It has been over 25 years since the last major overhaul of the tax code, but the Tax Reform Act of 1986 (’86 Act)1 continues to affect the manner in which taxpayers structure and conduct their business activities, particularly through the passive activity loss (PAL) rules introduced under Sec. 469.
In the years since this legislation was enacted, the Code has become more cumbersome, layered, and complex with many smaller bills that have added their own marks of differing sizes. Rather than accomplishing large-scale permanent reform, these bills have lately been very focused, addressing short-term revenue and expenditure goals, lasting for a precise number of years, and targeting specific populations and industries. In addition, regulations have expanded on some of the central aspects of the ’86 Act, and a quarter century of litigation, revenue rulings, and revenue procedures has added to the available interpretations, strategies, and considerations in arranging one’s affairs for tax purposes.
The interplay of specific components of recent and previously existing legislation provides opportunities for reducing tax exposure and the ability to avoid planning traps. This article addresses the specific interactions of Sec. 469 and its regulations with Rev. Proc. 2010-132 and the 2010 Health Care and Education Reconciliation Act (Health Care Act).3
Medicare Tax and Passive Activity Income
Congress enacted the Health Care Act and added Sec. 1411 to the Code partly in response to the perceived threat of unfunded future Medicare obligations. As a result, this section imposes a 3.8% Medicare tax on the lesser of net investment income or the excess of modified adjusted gross income over a specific threshold amount for individuals.4 Estates and trusts are assessed this additional tax on the lesser of undistributed net investment income or the excess of Sec. 67(e) adjusted gross income over the dollar amount at which the highest Sec. 1(e) tax bracket begins.5
The significant component of Sec. 1411 for this article’s purposes is its treatment of income from a trade or business that is a passive activity under Sec. 469 as “investment income.” This is a departure from the traditional definition of investment income, which usually includes interest, dividends, annuities, rents, royalties, and portfolio gains, and excludes trade or business income. It also presents a potentially costly side effect for passive activity owners. Awareness of this side effect should prompt a careful analysis of taxpayers’ activities and a thoughtful examination of whether these activities have been properly and optimally grouped. If a taxpayer has $300,000 of passive income but can group this with another activity and classify it as nonpassive, he or she has a potential tax savings of $11,400. Before addressing grouping considerations in addition to Sec. 1411 and in conjunction with Rev. Proc. 2010-13, it is useful to recap the passive activity loss rules in general, and Temp. Regs. Sec. 1.469-5T and Regs. Sec. 1.469-4 in particular.
Overview of Passive Activity Loss Rules
Sec. 469 was enacted under the ’86 Act to drastically reduce the prevalence of tax shelters. Many tax shelters at the time were partnerships that generated losses for investors who did not participate in the business. The investors would receive a share of the entity’s loss and use this to offset other income, including earned income. Sec. 469 limited the amount of losses from passive activities that could be recognized in a given year to the amount of income from passive activities, with any excess passive activity loss being suspended and carried forward to future tax years. This inhibited the ability of taxpayers to shelter their earned income by using losses from an entity in which they were simply passive investors rather than active owners.
In Sec. 469, Congress defines a passive activity as “any activity which involves the conduct of any trade or business, and in which the taxpayer does not materially participate”6 and states that any rental activity is passive, unless the taxpayer qualifies as a real estate professional. The definition of material participation in the Code is quite vague, requiring “regular, continuous, and substantial” involvement for the taxpayer to achieve it.
To alleviate confusion as to what actually constituted material participation, Temp. Regs. Sec. 1.469-5T provides seven tests, six of which are objective, to determine a taxpayer’s material participation in a given activity. Several of these tests require the taxpayer to participate in the activity for a certain number of hours each year. To be considered to materially participate in an activity, the taxpayer must satisfy one of these tests:7
- The individual participates in the activity for more than 500 hours during the year;
- The individual’s participation in the activity for the tax year constitutes substantially all of the participation in that activity by all individuals (including individuals who are not owners of interests in the activity) for the year;
- The individual participates in the activity for more than 100 hours during the tax year, and the individual’s participation in the activity for the tax year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for the year;
- The activity is a significant participation activity (meaning the individual participates in the activity for more than 100 hours a year) for the tax year, and the individual’s aggregate participation in all significant participation activities during the year exceeds 500 hours;
- The individual materially participated in the activity for any five tax years (whether or not consecutive) during the 10 tax years that immediately precede the tax year;
- The activity is a personal service activity, and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year; or
- Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year.
Limited partners can achieve material participation only by satisfying tests 1, 5, or 6.
Although the passive activity loss rules were originally enacted to stifle the use of abusive tax shelters, they clearly have more far-reaching consequences. Often, taxpayers that are subject to the passive activity loss rules are engaged in multiple activities. The activities may only be separate for legal reasons, to isolate a business owner’s liability exposure, or to separate various components of the overall business for marketing or branding purposes. They could certainly be separate activities for purposes of applying the passive loss rules yet collectively constitute the taxpayer’s primary business. In some cases, this may result in a taxpayer’s incurring losses that are considered passive and not currently deductible, even though they were directly related to the taxpayer’s primary earned income.
