New Restrictions on Passive Income Generators

By Thomas M. Dalton and James M. Luckey

In final regulations issued in 1994, the IRS reversed its position and held that rental income from closely held C corporations was to be treated as nonpassive income. This creates a problem for taxpayers with passive losses in not only planning for the future, but also in determining what to do with returns prepared based on the previous policy contained in temporary regulations.

The Treasury created a dilemma for many tax advisors when it flip-flopped on an important position in recently finalized passive loss regulations. Taxpayers who were confidently creating passive activity income by renting property to their closely held C corporations suddenly found their passive income generator (PIG) had become a pig in a poke when the Treasury reversed its position in October 1994 and declared the income to be nonpassive. Worse, bewildered tax advisors are left wondering whether the new rule or the old rule applies to 1992, 1993, and 1994 tax returns. At the least, tax advisors must scramble to restructure their client's rental arrangements to cope with the loss of passive activity income in the future.

The Self-Rental PIG

Tax advisors have been looking for ways to create passive income since 1987 when the passive loss rules went into effect. Simply put, the passive loss rules allow losses from so-called passive activities to be deducted only against income from passive activities, i.e., if a taxpayer does not have passive income, the taxpayer cannot deduct any passive losses. Passive activities generally include any trade or business in which the taxpayer does not materially participate and generally any rental activity [IRC Sec. 469(c)].

Tax advisors of clients with substantial passive losses have been very creative in devising ways for their clients to generate passive income. One common method is to have taxpayers rent property to their own closely held corporation. Since rental activities are automatically passive, any rental income from the arrangement can offset passive losses from the shareholder's other passive activities.

Example: A family owns an apartment complex and a manufacturing company that is a C corporation. The apartment complex generates losses for the family. These losses are passive under IRC Sec. 469(c). The apartment rental losses are unusable unless the family can generate income from a passive activity. The family has the building used in manufacturing transferred to them personally and then rents it to the corporation. If rents paid by the corporation can be set so that the family realizes net rental income from the arrangement, several benefits accrue to the family. If the rental arrangement is considered a passive activity, passive income is generated and the family can now deduct the passive losses from the apartment complex against this income. In addition, the family avoids double tax on corporate income by removing profits from the corporation in the form of rents.

The Flip Flop

The above example illustrates a method that worked admirably until October 1994 when the Treasury finalized its proposed passive loss regulations. In the final regulations, the Treasury (without comment) changed its position that self-rental income from C corporations would be passive. The Treasury had always prohibited taxpayers from generating passive income by renting property to their own passthrough entities such as partnerships or S corporations in which they materially participate. However, it did not prohibit taxpayers from generating passive income by renting property to their own C corporations or personal service corporations (PSCs). Under expired Temp. Reg. Sec. 1.469-4T(b)(2)(ii)(B), a taxpayer's activity conducted through a nonpassthrough entity, such as a C corporation, was not an activity for purposes of IRC Sec. 469 and could not cause the rental income to be nonpassive. It is through the authority of this temporary regulation that taxpayers have used rental agreements with their closely held C corporations and PSCs to create an oasis of passive income.

The temporary regulations that made this possible expired on May 11, 1992. They were replaced by Prop. Reg. Sec. 1.469-4 issued on May 15, 1992. The proposed regulation made no mention of the special rule for C corporations and PSCs. Tax advisors naturally assumed it was business as usual (even though the proposed regulation was silent on the issue) and continued to structure rental arrangements between owners and their C corporations and PSCs. The proposed regulation was finalized and adopted on October 3, 1994. Without an announcement of a change in position, however, the final regulation contained a statement that taxpayers' activities include those conducted through C corporations as well as S corporations and partnerships [Reg. 1.469-4(a)]. This means owners of closely held C corporations and PSCs in which the owners materially participate can no longer generate passive income by renting property to these entities.

The Quandary

Losing the ability to generate passive income through C corporations and PSCs is unfortunate. The problem is compounded, however, because the final regulation is retroactively effective for tax years ending after May 10, 1992 [Reg. Sec. 1.469-11(a)(1)]. A transitional rule allows taxpayers to rely on the proposed regulation for years ending after May 10, 1992, and beginning before October 4, 1994. The transitional rule also allows taxpayers to treat years beginning before May 10, 1992, under the old self-rental rule [Reg. Sec. 1.469-11(b)(2)(I)]. This leaves tax advisors in a quandary over the 1993 and 1994 tax years. Since the proposed regulation was silent regarding rental income generated from C corporations and PSCs, which rule applies for those years if the taxpayer follows the proposed regulation‹the rule of the temporary regulations or the rule of the final regulation? The temporary regulations allowed a taxpayer to generate passive activity income by renting property to his or her own C corporation or PSC while the final regulation does not. Should a tax advisor recommend amended returns for previously filed returns? Further, if the taxpayer decides to follow the rule of the temporary regulations and treat self-rental income as passive on an unfiled 1994 tax return, is there substantial authority for the position so that the understatement of tax penalty mandated by IRC Sec. 6662 can be avoided, or must the position be disclosed on the tax return to avoid the penalty?

