Opportunities and planning - passive activity regulations.by Talwar, Akshay K.
Tax Reform Act 86 dealt a severe blow to taxpayers who had tax shelter investments designed to produce tax losses (and credits) with which to offset compensation, business and portfolio income. Sec. 469 as enacted by TRA 86 was modified by both the Revenue Act of 1987 (RA 87) and the Technical and Miscellaneous Revenue Act of 1988 (TAMRA).
The new Passive Activity Loss Rules (PALs) of Sec. 469 have spawned a massive volume of regulations which are, as this article is written, incomplete. The "activity regulations" (ARs) issued in May 1989 alone run to almost 200 pages.
Importance of Defining an
Passive activity losses and credits are required to be accounted for on an activity by activity basis. To the extent that passive activity losses exceed the passive activity income and gains of a year, the excess--the PAL--must be allocated ratably to the activities that contribute to the gross PAL. As thus allocated, these losses are called suspended losses that can only be offset by income or gain in a subsequent year. Only on disposition of the taxpayer's entire interest in the activity is any remaining suspended loss available to reduce the taxpayer's other income--i.e., compensation, business, or portfolio income.
Furthermore, except in the case of rental activities which are considered to be inherently passive, the participation of the taxpayer in each activity is determined separately. Rental activities are segregated from trade or business activities and are dealt with later in this article.
The degree of active participation or involvement in a business can result in avoiding the passive activity stigma or, in the case of active participation in rental real estate activity, permit limited relief.
For purposes of the phase-in rules which apply to pre-enactment activities (i.e., before October 23, 1986), the 20% allowance in 1989 and the 10% in 1990 is determined separately for each pre-enactment activity.
Building Block Approach
The ARs--Temp. Reg. Sec. 1.469-4T--employ a building block approach in delineating an activity. There are three primary rules defining an activity, namely:
* The undertaking rules;
* The aggregation rules; and
* The special rules.
The smallest unit is an "undertaking." Temp. Reg. Sec. 1.469- 4T(a)(2). It is defined generally as "all operations of the same owner at a single location." Under this rule, an owner includes a pass-thru entity (PTE), i.e., a partnership, S Corporation, estate or trust; but only direct ownership is recognized. Different trades or businesses will ordinarily be aggregated so as to constitute one undertaking. Business and rental operations are at the same location if they are within the same physical structure or within close proximity of each other.
Illustrations 1 through 4 exemplify the concept of an undertaking as well as the distinguishing factors that result in certain apparently different units being treated as a single undertaking while others are treated as separate undertakings.
Mixed Business and Rental
Although rental business activities must generally be kept apart and cannot be part of an undertaking, there is an exception in which the rental activity is ancillary to the nonrental business activity or vice versa. Under an 80/20 rule, the smaller is considered part of the larger activity.
Example 1. Baker owns an 11 story commercial building in which he has a retail department store. The upper two floors, serviced by separate elevators, are rented to commercial and professional tenants. The gross income of the store exceeds significantly the gross rental income. Since the store dominates the "source of income," there is only one undertaking, the nonrental department store business which includes the rentals.
Example 2. Charlie owns an office block--a rental real estate operation. The basement parking facilities are available to tenants and the general public on a time basis. Even taking into account monthly parking rentals by tenants, the average rent period is less than two days. Under these circumstances the parking is not considered a rental activity--because the average customer use is less than seven days. It is a business activity which is ancillary to the rental activity since the parking accounts for less than 20% of the gross income of both activities.
Mandatory Aggregation for
Nonrental Business Undertakings
Temp. Reg. Sec. 1.469-4T(g)(2) requires the aggregation into a single activity of a taxpayer's interest in two or more trade or business undertakings which might ordinarily be separate undertakings. A trade or business undertaking by definition does not include a rental undertaking, an oil or gas undertaking or a professional service undertaking. Each of these excluded activities has its own separate rules.
Requirements for Mandatory
All of the following three requirements must be met for aggregation:
* Requisite ownership and/or participation;
* Similarity of business; and
* Commonality of control.
Ownership and/or Participation
The ownership requirement for aggregation is met if the taxpayer owns, either directly or through a substantial interest in a PTE, two or more undertakings. A more than 10% interest in a PTE is a substantial interest.