Consider the case of a chef who owns two restaurants and runs a catering business. For liability purposes he has established two separate S corporations for the restaurants and a single-member limited liability company (LLC) for the catering company. These three ventures are considered separate activities, and the chef must materially participate in each of them to consider each one nonpassive under Sec. 469. Because most of the material participation tests under Temp. Regs. Sec. 1.459-5T are based on hours worked, it may be physically impossible to work enough hours in each separate activity to satisfy a material participation test.
One technique for converting otherwise passive activities to nonpassive is by grouping them, treating them collectively as a single activity, and thereby combining the participation hours and improving one’s ability to achieve the necessary hours for material participation. Regs. Sec. 1.469-4 provides general rules and limitations for grouping activities and applies a facts-and-circumstances test to determine the appropriateness of a particular grouping. In general, activities can be grouped for purposes of Sec. 469 if they constitute an appropriate economic unit for measuring gain or loss. Factors to consider in determining whether a group can be viewed as a single activity are:8
- Similarities and differences in types of trades or businesses;
- The extent of common control;
- The extent of common ownership;
- Geographical location; and
- Interdependencies between or among the activities.
These factors are not all-inclusive, nor do they all have to be considered in every grouping, but they are given the most significance in determining whether a grouping is appropriate. There are some groupings that are expressly prohibited by the regulations. For example, rental activities cannot be grouped with other trade or business activities unless certain conditions are met.9 In addition, real property rentals may not be grouped with personal property rentals, and activities conducted as a limited partner or limited entrepreneur cannot be grouped with other activities that are not the same type of business. In addition to the guidance provided in Regs. Sec. 1.469-4, an election is available for real estate professionals to aggregate all interests in rental real estate into a single activity.10 This specific grouping option is beyond the scope of this article, as it is not affected by Rev. Proc. 2010-13.
Benefit and Drawback to Grouping
Grouping activities allows taxpayers to treat the activities as one when applying the tests to determine material participation. The chef can treat his two restaurants as a single activity, and if he spends 500 hours working in one of them during the year and none at the other, he will still pass the first test of the seven material participation tests under Temp. Regs. Sec. 1.469-5T(a) to be considered nonpassive. Since it likely forms an appropriate economic unit due to common ownership and similarity in business, he can add the catering company to this group as well. If the catering company produced a loss for the year and the chef did not materially participate in it, the passive loss may be suspended to a future tax year absent any passive income to offset it against in the current year. Grouping it with the restaurants as a single activity and thereby treating it as nonpassive will allow the chef to realize the tax benefit of the loss currently.
However, as is noted in the following section, once he chooses this grouping, it must remain in effect for all future tax years. This may affect his ability to use suspended losses in future tax years. When a passive activity is disposed of, its suspended losses are freed up to first offset any gain on the disposition, with the excess losses then treated as nonpassive and available to offset any other taxable income, including portfolio and earned income. But once the catering company is included in the grouping with the restaurants, to entirely dispose of the activity requires disposing of the two restaurants and the catering company. Merely selling or abandoning the catering company will not constitute disposing of all or significantly all of the activity anymore.
Clearly the existence of suspended losses should be considered when deciding whether to group certain activities into one. Another important consideration is the type of income and loss the taxpayer expects from other activities. If the chef owns residential rental property (which is a passive activity assuming the taxpayer is not considered a real estate professional under Sec. 469(c)(7)11) that typically generates losses, and the catering company is expected to produce income, the chef would do better tax-wise to leave the catering company as a separate activity without material participation.
The groupings that a taxpayer employs have been important in terms of the ability to deduct losses, but with the new 3.8% Medicare tax applying to passive income, the existing groupings become even more important. Practitioners and taxpayers will likely pay closer attention to the manner in which activities are aggregated now that additional tax may be assessed. But they also must take note of disclosures now required by Rev. Proc. 2010-13.
Rev. Proc. 2010-13
The Sec. 469 regulations describe allowed and prohibited forms of grouping but do not provide specific guidance for disclosing one’s groups. Rather they leave an opening for the IRS to promulgate that guidance as needed. Accordingly, there was no consensus among practitioners or the IRS on how to report a taxpayer’s groupings, particularly if any changes were made. Regs. Sec. 1.469-4 specifies that groupings must remain consistent from year to year unless (1) it is determined that a grouping was clearly inappropriate; (2) a material change in facts and circumstances warrants a grouping change; or (3) the IRS finds that a group of activities does not represent an appropriate economic unit and a principal purpose of the grouping is to circumvent the underlying purposes of Sec. 469.
After a comment period and some revisions to the initially proposed disclosure guidelines, the IRS released Rev. Proc. 2010-13, effective for tax years beginning on or after Jan. 25, 2010. Taxpayers must now attach a statement to their original tax return for certain tax years in which multiple activities are grouped as a single activity for purposes of Sec. 469. This disclosure enables the IRS to know when a grouping strategy has been employed so it can assess the appropriateness of the grouping and monitor it in future periods for consistency. The absence of this disclosure requirement made it easier for noncompliant taxpayers to change groupings from year to year to maximize tax effectiveness or to disregard the “appropriate economic unit” concept. Rev. Proc. 2010-13 specifies three times when the disclosure statement is required:
- The first year in which two or more activities are grouped.
