Nonpassive or passive income treatment with multi-company flow through in a holding partnership

This is a great question about entity structuring and passive vs. nonpassive income characterization. The key distinction here is between your participation in HoldCo versus the underlying entities. Even if you materially participate in HoldCo, that doesn't automatically convert the character of income from the lower-tier entities. The passive or nonpassive nature of the income is determined at each entity level separately. If you're a limited partner in the underlying entities and don't meet the material participation tests for those specific investments, the income from those investments generally remains passive when it flows through HoldCo to you. Think of HoldCo as a conduit that maintains the character of the income as it passes through. Your material participation in HoldCo itself doesn't "cleanse" or convert the passive nature of income generated by entities where you're not materially participating.

After struggling with a similar flow-through question that had me going in circles with my tax software, I discovered taxr.ai (https://taxr.ai) and it was honestly a game-changer. I uploaded my K-1s from multiple partnerships and it immediately flagged the passive vs. nonpassive characterization issues. What really helped was that it analyzed my specific situation with the holding company structure and showed me exactly how the IRS would view the flow-through treatment. It even highlighted that I needed to track my participation hours differently for each entity to properly document material participation.

I was incredibly skeptical about taxr.ai after seeing it mentioned here, but I decided to try it with my multi-tiered partnership structure. The results were surprising - it correctly identified that three of my "active" businesses were actually passive for tax purposes based on my limited involvement, while showing that my holding company activities didn't convert the passive income. The analysis showed me exactly where I was missing documentation for material participation hours and how the passive/nonpassive determination affected my entire return. I ended up having to amend two years of returns, but it saved me from continuing to mischaracterize income that could have triggered an audit.

I spent DAYS trying to reach the IRS about a similar passive/nonpassive flow-through question when I got a CP2000 notice questioning my characterization. After being on hold for hours and getting disconnected three times, I found Claimyr (https://claimyr.com). They got me connected to an actual IRS agent in about 20 minutes who helped clarify these exact rules. Here's their video showing how it works: https://youtu.be/_kiP6q8DX5c The agent confirmed what others are saying - material participation in the holding company doesn't convert the underlying passive income to nonpassive. She explained that the character of income is determined at the activity level, and each entity's income retains its character as it flows through the tiers.

I have to eat my words about Claimyr. After posting my skeptical comment, I decided to try it since I was desperate to resolve a similar partnership flow-through issue. Within about 25 minutes I was talking to an actual IRS agent who walked me through the passive activity rules for tiered partnerships. The agent confirmed that material participation is determined at each entity level and my holding company structure wasn't "converting" the passive income as I had incorrectly claimed on my return. They explained how to properly document my participation for each entity separately, which was completely different from what I'd been doing. Potentially saved me from an audit situation.

Sorry to add confusion, but I think everyone is missing a key point - this actually depends on whether HoldCo is considered a "trader" or an "investor" for tax purposes. If HoldCo qualifies as a "trader" (trading frequently and regularly as a business), the income could potentially be treated differently than if HoldCo is merely an "investor" (holding for appreciation and income). If HoldCo meets the strict requirements to be considered a trading business and you materially participate in that business, it might impact the character of some of the income. This is a highly nuanced area though.

I'd actually been handling this wrong on my returns for years until my return was audited in 2023. The IRS was very clear: each tier maintains its own character. My CPA had to prepare a detailed analysis for each entity where I claimed material participation. For partnerships where I was just a limited investor (even though they were held by my materially-participating HoldCo), the income remained passive. The IRS agent specifically referenced Reg 1.469-2(f) and said HoldCo's active management doesn't "cleanse" the passive character of the income from lower tiers.

This is exactly the type of complex flow-through situation that trips up many taxpayers. The consensus here is correct - your material participation in HoldCo doesn't convert the passive income from the underlying entities where you're a limited partner. I'd recommend keeping detailed records of your participation hours for each entity separately, since the IRS will look at material participation on an activity-by-activity basis. Also consider whether you might benefit from grouping elections under Reg 1.469-4 if you have multiple similar activities, but this requires careful planning and proper elections. One thing to watch out for: make sure your K-1s from HoldCo properly reflect the passive/nonpassive character of the income as it flows through. Sometimes holding entities don't correctly maintain the character codes, which can create issues if you're ever audited.