Owners May Exit Slowly to Mentor and Guide Their Successors

Key Takeaways:
  • Transitioning to a passive role can unlock new tax planning opportunities. Owners who scale back involvement may qualify for passive income treatment, allowing for strategic tax loss harvesting and reduced self-employment tax exposure.
  • Understanding IRS material participation rules is important. Whether your activity is considered active or passive affects your ability to deduct losses and impacts your overall tax strategy during the transition period.
  • Entity structure and succession planning should align with your exit goals. Evaluating whether a C corp, S corp or other structure best supports your long-term objectives and mentoring successors can help ensure a smooth and successful business transition.

 

Retirement from a company you founded and ran for many years is a momentous occasion. But you may not want to step away from the business completely and the company’s management team may not be ready to lose you from the day-to-day operations.

Retaining ownership, or a partial interest and continuing to provide guidance can serve as an important bridge to the day when you will be ready to sell your business.

For many business owners, this is a time to enter into a “passive” role for a period of time before making a final exit. This enables you to remain involved in the business, providing guidance and transitional help that helps prepare the business and the managerial team for the next step.

For you as a taxpayer, the passive phase also comes with a new set of tax rules that apply to business owners and investors who earn passive income.

Transition from ‘Active’ to ‘Passive’ Income

As you scale back your day-to-day role while keeping an ownership interest, your activity in the business may shift from active to passive in the eyes of the IRS.

The IRS uses a set of seven tests to determine whether a taxpayer is considered to have “materially participated” in a business activity. This is important because if you materially participate, your activity is considered “active” (not passive), and you can generally deduct losses from that activity against your other income. If you do not materially participate, the activity is “passive,” and your losses may be limited.

The Seven Material Participation Tests

  • 500-Hour Test – You participated in the activity for more than 500 hours during the year.
  • Substantially All Participation Test – Your participation was substantially all the participation in the activity by all individuals (including non-owners) for the year.
  • 100-Hour and Most Participation Test – You participated in the activity for more than 100 hours during the year, and no one else (including non-owners) participated more than you did.
  • Significant Participation Activities Test – The activity is a “significant participation activity” (you participated more than 100 hours in it, but did not otherwise materially participate), and your total participation in all such activities exceeds 500 hours for the year.
  • Prior Years’ Material Participation Test – You materially participated in the activity for any five of the last ten years (the years do not have to be consecutive).
  • Personal Service Activity Test – The activity is a personal service activity (such as health, law, engineering, accounting, performing arts, consulting or any business where capital is not a material income-producing factor), and you materially participated in it for any three prior years (the years do not have to be consecutive).
  • Facts and Circumstances Test – Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year. However, you must have participated more than 100 hours, and your management activities generally do not count if someone else was paid to manage the activity or spent more time managing it than you did.

Additional details that taxpayers with passive income should know include:

  • Participation means any work you do in connection with the activity, if you own an interest in it, except for work not customarily done by owners or work done mainly to avoid disallowing losses.
  • Your spouse’s participation counts as your participation, even if your spouse does not own an interest in the activity and you file separately.
  • Proof of Participation can be established by any reasonable means, such as appointment books, calendars or narrative summaries. You do not need to keep daily time logs, but you should be able to show what you did and approximately how much time you spent.

Why This Matters

If you meet any one of these seven tests for an activity, you are considered to have materially participated and the activity is not passive for you. This means you can generally deduct losses from the activity against your other income, subject to other limitations.

If you do not meet any of these tests, the activity is passive and your ability to deduct losses may be limited to the amount of income you have from other passive activities.

One factor to consider is whether the current entity structure of the business still supports your long-term goals. In some cases, it may make sense to explore switching from a C corporation to an S corporation or another structure, but this should be carefully evaluated with your tax advisor, as potential benefits like qualified small business stock (QSBS) treatment under Section 1202 could be impacted.

Differences in Tax Treatment

As noted above, the IRS treats active and passive income differently for tax purposes. Some of the differences may benefit taxpayers, while others may not.

Moreover, passive income has certain limitations under Section 469 of the Internal Revenue Code. For instance, depending on the makeup of your other income sources (Social Security, 401k, etc.) you could be limited as to how much business loss you can deduct. Generally, those deductions are phased out if your Modified Adjusted Gross Income is between $100,000 and $150,000.

Active income earners are able to utilize more tax deductions and credits, which effectively lower their taxable income. Additionally, passive income is more frequently subject to the 3.8% Net Investment Income Tax (NIIT).

The plus side for passive income earners is that passive income is not subject to self-employment tax.

Opportunity for Passive Tax Loss Harvesting

A major advantage for passive income earners is that passive losses incurred in previous years from other investment activities can now be deducted against your passive income. Passive losses can only be deducted against passive (not active) income, and they carry forward indefinitely as long as you still hold the investment in which the loss occurred. So, the transition to a passive role unlocks the opportunity to do some tax loss harvesting.

From an Advisory Standpoint

Taking a passive role in a business can be a welcome opportunity for an owner who wants to turn attention to the long-term health and success of the company before taking the step toward final exit. The ability to focus on strategic issues and feel good about how the company is positioned when it is time to sell can help an owner feel that they are leaving a legacy.

But it’s important to understand the end game and tailor your activity and involvement with the business to secure your investment and make sure the business thrives.

One factor to consider is whether the current entity structure of the business should be changed. It may benefit from better tax treatment if it were switched from a C corporation to S corporation, or another structure. A tax professional can help you run scenarios that would guide this discussion.

The point of examining a potential entity structure change is to align the company with your goals for ultimately selling it, either to a third party or to an internal management group.

That may entail identifying who will own the business eventually. If it will be bought by a group of current key managers and employees, are they prepared? Your role as a passive participant will include asking the right questions:

  • Are the right people in the right roles?
  • Is there enough time during your planned passive participation to allow those individuals to grow into their new roles?
  • Would it be wise to hire a leader to help mentor and guide the company for two to three years and help prepare it for the transition? This would help you protect your passive status with the IRS.

From a personal standpoint, you have some planning to do, as well. What will you do in retirement? How will you spend your time? And have you reviewed your estate plan recently? Estate plans should be reviewed and possibly amended any time you experience a major life event, such as retirement.

Questions?

Transitioning from an active to passive role can help you prepare business – and yourself – for your eventual exit and retirement. As you do this, it’s important to understand the IRS rules that govern taxation of passive income. It’s also important to establish goals for what you want to accomplish as you turn your attention to preparing your business and management team for your ultimate exit.

If you would like to discuss potentially entering a passive role with your business, contact an Adams Brown advisor.