The Portable MBA in Finance and Accounting, 3rd Edition

Taxes and Business Decisions 321

by a healthy long-term capital gain. Thus, an investor with high taxable income
could be offered short-term pass-through tax losses with a nice long-term gain
waiting in the wings. In those days, long-term capital gain was taxed at only 40%
of the rate of ordinary income, so the tax was not only deferred but substantially
reduced. These businesses were known as tax shelters.
The 1986 Act substantially reduced the effectiveness of the tax shelter by
classifying taxable income and loss in three major categories: active, portfolio,
and passive. Active income consists mainly of wages, salar ies, and bonuses;
portfolio income is mainly interest and dividends; while passive income and
loss consist of distributions from the so-called pass-through entities, such as
LLCs, limited partnerships, and subchapter S corporations. In their simplest
terms, the passive activity loss rules add to the limits set by the earlier de-
scribed basis limitations (and the similar so-called at-risk rules), making it im-
possible to use passive losses to offset active or portfolio income. Thus, tax
shelter losses can no longer be used to shelter salaries or investment proceeds;
they must wait for the taxpayer ’s passive activities to generate the anticipated
end-of-the-line gains or be used when the taxpayer disposes of a passive activ-
ity in a taxable transaction (see Exhibit 11.2).
Fortunately for Morris, the passive activity loss rules are unlikely to af-
fect his thinking for at least two reasons. First, the Code defines a passive ac-
tivity as the conduct of any trade or business “in which the taxpayer does not
materially participate.” Material participation is further defined in a series of
Code sections and Temporary Regulations (which mock the concept of tax
simplification but let Morris off the hook) to include any taxpayer who partic-
ipates in the business for more than 500 hours per year. Morris is clearly ma-
terially participating in his business despite his status as a stockholder of a
subchapter S corporation, and thus the passive loss rules do not apply to him.

EXHIBIT 11.2 Passive activity losses.

Active Portfolio Passive

Material

participation

Pass-throughs

from

partnerships,

Subchapter S,

LLCs, and so on

Passive loss

Salary,

bonus,

and so on

Interest,

dividends,

and so on