwelling unit used by a shareholder for personal purposes during the year for more than the greater of 14 days or 10% of the number of days that the residence was rented at fair rental value.
An activity of trading personal property for the account of owners of interests in the activity. For purposes of this rule, personal property means property that is actively traded, such as stocks, bonds, and other securities. See Temporary Regulations section 1.469-1T(e)(6).

Tip: The section 469(c)(3) exception for a working interest in oil and gas properties doesn’t apply to an S corporation because state law generally limits the liability of shareholders.

Trade or Business Activities A trade or business activity is an activity (other than a rental activity or an activity treated as incidental to an activity of holding property for investment) that:

Involves the conduct of a trade or business (within the meaning of section 162),
Is conducted in anticipation of starting a trade or business, or
Involves the conduct of research or experimental activities, including software development, subject to either section 174 (foreign research) or section 174A (domestic research).

If the shareholder doesn’t materially participate in the activity, a trade or business activity of the corporation is a passive activity for the shareholder.

Each shareholder must determine if they materially participated in an activity. As a result, while the corporation’s ordinary business income (loss) is reported on Form 1120-S, page 1, the specific income and deductions from each separate trade or business activity must be reported on attachments to Form 1120-S. Similarly, while each shareholder’s allocable share of the corporation’s ordinary business income (loss) is reported in box 1 of Schedule K-1, each shareholder’s allocable share of the income and deductions from each trade or business activity must be reported on statements attached to each Schedule K-1. See Passive Activity Reporting Requirements , later, for more information.

Rental Activities Generally, except as noted below, if the gross income from an activity consists of amounts paid principally for the use of real or personal tangible property held by the corporation, the activity is a rental activity.

There are several exceptions to this general rule. Under these exceptions, an activity involving the use of real or personal tangible property isn’t a rental activity if any of the following apply.

The corporation provides property for use in a nonrental activity of a partnership in its capacity as an owner of an interest in such partnership. Whether the corporation provides property used in an activity of a partnership in the corporation’s capacity as an owner of an interest in the partnership is determined on the basis of all the facts and circumstances.

In addition, a guaranteed payment described in section 707(c) is never income from a rental activity.

Average period of customer use. Figure the average period of customer use for a class of property by dividing the total number of days in all rental periods by the number of rentals during the tax year. If the activity involves renting more than one class of property, multiply the average period of customer use of each class by the ratio of the gross rental income from that class to the activity’s total gross rental income. The activity’s average period of customer use equals the sum of these class-by-class

The average period of customer use (defined later) for such property is 7 days or less.
The average period of customer use for such property is 30 days or less and significant personal services (defined later) are provided by or on behalf of the corporation.
Extraordinary personal services (defined later) are provided by or on behalf of the corporation.
The rental of such property is treated as incidental to a nonrental activity of the corporation under Regulations section 1.469-1(e)(3)(vi).
The corporation customarily makes the property available during defined business hours for nonexclusive use by various customers.

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average periods weighted by gross income. See Regulations section 1.469-1(e)(3)(iii).

Significant personal services. Personal services include only services performed by individuals. To determine if personal services are significant personal services, consider all the relevant facts and circumstances. Relevant facts and circumstances include:

How often the services are provided,
The type and amount of labor required to perform the services, and
The value of the services in relation to the amount charged for use of the property.

definition of rental activities for purposes of the passive activity limitations.

Reporting of rental activities. In reporting the corporation’s income or losses and credits from rental activities, the corporation must separately report rental real estate activities and rental activities other than rental real estate activities.

Shareholders who actively participate in a rental real estate activity may be able to deduct part or all of their rental real estate losses (and the deduction equivalent of rental real estate credits) against income (or tax) from nonpassive activities. Generally, the combined amount of rental real estate losses and the deduction equivalent of rental real estate credits from all sources (including rental real estate activities not held through the corporation) that may be claimed is limited to $25,000.