Example 3. David owns all the stock of three S Corporations, each conducting a liquor store. The liquor stores are located respectively in three adjoining towns. The ownership requirement is met. If, instead of ownership through PTEs, David owned each as a sole proprietor, the ownership requirement would also have been met. Similarly, if David owned less than all of the stock, the ownership requirement would have been met provided that his interest was substantial, i.e., more than 10%.
It should be noted that the attribution rules of Secs. 267 and 707 are applied in computing the degree of ownership. In the case of a partnership, the largest percentage interest by value in the capital or the greatest distributive share of any item of income or gain other than any guaranteed payment, meets the requirements.
The participation requirement is met if a taxpayer owns a less than substantial interest but participates in one or more of the undertakings for more than 100 hours (significant participation) let alone more than 500 hours (material participation).
Example 4. Eileen has a less than 10% interest in four S Corporations each operating a ladies' boutique. The participation requirement would be met under all of the following conditions:
* She participates in each of the four for 40 hours--over 100 hours is significant participation.
* She participates in each for 130 hours--over 500 hours is material participation.
* She participates in two of the four for 90 hours each--over 100 hours is significant participation. She has satisfied the participation test for all four investments.
In examples (3) and (4), the similarity requirement was met since the lines of business were, respectively, liquor stores and ladies' boutiques. Rev. Proc. 89-38 recognizes 79 distinct--and not so distinct--lines of business. Agriculture, for instance, is one line of business without regard to what is grown. With the exception of the separate category of "Motels and Lodging Places," nonrental real estate undertakings are a single line of business.
Whether two commonly controlled undertakings are engaged in the same line of business is a question of fact. Temp. Reg. Sec. 1.469- 4T(f)(4)(i) provides that horizontal undertakings are considered similar if there are predominant operations in each undertaking and they are in the same line of business.
Similarity is also found for vertically integrated undertakings. Accordingly, supplier and recipient are similar if commonly controlled and the business relationship exceeds 50%, i.e., more than 50% of the value of sales or production goes to the commonly controlled recipient or if the recipient gets more than 50% from the commonly controlled suppliers.
Actuality of control, whether direct or indirect and whether or not enforceable and however exercised, is determinative. This is buttressed by a mechanical test under which two or more undertakings are considered commonly controlled unless the contrary is established.
The mechanical test is based on the combined group definition of Sec. 1563. Control is presumed if five or fewer individuals, estates or trusts, taking into account only their lowest common interest, own more than 50% in two or more PTEs.
Is Mandatory Aggregation
Favorable or Unfavorable?
The answer depends on the facts and circumstances of each situation. In general, aggregation will, in many instances, lead to material participation and, thereby render the PAL rules inapplicable.
But who spends 500-plus hours to incur a loss? Presumably such undertakings are intended to be profitable. Loss undertakings with these large investments of time do not represent the profile one expects to find in a tax shelter. Even 100-plus hours of participation is unlikely for the pleasure of incurring a loss. That is why significant participation is a "heads you win, tails I lose" proposition, since losses are passive and profits active. By aggregating the 40 hours of participation in four S Corporations engaged in ladies' boutiques, Eileen's otherwise passive income--if there had been no aggregation--is turned into active income unavailable for use against other passive losses. (See example 4.)
What would have been freely available suspended losses because of the disposition of an entire interest in one of the aggregated undertakings would remain suspended if that undertaking had been aggregated with others into a single activity. However, a special election (to be made on the return for the year ending after August 9, 1989) puts taxpayers in substantially the same position had there been no mandatory aggregation Temp. Reg. Sec.1.469-4T(o) (i). For purposes of the disposition of an entire interest, the aggregation of the constituent undertakings is disregarded.
Temp. Reg. Sec.1.469-4T(g)(3), the so-called super aggregation provision, sets out 12 criteria to be considered in determining whether, under the facts and circumstances, two or more trade or business undertakings are a single integrated business activity. Those seeking to escape the PAL rules might well start with the super aggregation rules. Although the rules may have been designed to enable the IRS to apply the PAL rules where the specific rules are not satisfied, it would seem that taxpayers may, when it suits their purposes, use the same tactics to thwart IRS attempts to apply specific rules. Under the super aggregation rules, even different lines of business can be aggregated into a single activity.
