Grouping Activities as an AEU

Many taxpayers operate similar and related business ventures under separate legal entities for various reasons. For example, a taxpayer who owns a manufacturing S corporation and a building often ma-terially participates in the S corporation and rents the building to it. As a result, the S income or loss is nonpassive. Normally, if treated separately, any rental loss is passive and any rental income is nonpassive, pursuant to Regs. Sec. 1.469-2(f)(6). Suspended passive activity losses (PALs) are a common occurrence in this type of situation. Assuming the taxpayer does not have any passive income, it cannot deduct any rental losses currently because it lacks passive income to offset the losses. However, this trap is avoidable. Proactive tax planning for grouping activities in appropriate economic units (AEUs) can alleviate this issue for some taxpayers.

Regs. Sec. 1.469-4 sets forth the rules for grouping a taxpayer’s trade or business activities and rental activities for purposes of applying Sec. 469 PAL limitation rules. A taxpayer’s activities include those conducted through C and S corporations. Under the general rules for grouping activities (Regs. Sec. 1.469-4(c)), one or more trade or business activities or rental activities might be treated as a single activity, if the activities constitute an AEU for measuring gain or loss under Sec. 469.

This rule follows the facts-and-circumstances test. Although they are not all necessary, the following factors receive the greatest weight in determining whether activities are an AEU:

1. Similarities and differences in types of trades or businesses;

2. The extent of common control;

3. The extent of common ownership;

4. Geographical location; and

5. Interdependencies between or among the activities.

Regs. Sec. 1.469-4(c)(3) provides the following example:

Taxpayer C has a significant ownership interest in a bakery and a movie theater at a shopping mall in Baltimore and in a bakery and a movie theater in Philadelphia. In this case, after taking into account all the relevant facts and circumstances, there may be more than one reasonable method for grouping C’s activities. For instance, depending on the relevant facts and circumstances, the following groupings may or may not be permissible: a single activity; a movie theater activity and a bakery activity; a Baltimore activity and a Philadelphia activity; or four separate activities.

Regs. Sec. 1.469-4(e) requires consistency in groupings. Once a taxpayer has grouped activities under this section, it may not regroup them in subsequent tax years. Two exceptions are (1) a determination that the taxpayer’s original groupings were clearly inappropriate or (2) a material change in facts and circumstances that makes the original groupings inappropriate. In either of these cases, the taxpayer must regroup the activities and comply with IRS disclosure requirements.

Regs. Sec. 1.469-4(f)(2) provides another example, involving a group of doctors who operate separate medical practices. The doctors had PALs from tax shelters and real estate that they cannot deduct on their personal returns, so they formed a limited partnership (LP) to acquire and operate x-ray equipment. In exchange for contributing equipment, the doctors received an LP interest. A general partner manages the partnership and none of the doctors materially participates. Substantially all of the partnership’s services were provided to the doctors or their patients. The doctors treated the LP as a separate activity to offset their PALs.

According to the regulations, the LP is not separately an AEU. Thus, the IRS may require the doctors to treat their medical practices and the LP as one AEU. Moreover, the reason for treating the medical practices and LP as separate activities is to avoid Sec. 469 limits, so that the doctors can deduct their PALs. However, an AEU grouping may not be used to circumvent Sec. 469’s purpose.

Sec. 469 passive activities include (1) a trade or business in which the taxpayer does not materially participate or (2) a rental activity, subject to the exceptions listed in Temp. Regs. Sec. 1.469-1T(e)(3)(ii).

The first exception is that the average period of customer use for such property is seven days or less. The second is that the period is 30 days or less, and the taxpayer provides significant personal services. The third exception is that the taxpayer provides extraordinary personal services. The fourth exception states, "[t]he rental of such property is treated as incidental to a nonrental activity of the taxpayer under paragraph (e)(3)(vi) of this section." According to this paragraph, an activity would be incidental to a trade or business if (1) the taxpayer owns an interest in the trade or business; (2) the property was predominantly used in such trade or business; and (3) the gross rental income from such property for the tax year is less than 2% of the lesser of the property’s unadjusted basis or fair market value (FMV).