Report rental real estate activity income (loss) on Form 8825 and on Schedule K, line 2, and in box 2 of Schedule K-1, rather than on Form 1120-S, page 1. Report credits related to rental real estate activities on Schedule K, lines 13c and 13d (box 13, codes E and F of Schedule K-1), and low-income housing credits on Schedule K, lines 13a and 13b (box 13, codes C and D of Schedule K-1).

Report income (loss) from rental activities other than rental real estate on Schedule K, line 3, and credits related to rental activities other than rental real estate on Schedule K, line 13e, and in box 13, code G, of Schedule K-1.

Portfolio Income Generally, portfolio income includes all gross income, other than income derived in the ordinary course of a trade or business, that is attributable to interest; dividends; royalties; income from a real estate investment trust, regulated investment company, real estate mortgage investment conduit, common trust fund, controlled foreign corporation, qualified electing fund, or cooperative; income from the disposition of property that produces income of a type defined as portfolio income; and income from the disposition of property held for investment. See Self-Charged Interest , later, for an exception.

The following services aren’t considered in determining whether personal services are significant.

Services necessary to permit the lawful use of the rental property.
Services performed in connection with improvements or repairs to the rental property that extend the useful life of the property substantially beyond the average rental period.
Services provided in connection with the use of any improved real property that are similar to those commonly provided in connection with long-term rentals of high-grade commercial or residential property. Examples include cleaning and maintenance of common areas, routine repairs, trash collection, elevator service, and security at entrances.

Extraordinary personal services. Services provided in connection with making rental property available for customer use are extraordinary personal services only if the services are performed by individuals and the customers’ use of the rental property is incidental to their receipt of the services.

For example, a patient’s use of a hospital room is generally incidental to the care received from the hospital’s medical staff. Similarly, a student’s use of a dormitory room in a boarding school is incidental to the personal services provided by the school’s teaching staff.

Rental activity incidental to a nonrental activity. An activity isn’t a rental activity if the rental of the property is incidental to a nonrental activity, such as the activity of holding property for investment, a trade or business activity, or the activity of dealing in property.

Solely for purposes of the preceding paragraph, gross income derived in the ordinary course of a trade or business includes (and portfolio income, therefore, doesn’t include) the following types of income.

Rental of property is incidental to an activity of holding property for investment if both of the following apply.

The main purpose for holding the property is to realize a gain from the appreciation of the property.
The gross rental income from such property for the tax year is less than 2% of the smaller of the property’s unadjusted basis or its fair market value (FMV).

Rental of property is incidental to a trade or business activity if all of the following apply.

Interest income on loans and investments made in the ordinary course of a trade or business of lending money.
The corporation owns an interest in the trade or business at all times during the year.
Interest on accounts receivable arising from the performance of services or the sale of property in the ordinary course of a trade or business of performing such services or selling such property, but only if credit is customarily offered to customers of the business.
Income from investments made in the ordinary course of a trade or business of furnishing insurance or annuity contracts or reinsuring risks underwritten by insurance companies.
Income or gain derived in the ordinary course of an activity of trading or dealing in any property if such activity constitutes a trade or business (unless the dealer held the property for investment at any time before such income or gain is recognized).
The rental property was mainly used in the trade or business activity during the tax year or during at least 2 of the 5 preceding tax years.
The gross rental income from the property for the tax year is less than 2% of the smaller of the property’s unadjusted basis or its FMV.

If the corporation sells or exchanges property that is also rented during the tax year (in which the gain or loss is recognized), the rental is treated as incidental to the activity of dealing in property if, at the time of the sale or exchange, the property was held primarily for sale to customers in the ordinary course of the corporation’s trade or business.

See Temporary Regulations section 1.469-1T(e)(3) and Regulations section 1.469-1(e)(3) for more information on the

Other income identified by the IRS as income derived by the taxpayer in the ordinary course of a trade or business.

