Passive v. Active – Categorization of Investment Tax Credit

Investment tax credit rules are complex, particularly when it comes to active and passive categorization. That being said, we share the following scenarios with regard to a member of a limited liability company.

When an investment tax credit is issued to a member of a limited liability company, the credit adopts the same status that the member holds in the entity. So, if a member is an active member and materially participates in the activity, the investment tax credit that the member receives will be considered an active credit. This means that the member will be able to utilize the credit against their non-passive income such as wages and self-employment earnings.

But what happens when that member of the entity no longer materially participates in the activity and becomes a passive member? Based on the passive activity rules, that member’s income or loss will now become passive moving forward. However, another item that should be addressed with this status change is investment tax credits received during their previously active period. Do the credits remain as active or are they reevaluated each year for their eligibility and potentially reclassified as passive?

Future Categorization

In order to determine the future categorization of the credit, the rules regulating passive activity losses need to be reviewed. They state that in order to determine whether a credit is subject to passive activity credit rules, the activity that it relates to needs to be determined to be passive or active for the particular tax year that the credit is received.

The material participation tests used to determine active member status should be used to determine whether a member is active or passive in an activity for a specific year. Members need to surpass multiple hurdles relating to their undertakings within the entity in order to be classified as non-passive, with one of them referencing how many of the last 10 preceding years they have been active. It is important to note that members cannot just switch from being passive to active each year due to this hurdle, but can easily move from an active to passive member.

Under the passive activity credit rules of Reg. Sec. 469, it can be understood that a credit will be a passive credit only if it is categorized as so in the year in which the credit arises. Regulation Section 1.469-3(e) states that the status of the credit as passive will be determined in the year in which the credit becomes available to take. Therefore, if a member is active in the year in which the investment tax credit is received, the credit will remain as an active credit even though the member no longer materially participates in the activity. The previously referenced section of the regulations also notes that the limitations of passive activity credits applies before all other limitations that could be applied to tax credits, which can be interpreted to mean that once a credit has passed through Sec. 469, it is now available to be utilized as any other credit would be.

In the example of a member going from active to passive, the investment tax credit received during their active years never touched Sec. 469, therefore meaning it completely bypasses those rules entirely in its lifetime. If the taxpayer had sufficient tax liability during year one to completely utilize the credit, then there would be no further issues relating to passive activity loss rules on claiming the credit.


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