New Vehicle Dealership Audit Technique Guide 2004 - Chapter 12 - Passive / Non-Passive Considerations (12-2004)
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Many taxpayers involved with auto dealerships have interests in other entities and activities. As a result of their complex financial affairs, the compliance with passive loss rules and regulations of IRC section 469 should be verified. Please recall that due to the rules of that section, generally only passive income can offset passive losses. This means that the taxpayers will have losses from passive activities that are not deductible in a particular year unless income from other sources is properly characterized as passive income.
Should this issue be considered?
It is important for the agent look at the individual and related entity returns to determine if the taxpayer is in compliance with the passive loss rules. The only way to determine compliance with this complex section of the law is to gain an understanding of the relationships of the various entities and activities the taxpayer has an interest in.
The taxpayer, who is also a shareholder in a large C-Corporation auto dealership owns several rental properties (passive by definition, with some exceptions, under IRC section 469(c)(2)). Making over $150,000 per year, taxpayer is not entitled to the $25,000 passive loss offset for rental real estate. The taxpayers’ rental losses for the year are about $100,000. The taxpayer creates a partnership that purchases assets from the C-Corporation and then rents the dealership the land and building at a rent that produces partnership net income of $100,000. Taxpayer flows this $100,000 partnership net income through to his 1040 as passive income. The taxpayer is attempting to offset his passive loss of $100,000 against this income.
Under Treas. Reg. section 1.469-2(f)(6), the rental income is recharacterized as non-passive. This means that the taxpayer cannot offset passive losses from other activities against the rental profit. Any rental income generated from the rental of property by the taxpayer to a trade or business in which the taxpayer materially participates is treated as non-passive income.
In this situation, the $100,000 profit would be recharacterized as non-passive and the $100,000 passive loss would be carried forward.
Secure all lease agreements.
Inspect Shareholder's Forms 1040 to determine if the issue is viable.
Question the taxpayer directly where circumstances warrant such action.
If after inspecting Forms 1040, passive income is seen to be offsetting passive losses, it should be scrutinized. Make sure the income is not subject to the recharacterization rules of Treas. Reg. sections 1.469-2 and 1.469-2T as well as the material participation rules of Treas. Reg. section 1.469-5T.
Treas. Reg. section 1.469-2T(f) sets forth specific criteria for recharacterizing income from passive to non-passive. The most pertinent to auto dealerships follow:
Treas. Reg. section 1.469-2T(f)(3)
Net income from the rental of property in which less than 30 percent of the unadjusted basis of the property is subject to depreciation is considered NON-PASSIVE.
Treas. Reg. section 1.469-2(f)(6)
For tax years ending after May 10, 1992, the net income from the rental of any property to a closely held C-Corporation, an S-Corporation, a partnership, is considered NON-PASSIVE if the taxpayer to whom this income flows to materially participates in the activities of the lessee.
Note: It is unclear where in the regulations that a trust is included in these rules. A trust is included as a pass through entity in Treas. Reg. section 1.469-4T(b)(2)(i) which is applicable only to that section. Treas. Reg. section 1.469-4T(b)(2)(ii)(B) is no longer included as a temporary regulation.
Note: That for 1992 and before, this rule applied for all except a closely held C-Corporation (Treas. Reg. section 1.469-4T(b)(2)(ii)(B)). Treas. Reg. section 1.469-2T(f)(8) limits recharacterization if the taxpayer is required to recharacterize gains from significant participation activities and also gains from the rental of nondepreciable property, the maximum amount of gain to be recharacterized is the greater of the two computations.
If the rental income producing entity is not clearly connected to the dealership, it may
still be necessary to pursue the issue.
If the taxpayer materially participated in an activity other than rental activity, then the income is non-passive per IRC section 469. Treas. Reg. section 1.469-5T sets forth the criteria for determining material participation.
In identifying the correct treatment of income from an activity, it may be necessary to question the taxpayer directly.
Whenever an agent encounters a Passive / Non-Passive situation it is suggested the MSSP guide on Passive Activity Losses be referenced for a more detailed discussion of the passive loss rules and suggestions for audit techniques of passive loss issues.
The most efficient way of looking for a passive issue is by securing all related returns. Verify the taxpayer did not mitigate his tax liability with respect to a passive loss. If so, a close scrutiny of the means by which this was accomplished is warranted.