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Planning to transition the ownership and management of a business from the retiring “boomer” generation to the next generation presents challenging business, tax and other legal issues.

One issue in structuring this transition is how a retiring business owner can “materially participate,” and therefore be considered active in the business for tax purposes, after he has transitioned the business to his children.

A taxpayer who is active in a business can take advantage of several tax planning techniques, such as reducing the Net Investment Income (“NII”) tax on S corporation profits.

But, can a taxpayer who has moved to Florida remain active in an Ohio manufacturing operation? A tax court case recently explored this issue.

You may recall that the NII tax is a 3.8% tax on investment income to the extent that the taxpayer's adjusted gross income (with some modifications) exceeds $250,000 (for married couples filing jointly).

“Investment income” for purposes of the NII tax includes allocations of business income from S corporations, but only if the owner is not active in the business.

Historically, taxpayers have tried to qualify as active in their businesses to avoid the limitations on offsetting other types of income with losses allocated from their businesses.

The imposition of the NII tax now makes it important to qualify as active even when the company is profitable.

In the tax court case, a father transitioned management of two S corporations (in which he and his wife continued to own a significant interest) to his son.

He continued to periodically visit the facilities and call on customers, even though he had moved to Florida.

The companies began struggling on account of a variety of factors. The father therefore made additional trips to the facilities to boost employee morale, secured additional financing and increased his research and development activity, ultimately developing a new product.

He asserted that this level of activity met the “material participation” standard, and that he should be able to deduct over $3 million in losses allocated to him from the business.

There are a number of tests that taxpayers can use to satisfy the “material participation” standard. The most common test that many are familiar with is where the taxpayer participates in the activity for more than 500 hours during the year.

Normally a “retired” business owner would expect (as did the father) to spend less time than that in the business.

Other tests for meeting the material participation test typically cannot be satisfied if the business is run by someone else on a full-time basis.

In this case, however, the tax court focused on another test — the “regular and continuous” test, where the taxpayer participates in the activity on a regular, continuous and substantial basis during the year, for at least 100 hours.

The difficulty in meeting this test in most cases is that “management activities” do not count toward the 100-hour threshold if the business is being managed by someone else.

In this case, although his son was managing the businesses, the father's activities were geared more toward product development and securing financing, allowing him to argue that he met the 100-hour test.

It is understandable that the IRS equated a move to Florida with the absence of active participation. The tax court disagreed, and found that the father's efforts were “regular and continuous,” and that he did spend more than 100 hours participating in the companies' activities during the year.

Even though actual management of the companies had been turned over to his son, this fact did not preclude the father from meeting the material participation test based on his non-management activities.

There is nothing in the tax court's opinion to suggest that a semi-retired business owner needs to save a financially struggling company or invent new products in order to meet this material participation test.

Rather, material participation is measured by more than 100 hours of regular, continuous non-management activities.

This case illustrates that it is possible to step down from having primary responsibility for running a business but still be considered active in that business for tax purposes, even after “retiring” to Florida.

It also illustrates that the question of “material participation” depends on the facts and circumstances of a particular case.

If material participation will be a key issue in determining whether an owner will be able to exempt business income from the NII tax, business activities should be carefully planned and documented in a way that is consistent with the material participation rules.