The Treasury's Policy

The authors recently asked a Treasury official whether the new rule was intended to apply to 1992, 1993, and 1994 under the proposed regulation. The official stated the Treasury would apply the new rule to 1993 and 1994, but not 1992. According to the official, the Treasury did not change its position when the proposed regulations were finalized but had merely responded to taxpayer comments by making the final regulation explicit on the issue. He contended the Treasury's policy since 1989 has been to prevent taxpayers from creating passive activity income using self-rentals to C corporations and PSCs. The Treasury was prevented from implementing its policy until 1993 only because the temporary regulations had not yet expired. Acknowledging the policy of applying the new rule to 1993 and 1994 has not yet been formally announced, he said taxpayers should expect a revenue ruling on the issue.

The Treasury's policy was foreshadowed when the IRS released a Market Segment Specialization Program Paper (MSSP) on passive activity losses on April 25, 1994. The MSSP directed agents to treat rental income of materially participating shareholders from closely held C corporations and PSCs as nonpassive income for years beginning after May 11, 1992.

Substantial Authority?

The Treasury has power under IRC Sec. 7805(b) to retroactively apply regulations. Although temporary regulations (until withdrawn or replaced) and final regulations have equal authority, proposed regulations have little force or effect. Prop. Reg Sec. 1.469-4, however, has been given authority by virtue of the transitional rule contained in the final regulation. Following the proposed regulation for 1993 and 1994 leaves the taxpayer with an expired temporary regulation allowing passive income generation by a shareholder renting property to a closely held C corporation, followed immediately by an equally authoritative proposed regulation that is silent on the issue.

It seems reasonable to conclude from this analysis that taxpayers should be able to treat income from property rented to their closely held C corporations or PSCs as passive income during 1992, 1993, and 1994. Unfortunately, the stated Treasury policy of retroactively applying the new rule and the MSSP issued to agents instructing them to retroactively apply the new rule puts taxpayers in danger for at least the 1993 and 1994 tax years. However, the new rule contained in the final regulations was, in fact, a complete reversal of the old rule with no public notification prior to the change. The MSSP was not public notification, and no matter how long the Treasury debated the issue internally, no other public announcement of the policy change was made until the final regulations were issued.

Help from the Courts

The courts provide some hope for taxpayers. Taxpayers have been upheld occasionally when they relied on proposed regulations as opposed to differing final regulations. The Court of Claims, in American Standard, Inc., (79-5 USTC 9417), held that final Reg. Sec. 1.1502-25© was invalid because it violated the notice requirements of the Administration Procedure Act (APA). The APA requires any Federal agency, including the IRS, to publish substantive rules in proposed form 30 days prior to adoption to give interested persons an opportunity to comment. In the Court's opinion, the notice requirement was violated in American Standard, Inc. because the final regulation described the calculation of a deduction under IRC Sec. 992 differently than the proposed regulation. Similarly, the Tax Court, in Paul Elkins, (81 TC 669) ruled the IRS cannot impose differing final regulations on a taxpayer who has relied on the proposed regulations to his detriment.

Transitional Rule

Taxpayers lucky enough to have a binding contract created before February 19, 1988, governing their property rentals to their closely held corporation may benefit from the transitional rule of Reg. Sec. 1.469-11(c)(1)(ii). This rule allows the shareholder to disregard the new rule (for rentals under the binding contract) and treat the net rental income as passive.

Needed: A Plan for the Future

Whatever advisors conclude about the transitional period, they must cope with the final regulations for 1995 and beyond. Tax advisors should consider several ideas when attempting to adjust to the new rule.

Exceptions. A taxpayer with adjusted gross income of less than $100,000 can still deduct up to $25,000 of losses from actively managed rental real estate even without passive activity income. Taxpayers not taking advantage of this provision already may wish to restructure their passive investments to fit within the provision's requirements.

Restructuring. Taxpayers could restructure their passive loss activities to reduce their total passive losses. Materially participating in nonrental activities could remove their passive character. Unused passive losses could be released by selling the activity. The unused losses could then be used against nonpassive income. Rental activities could be contributed to the corporation owned by the taxpayer so that income and losses could be offset within the corporation.

Aggregation. Advisors should review the final regulations to see if passive income and loss generators could be aggregated into one activity under the facts and circumstances test. The final regulations are much less complex than the now expired temporary regulations. The factors given the greatest weight under the final regulations in determining whether activities constitute an appropriate economic unit are 1) similarities and differences in types of business, 2) the extent of common control, 3) extent of common ownership, 4) geographical location, and 5) interdependencies between the activities [Reg. Sec. 1.469-4(c)(2)]. A client's activities may qualify for aggregation under the present rules.

Avoiding Material Participation. It may be possible for the taxpayer to avoid material participation in his or her own C corporation. If the shareholder does not materially participate in the business, the rental income will retain its passive character to the shareholder. Avoiding material participation may be difficult in a closely held corporation, however, and this approach may be more appropriate when the shareholder is nearing retirement and is turning over the operation of the corporation to nonshareholder children. *

Thomas M. Dalton, PhD, CPA, is an assistant professor at the University of San Diego. James M. Luckey, CPA, is a senior tax manager at the San Diego office of Deloitte & Touche LLP.

JANUARY 1996 / THE CPA JOURNAL