Aggregation of Personal
Personal service undertakings (i.e., those engaged in deriving more than 50% of their income in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting) are subject to mandatory aggregation if controlled by the same interests. Should the control test not be satisfied, the personal service undertakings may nonetheless be aggregated if the professional services are significantly similar or related. Such aggregated professional service undertakings can again be subject to further aggregation under the control or similar service rules.
To be considered significantly similar, it is enough if each professional service undertaking provides services similar to the services provided by the others. For example, different types of law practices constitute legal services and the fact that one undertaking is primarily, or even exclusively, engaged in criminal law while the other in corporate, or tax law, does not matter. All provide legal services. Whether the services are significant is based on the gross income derived from the professional services. More than 20% is the watershed that separates undertakings. Under this 80/20 rule, the dominant operation absorbs the insignificant.
Example 5. Fran is a law partner in both the New York and Washington partnerships engaged, respectively, in corporate and patent law. If the two partnerships are under common control--the five or fewer owning more than 50% test--there is a single professional service activity. Note that by virtue of geography, there are two undertakings, but because of common control and similarity, they are required to be aggregated.
Had there not been common control, the partners in the several partnerships would nonetheless have had to aggregate their individual interests because each partnership derives its income from the practice of law.
Personal Service Undertakings
Not Most Favored
Personal service undertakings are pariahs under our tax laws. To prevent the conversion of what for many years was active income into passive income--available to be offset by passive losses--retirees from partnerships must account for their retirement income (the guaranteed payment) as active income, despite their retirement and consequent lack of material participation. Material participation in any five out of the preceding 10 years treats income from any activity involving a trade or business as active income. In the case of a personal service activity, the active income characterization is even harsher. Material participation in any three years, whether or not consecutive, suffices for characterization of income as active.
Under the mandatory aggregation rules even harsher results are obtained as the following example illustrates.
Example 6. George took early retirement from the accounting partnership, A, where he had been a partner for more than 10 years. Subsequently, he joined accounting partnership B for a two-year stint. For George both A and B partnerships are considered part of a single activity. The three year professional service participation rule recharacterizes George's retirement income from B as active.
Election to Treat Business
Undertakings as Separate
Activities for Purpose of
Applying the Disposition
As previously noted, an election is available to treat each undertaking which has been aggregated as a separate activity for purposes of complete dispositions. The election must be made in the later of the year in which such aggregation is required or in the first taxable year ending after August 8, 1989. It seems that such an election could also be made on an amended return. Some observers consider that the need to elect the separate use of a suspended loss attributable to an aggregated undertaking as a trap for the unwary. Accordingly, those observers feel that the regulations should be changed to require an election to aggregate for purposes of dispositions, rather than for separate treatment, as is now the case.
Consider the following simple example:
Example 7. Harry owns three movie houses in three different locations. These three undertakings have to be aggregated into a single activity. The logic of the special election is not difficult to understand. Should Harry sell one movie house he would not be allowed to use any suspended loss from the aggregated undertakings since he did not dispose of his entire interest in the activity. This logic is impaired as Harry now knows precisely the loss, if any, sustained and not yet recovered with respect to the movie house that was sold. Relief is provided by the election under which each movie house is treated as a separate activity, but only for purpose of the disposition rules. The election is disregarded for purpose of measuring participation.
Taxpayers with interests through a PTE must follow the position adopted by the PTE. In other words, only the PTE can make the election.
The form of the election is by way of a written statement attached to the return for the year for which the election is to be made. Illustration 5 provides a sample election based on Example 3.
Personal Property Rental
While rental real estate undertakings can be freely aggregated or kept separate, personal property rental undertakings cannot be aggregated at the whim of the taxpayer. This restriction does not apply if the personal property rentals are regarded as the carrying on of an active trade or business; this would be the case in, for example, the renting of tuxedos, videos and bicycles. Rentals of property for an average of seven days or less is not considered a rental activity.