See Temporary Regulations section 1.469-2T(c)(3) for more information on portfolio income.

Royalties derived by the taxpayer in the ordinary course of a trade or business of licensing intangible property.
Amounts included in the gross income of a patron of a cooperative by reason of any payment or allocation to the patron based on patronage occurring with respect to a trade or business of the patron.

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Report portfolio income and related deductions on Schedule K rather than on page 1 of Form 1120-S.

Self-Charged Interest Certain self-charged interest income and deductions may be treated as passive activity gross income and passive activity deductions if the loan proceeds are used in a passive activity. Generally, self-charged interest income and deductions result from loans between the corporation and its shareholders. Self-charged interest also occurs in loans between the corporation and another S corporation or partnership if each owner in the borrowing entity has the same proportional ownership interest in the lending entity.

The self-charged interest rules don’t apply to a shareholder’s interest in an S corporation if the S corporation makes an election under Regulations section 1.469-7(g) to avoid the application of these rules. To make the election, the S corporation must attach to its original or amended Form 1120-S a statement that includes the name, address, EIN of the S corporation, and a declaration that the election is being made under Regulations section 1.469-7(g). The election will apply to the tax year for which it was made and all subsequent tax years. Once made, the election can only be revoked with the consent of the IRS.

For more details on the self-charged interest rules, see Regulations section 1.469-7.

Grouping Activities Generally, one or more trade or business or rental activities may be treated as a single activity if the activities make up an appropriate economic unit for measurement of gain or loss under the passive activity rules. Whether activities make up an appropriate economic unit depends on all the relevant facts and circumstances. The factors given the greatest weight in determining whether activities make up an appropriate economic unit are:

Similarities and differences in types of trades or businesses,
The extent of common control,
The extent of common ownership,
Geographical location, and
Reliance between or among the activities.

Example. The corporation has a significant ownership interest in a bakery and a movie theater in Baltimore and a bakery and a movie theater in Philadelphia. Depending on the relevant facts and circumstances, there may be more than one reasonable method for grouping the corporation’s activities. For instance, the following groupings may or may not be permissible.

A single activity.
A movie theater activity and a bakery activity.
A Baltimore activity and a Philadelphia activity.
Four separate activities.

A rental activity with a trade or business activity unless the activities being grouped together make up an appropriate economic unit and:

a. The rental activity is insubstantial relative to the trade or business activity or vice versa; or

b. Each owner of the trade or business activity has the same proportionate ownership interest in the rental activity. If so, the portion of the rental activity involving the rental of property to be used in the trade or business activity can be grouped with the trade or business activity.

An activity involving the rental of real property with an activity involving the rental of personal property (except personal property provided in connection with the real property or vice versa).
Any activity with another activity in a different type of business and in which the corporation holds an interest as a limited partner or as a limited entrepreneur (as defined in section 461(k)(4)) if that other activity is holding, producing, or distributing motion picture films or videotapes; farming; leasing section 1245 property; or exploring for or exploiting oil and gas resources or geothermal deposits.

Activities conducted through partnerships. Once a partnership determines its activities under these rules, the corporation as a partner can use these rules to group those activities with:

Each other,
Activities conducted directly by the corporation, or
Activities conducted through other partnerships. The corporation can’t treat as separate activities those activities grouped together by a partnership.

Recharacterization of Passive Income Under Temporary Regulations section 1.469-2T(f) and Regulations section 1.469-2(f), net passive income from certain passive activities must be treated as nonpassive income. Net passive income is the excess of an activity’s passive activity gross income over its passive activity deductions (current year deductions and prior year unallowed losses).

Any net passive income recharacterized as nonpassive income is treated as investment income for purposes of figuring investment interest expense limitations if it is from (a) an activity of renting substantially nondepreciable property from an equity-financed lending activity or (b) an activity related to an interest in a pass-through entity that licenses intangible property.

