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Market Segment Specialization Program (MSSP)

Placer Mining Industry

Table of Contents


Chapter 5 - Passive Activities

A passive activity is defined as a trade or business, or activity conducted in anticipation of becoming a trade or business, in which the taxpayer does not materially participate. Passive activities are controlled by IRC section 469; those rules apply to individuals and estates, trusts, personal service corporations, and closely held C-Corporations with five or fewer individuals owning more than 50 percent in value of its outstanding stock anytime during the last half of the taxable year. A passive activity is a Schedule C or F activity with no material participation, a limited partner interest without more stringent material participation, and a rental (regardless of the level of participation).

Most of the returns examined will be for miners who are actually working a claim, and the basic concepts of passive activities should be addressed when interviewing the taxpayer to obtain information regarding the taxpayer's participation in the activity. Determine the approximate number of hours worked by the taxpayer. This figure can then be compared with that on the Affidavit of Annual Labor. If there is a substantial variance, it may be worthwhile to probe the issue in more depth.

Generally, the owner of the claim is the main person working the claim. However, check to see if the claim is leased. If this is the case, the lessee has the same rights as the owner. While most mining claims are worked by individuals, there will be times when a partnership or S-Corporation may be involved with the running of the operation. It is important to determine who actually handles the day-to-day operations, or who is actually materially participating in the activity. It is not uncommon for partners or shareholders to live out of state (lending credence to the fact that the activity may be passive to that individual). Be sure and check the EIN and compare it to the state in which the taxpayer resides. Limited partners are by Code presumed passive unless they pass the exception tests outlined in Treas. Reg. 1.469-5T(e)(2). If this type of return is examined, copies of the Forms K-1 should be obtained and examined. If it appears that the issue of material participation may be applicable, obtain an RTVUE and review the individual's return for possible examination. The glossary contains definitions of certain terms used in this section.

There are seven tests which can be applied to determine material participation. The taxpayer need only meet ONE of these tests to qualify. Pay particular attention to items 1 through 3. The seven tests are outlined below.

Material Participation

A trade or business activity is not a passive activity if the taxpayer materially participates in the activity. One materially participates in a trade or business activity for a tax year by satisfying one of the following tests.
  1. The taxpayer participates for more than 500 hours during the taxable year. In counting hours of participation, spouses' hours are added together. An individual's participation in an activity may be established by any reasonable means. Time reports and logs are not required. Treas. Reg. section 1.469-5T(f)(4).

     

  2. The taxpayer's participation is substantially all of the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.

     

  3. The taxpayer participated in the activity for more than 100 hours during the tax year, and he/she participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year.

     

  4. The activity is a Significant Participation Activity, (SPA) and the taxpayer's aggregate participation in all SPA's for the taxable year exceeds 500 hours. A significant participation activity is any trade or business activity in which the taxpayer participated for more than 100 hours during the year and in which the taxpayer did not materially participate under any of the material participation tests, other than this test.

     

  5. The taxpayer materially participated in the activity for any 5 (whether or not consecutive) of the 10 preceding years. When determining whether the taxpayer materially participated in tax years beginning before 1987 (other than a tax year of a partnership, S-Corporation, estate, or trust ending after 1986), the taxpayer materially participated only if he/she participated for more than 500 hours during the tax year.

     

  6. The activity is a personal service activity in which the taxpayer materially participated for any 3 (whether or not consecutive) preceding tax years. To determine material participation in tax years beginning before 1987 (other than a tax year of a partnership, S-Corporation, estate, or trust ending after 1986), the taxpayer materially participated only if he/she participated for more than 500 hours during the tax year.
    1. For the passive activity rules, a corporation is a personal service corporation if it meets all of the following requirements.
      1. It is a corporation (other than an S-Corporation).
      2. Its principal activity during the "testing period" is performing personal services. The testing period for any tax year is the previous tax year. If the corporation has just been formed, the testing period begins on the first day of its tax year and ends on the earlier of:
        1. the last day of its tax year, or
        2. the last day of the calendar year in which its tax year begins.
        3. The services in (2) must be substantially performed by employee-owners. This is met if more than 20 percent of the corporation's compensation cost for its activities of performing personal services during the tax year are for services performed by employee-owners, and
        4. Its employee-owners own more than 10 percent of the fair market value of its outstanding stock on the last day of the testing period.