- Any year in which a new activity is added to an existing grouping.
- Any year in which a regrouping is necessary under Regs. Sec. 1.469-4(e)(2), which requires regrouping if the original grouping was clearly inappropriate or a material change in the facts and circumstances has occurred that makes the original grouping clearly inappropriate.
The disclosure statement must contain the names, addresses, and employer identification numbers (if applicable) for the trade or business or rental activities involved in the grouping as well as a statement affirming that the grouped activities constitute an appropriate economic unit for the measurement of gain or loss under Sec. 469. If the statement is reporting a regrouping, then an explanation of why the prior grouping was inappropriate or describing the change in facts and circumstances that necessitated the change must be included.
A very important concept to note is that the disclosure rules of Rev. Proc. 2010-13 do not apply to groupings that have already been made prior to tax years beginning on or after Jan. 25, 2010, until a change is made to those groupings. So taxpayers that have already applied the grouping rules appropriately and tax-effectively will not be subject to disclosing those groupings unless they add an activity. (Rev. Proc. 2010-13 specifically states that disclosure is not required for a disposition of an activity within a chosen grouping.) However, taxpayers and their practitioners that are attempting to employ a grouping strategy to minimize passive income and thereby reduce the additional Medicare tax must be prepared for full transparency and IRS scrutiny of their groupings. Failure to attach the grouping statement will result in all activities being treated as separate for purposes of applying the rules of Sec. 469.12
While this revenue procedure generally applies to all taxpayers that use Regs. Sec. 1.469-4 to group multiple activities, it does not apply to real estate professionals who have made the grouping election of Regs. Sec. 1.469-9(g).13 It also does not require partnerships or S corporations to attach the written disclosure statement described above. Those entities continue to be governed by the instructions to Forms 1065, U.S. Return of Partnership Income, and 1120S, U.S. Income Tax Return for an S Corporation, which require a Schedule K-1 attachment informing owners of the income and loss by grouping. Further, the partner or shareholder receiving the K-1 does not have to disclose the entity’s groupings under Rev. Proc. 2010-13, but must report if the partner or shareholder groups any of the activities that the entity did not, or groups the entity’s activities with any others conducted by the partner/shareholder or any other Sec. 469 entities that the partner or shareholder owns. With the onset of these new requirements, it is clearly important for practitioners and taxpayers to be fully aware of the groupings they have been following prior to Jan. 25, 2010, and to maintain appropriate records documenting these and future groupings.
Since the passive activity loss rules of Sec. 469 were enacted in 1986, practitioners have wrestled with the concept. They are often faced with an arduous task in obtaining the relevant facts to ensure their clients’ compliance with the rules. Clients’ participation levels in various activities usually require annual examination, and material participation can sometimes be difficult to discern, especially with LLC members or limited liability partnership partners. The activity grouping rules of Regs. Sec. 1.469-4, which were introduced in the mid-1990s, added an element of strategy as well as another level of complexity to the passive loss rules.
Activity grouping is an often overlooked or misused component of tax strategy and compliance, and with the issuance of Rev. Proc. 2010-13, the importance of getting it right has increased. How activities are grouped going into 2011 (for calendar-year taxpayers) is already significant from a compliance perspective, but due to the Health Care Act, it could also have considerable effects on tax liability in 2013 and beyond. With the 3.8% Medicare contribution tax imposed by the act, it is therefore imperative to understand the interplay of the passive activity grouping regulations, Rev. Proc. 2010-13, and the Health Care Act. By understanding each of these components separately, one can then see how they interact. A practitioner’s awareness of this interaction could be advantageous in developing clients’ tax strategies for addressing the impact of the additional Medicare tax.
1 Tax Reform Act of 1986, P.L. 99-514.
2 Rev. Proc. 2010-13, 2010-1 C.B. 349.
3 Health Care and Education Reconciliation Act, P.L. 111-152.
4 Sec. 1411(a)(1).
5 Sec. 1411(a)(2). See Shuneson and Slivanya, “Health Care Legislation Requires New Planning Strategies,” 41 The Tax Adviser 600 (September 2010), for a thorough discussion of this tax on investment income, including applicable thresholds for individual taxpayers.
6 Sec. 469(c)(1).
7 Temp. Regs. Sec. 1.469-5T(a).
8 Regs. Sec. 1.469-4(c)(2).
9 Regs. Sec. 1.469-4(d)(1)(i).
10 Regs. Sec. 1.469-9(g).
11 For a taxpayer who is considered a real estate professional under this section, rental real estate activities with material participation are not passive.
12 See Rev. Proc. 2010-13, §4.07, for relief provisions.
13 Rev. Proc. 2010-13, §3.
Daniel Rowe is a tax manager at Deemer Dana & Froehle LLP in Savannah, Ga. For more information about this article, contact Mr. Rowe at email@example.com.