The amount of income from the activities in items (1) through (3) below that any shareholder will be required to recharacterize as nonpassive income may be limited under Temporary Regulations section 1.469-2T(f)(8). Because the corporation won’t have information regarding all of a shareholder’s activities, it must identify all corporate activities meeting the definitions in items (2) and (3) as activities that may be subject to recharacterization.

Income from the following six sources is subject to recharacterization.

Significant participation passive activities. A significant participation passive activity is any trade or business activity in which the shareholder participated for more than 100 hours during the tax year but didn’t materially participate. Because each shareholder must determine the shareholder’s level of participation, the corporation won’t be able to identify significant participation passive activities.
Certain nondepreciable rental property activities. Net passive income from a rental activity is nonpassive income if less than 30% of the unadjusted basis of the property used or held for use by customers in the activity is subject to depreciation under section 167.

Once the corporation chooses a grouping under these rules, it must continue using that grouping in later tax years unless either:

The corporation determines that the original grouping was clearly inappropriate, or
A material change in the facts and circumstances makes that grouping clearly inappropriate.

The IRS may regroup the corporation’s activities if the corporation’s grouping isn’t an appropriate economic unit and one of the primary purposes for the grouping (or failure to regroup as required under Regulations section 1.469-4(e)) is to avoid the passive activity limitations. If you group your activities under these rules for section 469 purposes, check the appropriate box in item J.

Limitation on grouping certain activities. The following activities may not be grouped together.

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Passive equity-financed lending activities. If the corporation has net income from a passive equity-financed lending activity, the smaller of the net passive income or the equity-financed interest income from the activity is nonpassive income.
Rental of property incidental to a development activity. Net rental activity income is the excess of passive activity gross income from renting or disposing of property over passive activity deductions (current year deductions and prior year unallowed losses) that are reasonably allocable to the rented property. Net rental activity income is nonpassive income for a shareholder if all of the following apply.

a. The corporation recognizes gain from the sale, exchange, or other disposition of the rental property during the tax year.

b. The use of the item of property in the rental activity started less than 12 months before the date of disposition. The use of an item of rental property begins on the first day on which (a) the corporation owns an interest in the property, (b) substantially all of the property is either rented or held out for rent and ready to be rented, and (c) no significant value-enhancing services remain to be performed.

c. The shareholder materially or significantly participated for any tax year in an activity that involved performing services to enhance the value of the property (or any other item of property, if the basis of the property disposed of is determined in whole or in part by reference to the basis of that item of property).

Because the corporation can’t determine a shareholder’s level of participation, the corporation must identify net income from property described above (without regard to the shareholder’s level of participation) as income that may be subject to recharacterization.

Rental of property to a nonpassive activity. If a taxpayer rents property to a trade or business activity in which the taxpayer materially participates, the taxpayer’s net rental activity income (defined in item (4)) from the property is nonpassive income.
Acquisition of an interest in a pass-through entity that licenses intangible property. Generally, net royalty income from intangible property is nonpassive income if the taxpayer acquired an interest in the pass-through entity after the pass-through entity created the intangible property or performed substantial services or incurred substantial costs in developing or marketing the intangible property. Net royalty income is the excess of passive activity gross income from licensing or transferring any right in intangible property over passive activity deductions (current year deductions and prior year unallowed losses) that are reasonably allocable to the intangible property. See Temporary Regulations section 1.469-2T(f)(7)(iii) for exceptions to this rule.

Passive Activity Reporting Requirements To allow shareholders to correctly apply the passive activity loss and credit limitation rules, the corporation must do the following.

If the corporation carries on more than one activity, provide an attached statement for each activity conducted through the corporation that identifies the type of activity conducted (trade or business, rental real estate, or rental activity other than rental real estate). See Grouping Activities, earlier.
The attachment(s) must identify each group. The attached group activity description must be sufficient for the shareholders to determine if their other activities qualify to be added to any groups provided by the corporation.
On the attached statement for each activity, provide a statement using the same box numbers as shown on Schedule K-1 and detailing the net income (loss), credits, and all items required to be separately stated under section 1366(a)(1)

from each trade or business activity, from each rental real estate activity, from each rental activity other than a rental real estate activity, and from investments.