Rental Real Estate
Rental real estate undertakings enjoy favored tax status even under the PAL rules. Such undertakings can be aggregated or kept separate as best suits the taxpayer. A rental real estate undertaking exists only if at least 85% of the unadjusted basis of rental property is real property.
To Aggregate or Refrain from
Aggregation of Real Estate
Treatment of rental real estate undertakings as either a single or as aggregate activities is made without regard to similarity or commonality of control. However, taxpayers whose interest is through a PTE are bound by the treatment elected by the PTE.
Temp. Reg. Sec. 1.469-4T(k)(2)(iii) allows a taxpayer to split up a single undertaking engaged in leasing real property, provided that under applicable law such interests can be conveyed separately. This provision permits owners of condo or cooperative housing units to utilize their suspended losses on a unit by unit basis rather than wait until they have disposed of their entire interest in the single real estate rental undertaking. Co-op developers can also benefit from this provision.
Consistency Between Years
Although taxpayers are at liberty to aggregate or separate rental real estate activities in any manner they choose, they must do so on the return on which such real estate is first reported. The consistency rules of Temp. Reg. Sec. 1.469-4T(k)(3) deny any change in grouping for subsequent years. A special rule permits a change to be made on the return for the first taxable year ending after August 9, 1989, from the grouping in prior years. The consistency rules ensure that taxpayers adhere to their original concept of what is a proper grouping in their particular case. Thus is ex post facto tax planning thwarted. However, it seems that a change can be made as long as the statute of limitations for the year of acquisition or the year the PAL rules first apply is not closed. A review of 1987 and 1988 returns in which there was a disposition should be considered if a change in grouping could produce better results.
Since activity guidance was only provided in May 1989, there are transitional rules that provide acceptance of any "reasonable method" the taxpayers may have chosen in defining an activity for years ending before August 10, 1989. Among reasonable methods are the rules applicable to years ending after August 9, 1989. Thus a taxpayer need not file an amended return if his or her method of determining what constitutes an activity for pre-August 10, 1989 years is inconsistent with the provisions of Temp. Reg. Sec. 1.469-4T. However, such a taxpayer must, for years ending after August 9, 1989, change to a permitted method under the ARs.
An amended return should be considered when the adoption of current rules for pre-August 10, 1989 years relating to what constitutes an activity is advantageous.
Aggregating Rental Real Estate
Generally, in rental real estate it is advantageous to fragment a taxpayer's holdings into as many activities as possible. The reason for this is that on disposition suspended losses are liberated for use against other income--compensation, business and portfolio income. This has to be weighed against the inconvenience of additional record keeping associated therewith. Although beyond the scope of this article, it should be noted that in the case of publicly traded partnerships aggregation rather than segregation will generally be preferable.
One note of caution--the rules that permit aggregation or fragmentation apply only if the unadjusted basis of the real estate rental property that is subject to depreciation is at least 30% of the unadjusted basis of the activity. However, in some situations, through aggregation the combined unadjusted basis of depreciable real estate can be brought to exceed 30%.
The PAL activity regulations are complex, perhaps exceedingly so. If properly used, one can mitigate the intended harsh consequences. For trade and business situations, the aggregation rules will separate the significantly, and thus possibly the materially, participating business taxpayers from passive investors. Vertical integration rules will prevent passive losses from being kept apart from active business profits.
In real estate situations, under the 80/20 rule, the rental of excess floor space by a business will permit rental losses to be treated as part of the active trade utilizing the bulk of the available floor space. Further, by fragmentation of rental real estate undertakings, taxpayers can utilize suspended losses when they dispose their real estate investments.
Ernest Gans, MBA, CPA, is Chairman of the Department of Accounting, Taxation and Law at the Brooklyn Campus of Long Island University. He is a member of the AICPA, the NYSSCPA, has served on a number of technical committees of the NYSSCPA, and has published articles in several professional publications.
Akshay K. Talwar, JD, LLM, CPA, is an Associate Professor of Accounting and Taxation and a member of the graduate faculty of Baruch College, as well as a consultant. He is Technical Editor, Taxes of The CPA Journal, Chairman of the Tax Education Committee and a member of the AICPA, NYSSCPA, ABA, and NYSBA. Mr. Talwar has written articles for many accounting and other journals.
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