       

    2. Personal services are those performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting.

       

    3. A person is an employee-owner of a personal service corporation if both of the following apply.
      1. He or she is an employee, or performs personal services for or on behalf of the corporation as an independent contractor, during any day of the testing period, and
      2. He or she owns directly or indirectly any stock in the corporation at any time during the testing period.

     

  7. The taxpayer's participation is regular, continuous, and substantial. The participation must be more than 100 hours per year and then it is a facts and circumstances determination. Treas. Reg. section 1.469-4(b)(1) defines trade or business activities as:

    * * * activities, other than rental activities [as defined in Treas. Reg. section 1.469-1T(e)(3)] or activities that are treated under Treas. Reg. section 1.469-1T(e)(3)(vi)(B) as incidental to an activity of holding property for investment, that-

    1. Involve the conduct of a trade or business (within the meaning of [IRC] section 162);
    2. Are conducted in anticipation of the commencement of a trade or business; or
    3. Involve research or experimental expenditures that are deductible under [IRC] section 174 (or would be deductible if the taxpayer adopted the method described in [IRC] section 174(a)).

Determination of material participation is crucial in determining whether the mining activity is passive or not. IRC section 469(h)(1) states: "* * *A taxpayer shall be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis which is: (A) regular, (B) continuous, and (C) substantial." See the seven tests for material participation discussed above.

Exploration and development expenditures for any given claim can only be deducted by the owner of the claim or by another when there has been an arrangement, such as a contract with a renter/lessee. Ownership or control can be verified by examining the documents pertaining to the claim in the Department of Natural Resources files. If the claim is leased or rented to another, the contract should be examined to determine the terms of the agreement. If there is a verbal contract, both parties should be queried to determine the facts.

If the claim is leased and the lessee has control of the operations, this would convert the claim to a rental activity for the owner and generally convert it to a passive activity. IRC section 469(c)(2) defines a passive activity as including any rental activity. Treas. Reg. section 1.469-1T(e)(3) further defines the concept of "rental activity". The owner/lessor would thus not be entitled to any expenses which would fall under IRC sections 616 or 617. The activity would not be allowed to be claimed on the Schedule C but would have to be filed on Schedule E and the appropriate passive loss schedules completed.

To determine if the mining activity for the individual is passive, begin with the ownership documents to verify the taxpayer's position. After ownership is established, examination of the Affidavits of Annual Labor should be pursued, if the taxpayer is required to file them. They describe how much work was done in terms of man-days, the dollar amounts, who actually did the work, and what type of work was done. The reports also give the dates the work was performed. The reporting period runs from September 1 thru September 1 of the following year, requiring the need to review 2 years of affidavits.

Often, the reports will reveal that the owner of the claim did not actually do the physical labor of working the claim. This standing alone would not immediately make the activity passive to the owner. Management of the activities, hiring the laborers, and filing the necessary documentation pertaining to the claim all must be considered in the determination of the participation by the owner. (Note: Treas. Reg. sections 1.469-5T(b)(2)(ii) and (f)(2) exclude certain types of participation from consideration.) This may be difficult to ascertain as there are no strict record-keeping requirements. Thus, obtaining information at the initial interview is critical. Third-party contacts with those individuals identified on the labor reports may also be helpful in determining the amount of participation on the part of the owner.

Remember, the Affidavits of Annual Labor are NOT verified by the Department of Natural Resources. This information must be used only as reference information. Audit comments should be made regarding the extent of reliance on the information.

The mining season for the small scale miner can be a short period during the spring and summer. This is due to the extreme weather conditions and the need for heavy duty equipment to work in the winter months. Larger operations have more resources and are better able to extend the period of operations. However, for the individual, this relatively shorter working season should be considered when making an analysis of the numbers of hours worked.

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Page Last Reviewed or Updated: 30-Aug-2012