Identify the net income (loss) and the shareholder’s share of corporation interest expense from each activity of renting a dwelling unit that any shareholder uses for personal purposes during the year for more than the greater of 14 days or 10% of the number of days that the residence is rented at fair rental value.
Identify the net income (loss) and the shareholder’s share of interest expense from each activity of trading personal property conducted through the corporation.
For any gain (loss) from the disposition of an interest in an activity or of an interest in property used in an activity (including dispositions before 1987 from which gain is being recognized after 1986):

a. Identify the activity in which the property was used at the time of disposition;

b. If the property was used in more than one activity during the 12 months preceding the disposition, identify the activities in which the property was used and the adjusted basis allocated to each activity; and

c. For gains only, if the property was substantially appreciated at the time of the disposition and the applicable holding period specified in Regulations section 1.469-2(c)(2)(iii) (A) wasn’t satisfied, identify the amount of the nonpassive gain and indicate whether or not the gain is investment income under Regulations section 1.469-2(c)(2)(iii)(F).

Specify the amount of gross portfolio income, the interest expense properly allocable to portfolio income, and expenses other than interest expense that are clearly and directly allocable to portfolio income.
Identify the ratable portion of any section 481 adjustment (whether a net positive or a net negative adjustment) allocable to each corporate activity.
Identify any gross income from sources specifically excluded from passive activity gross income, including:

a. Income from intangible property if the shareholder is an individual whose personal efforts significantly contributed to the creation of the property;

b. Income from state, local, or foreign income tax refunds; and

c. Income from a covenant not to compete if the shareholder is an individual who contributed the covenant to the corporation.

Identify any deductions that aren’t passive activity deductions.
If the corporation makes a full or partial disposition of its interest in another entity, identify the gain (loss) allocable to each activity conducted through the entity and the gain allocable to a passive activity that would have been recharacterized as nonpassive gain had the corporation disposed of its interest in property used in the activity (because the property was substantially appreciated at the time of the disposition, and the gain represented more than 10% of the shareholder’s total gain from the disposition).
Identify the following items from activities that may be subject to the recharacterization rules (see Recharacterization of Passive Income, earlier).

a. Net income from an activity of renting substantially nondepreciable property.

b. The smaller of equity-financed interest income or net passive income from an equity-financed lending activity.

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c. Net rental activity income from property developed (by the shareholder or the corporation), rented, and sold within 12 months after the rental of the property commenced.

d. Net rental activity income from the rental of property by the corporation to a trade or business activity in which the shareholder had an interest (either directly or indirectly).

e. Net royalty income from intangible property if the shareholder acquired the shareholder’s interest in the corporation after the corporation created the intangible property or performed substantial services, or incurred substantial costs in developing or marketing the intangible property.

Identify separately the credits from each activity conducted by or through the corporation.
Identify the shareholder’s pro rata share of the corporation’s self-charged interest income or expense (see Self-Charged Interest , earlier).

a. Loans between a shareholder and the corporation. Identify the lending or borrowing shareholder’s share of the self-charged interest income or expense. If the shareholder made the loan to the corporation, also identify the activity in which the loan proceeds were used. If the proceeds were used in more than one activity, allocate the interest to each activity based on the amount of the proceeds used in each activity.

b. Loans between the corporation and another S corporation or partnership. If the corporation’s shareholders have the same proportional ownership interest in the corporation and the other S corporation or partnership, identify each shareholder’s share of the interest income or expense from the loan. If the corporation was the borrower, also identify the activity in which the loan proceeds were used. If the proceeds were used in more than one activity, allocate the interest to each activity based on the amount of the proceeds used in each activity.