The fifth exception is that the taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers. According to the final exception, an activity is not a rental activity if "[t]he provision of the property for use in an activity conducted by a partnership, S corporation, or joint venture in which the taxpayer owns an interest is not a rental activity." As an illustration, the regulations state that the taxpayer is making the property available in his or her capacity as an owner if he or she contributes the right to use it for no rent.

Regs. Sec. 1.469-4(d) limits the grouping of rental activities with other trades or businesses. A rental activity cannot be grouped with a trade or business unless the activities grouped constitute an AEU and (1) the rental activity is insubstantial in relation to the trade or business, (2) the trade or business is insubstantial in relation to the rental activity or (3) each owner of the trade or business activity has the same proportionate ownership interest in the rental activity.

If the insubstantiality requirement is met, the taxpayer could group the activities together even if they do not meet the ownership test. "Insubstantial" is not defined by the regulations. Temp. Regs. Sec. 1.469-4T(d)(2), now expired, did not use the word "insubstantial," but in effect found this to be the case when 20% or less of the gross income of the combined rental and nonrental activities were from one or the other type of source.

Technical Advice Memorandum (TAM) 200014010 states that there is no conclusive test of "insubstantial." Under the final regulations, "insubstantial" refers to additional factors other than gross income. Temp. Regs. Sec. 1.469-4T(c)(2) stated that business and rental operations should be treated as a single undertaking with a separate source of income production if such operations are conducted at the same location and are owned by the same person, and income-producing operations owned by such person are conducted at such location.

Background

Congress enacted Sec. 469 in 1986, effective for years beginning in 1987. The IRS issued temporary regulations on May 11, 1989, which expired three years later. The regulations were very mechanical in nature and extremely cumbersome. They were replaced by proposed regulations just before the sunset provision came into effect in 1992.

These proposed regulations were much less mechanical and extremely facts-and-circumstances oriented. They were finalized (in substantially the same form as proposed, with some minor changes) in 1994. TD 8565 (10/3/94) gives some history on the thought process of these regulations (Regs. Sec. 1.469-4). The final regulations were meant to clarify that, after considering all the facts and circumstances, more than one reasonable method for grouping a taxpayer’s activities is permissible. Although several commentators re-quested clarification of "insubstantial," the final regulations avoided complex and mechanical rules, and did not adopt a safe-harbor test. Also, under the final regulations, the IRS would have the right to regroup a taxpayer’s activities if they do not constitute an AEU.

Case Law

In Glick, DC IN, 2000, Glick owned interests in 116 partnerships (passive rental activities) and a management company (a nonpassive S corporation). The management company existed primarily to provide services to the partnerships and was insubstantial under the "80/20" rule. Glick explored the meaning of "insubstantial," noting that the Secretary has not defined "insubstantial" other than to note that it refers to factors other than just gross income. The case examines the facts and circumstances, both qualitative and quantitative. For the qualitative factors, it looked at the purpose for forming the corporation and the corporation’s role in relation to other activities.

For the quantitative factors, the court first examined the gross income and the 80/20 test under Temp. Regs. Sec. 1.469-4T, a good starting point, according to the Service, even though it had expired for the tax period at issue.

The second quantitative test is a comparison between the percentage of the overall asset value attributable to the total FMV of the S corporation, and the FMV of the partnerships. After analyzing both the quantitative and qualitative tests, the court determined that these two activities required AEU treatment. Additionally, the management company was determined to be insubstantial to the 116 partnerships. Hence, the PALs of the 116 partnerships could offset the company’s income.

Conclusion

Many taxpayers have both nonpassive and passive activities. Individuals who own related activities may be able to obtain a tax advantage that often results from appropriate economic grouping. However, tax practitioners must analyze new activities to group them appropriately. The opportunity exists in the first year of an activity to group appropriately and avoid future problems. Because changing groupings is difficult, future ramifications might be great, even if the groupings seem immaterial in the first year.

From Sarah Allen Miller, CPA, South Bend, IN