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Passive Activity Loss ATG - Chapter 6, Entity Issues

Publication Date - December, 2004

NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.

 


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Chapter 6, Entity Issues

Overview

This chapter consists of four separate and distinct topics as they relate to passive activities: C Corporations, Trusts, LLCs, and the self-charged rules.

The passive loss rules do not apply to partnerships and S Corporations. They apply to investors in these entities. Thus, material participation for a partner or shareholder is determined at the individual level.   The IRC § 469 does, however, apply to C Corporations and to trusts.  There are also special rules for LLCs.   Finally, unlike most interest income, self-charged interest from loans to passive activities may be used as passive income on Form 8582. 

C Corporations In a Nutshell

The passive loss limitations apply to all Personal Service Corporations (PSCs).  For other closely held C Corporations, they apply only to a limited extent.  The passive loss rules do not apply to large C Corporations that are not closely held and are not PSCs.  See the checksheet for C Corporations at end of chapter.

Material Participation for Corporations

It must be determined if a PSC or closely held corporation materially participates in its activities (including partnership and S Corporations) for losses to be deductible.  Generally, the level of participation of the shareholders determines material participation.  Of course, rentals are passive regardless of the level of participation[1], and there is no $25,000 offset as a corporation is not a natural person[2].

One or more of the individuals who hold more than 50 percent of the outstanding stock must materially participate in each activity for the corporation to meet the material participation standard.  See Chapter 4 for the seven material participation tests.   If not, losses are passive and belong on Form 8810, Corporate Passive Activity Loss and Credit Limitations.  They are not deductible in the absence of passive income.

Closely held corporations, but not PSCs, may also materially participate by meeting the requirements of IRC § 465(c)(7)(C).   In certain limited circumstances, a full-time employee of the corporation can meet the material participation test.

Personal Service Corp 

A PSC is a corporation whose principal activity is the performance of personal services by employee-owners. 

Examples:   doctors, attorneys, engineers, actors, consultants, accountants, actuaries, and financial planners.

  • Passive loss limitations apply in full to all PSCs, including closely held PSCs.
  • A loss is passive if the loss stems from rental real estate or equipment leasing activities or from any partnership or S- Corporation business in which shareholders holding more than 50 percent of the outstanding stock do not materially participate.
  • Passive losses can offset only net income from another passive activity.
  • Passive losses cannot offset PSC ordinary income, or portfolio income, or any other non-passive income.

Rental real estate losses

  • Not deductible against PSC ordinary income or income from interest, dividends, stocks or other non-passive income.
  • No $25,000 offset is available, as a corporation is not a natural person.
  • Passive losses are deductible only to the extent of passive income.

There is no carryback of rental losses or passive business losses in which the corporation does not materially participate.  They can only be carried forward[3].

Audit Considerations PSCs 

Equipment leasing [4]

  • Even if shareholder materially participates, losses generally are passive.  Whether the leasing activity is conducted by the C- Corporation or through a partnership or S Corporation flowing into the entity, losses are passive.[5]
  • Losses from equipment leasing activities generally belong on Form 8810 and can offset only passive income.

Partnership and S Corporation business losses flowing into the PSC

  • Not deductible against non-passive business income and portfolio income unless the PSC materially participates in the partnership or S Corporation.
  • Material participation means that shareholders owning more than 50 percent of the stock work on a gular, continuous and substantial basis in the operations of the partnership or S Corporation.
  • The IRC § 469(h)(4) exception, referencing IRC 465(c)(7)(C) and involving employees, for closely held C Corporations does not apply to PSCs!  A shareholder, not an employee, must always prove he materially participates.
  • If the PSC (i.e. a shareholder) does not materially participate, partnership or S Corporation losses are passive.
  • Losses belong on Form 8810.  They are not deductible unless there is passive income.  Similarly, if the PSC does not materially participate, net income is passive.
  • It is possible that the partnership or S Corporation is a related entity to the C Corporation and has been grouped as a single activity under Reg. § 1.469-4(c); thus losses will be deductible.  Under the anti-abuse rule in Reg. § 1.469-4(f), an examiner may also want to consider whether an income producing entity should be grouped with another related entity.  In other words, the examiner should consider whether the taxpayer’s grouping truly is an appropriate economic unit and that the principal purpose is not to circumvent § 469.   See Chapter 8.

Questions to ask:

  • Are there any losses or credits from rental or leasing activities offsetting corporate and portfolio income (i.e. non-passive income)?
  • Are there any partnership or S Corporation losses or credits which are from rental real estate or leasing activities?
  • Which shareholders work in the partnerships or S Corporations?   Are there any businesses conducted in partnerships and S- Corporations in which shareholders owning more than 50 percent of the stock do not materially participate?

Closely Held C Corporations

General Rule:  For closely held C Corporations that are not PSCs, passive losses and credits can offset C-Corporate net income BUT not portfolio income.  Stated differently, a passive losses can offset corporate earnings of a closely held C Corporation business, but not portfolio income[6].

Closely held simply means that 5 or fewer shareholders control more than 50 percent of the outstanding stock during the last half of the year[7].  Even many publicly traded corporations are closely held, despite having hundreds of shareholders.

If the shareholder(s) do not material participation, passive losses can offset net active corporate income, but not portfolio income. Furthermore, a passive loss cannot be carried back, but instead must be carried forward.  

Audit Considerations on Closely held C Corporations     

Identify rental real estate losses, equipment leasing losses, and partnership or S Corporation losses.

  • Verify that that passive losses have not been used to offset interest, dividends, royalties, gains on stocks and bonds and other portfolio income.
  • Verify that passive losses have not created or increased a NOL.  If so, pick up the NOL years and adjust them.  Unlike an NOL, a passive activity loss cannot be carried back.  It may only be carried forward[8].

Issues on the shareholder’s individual return:

  • Assets owned personally by a shareholder and leased to the corporation:   If the building or equipment is personally owned by the shareholder and leased to the corporation, net rental income may be non-passive (Reg. § 1.469-2(f)(6)).
  • Equipment held in a partnership/LLC and leased to the corporation:  If equipment is held in a separate partnership or S Corporation and leased to the corporation, losses generally are not deductible by the investors in the absence of passive income.

Consolidated Corporations

A consolidated corporation is treated as one corporation.  Thus, if the shareholder materially participates in any entity, he is deemed to materially participate in all.  See IRC § 469(j)(11) and Reg. § 1.469-1(h).

Supporting Law       

Closely Held C Corporations

  • IRC § 469(a)(2)(B):  The passive loss limitations apply to closely held C- Corporations.
  • IRC § 469(j)(1) Closely held C Corporation is defined via reference to § 465(a)(1)(B), i.e. 5 or fewer shareholders that control more than 50 percent of the outstanding stock.
  • IRC § 469(e)(2) and Reg.  1.469-1T(g)(4):  For closely held C- Corporations that are not personal service corporations, a passive loss can offset net active corporate income, but not portfolio income.
  • IRC 469(c)(7)(D)(i):  Rental real estate losses of a corporation are excepted from the passive loss limitations if more than 50 percent of the corporation’s gross receipts are from real property businesses and the corporation materially participates in the rental activity (Reg. § 1.469-9(e)(1)).
  • IRC § 469 (h)(4)(A) and Reg. § 1.469-1T(g)(3):  A personal service corporation and a closely held C Corporation materially participate in an activity (partnership or S Corporation business) only if one or more shareholders owning more than 50 percent of the stock materially participate in the activity.
  • IRC § 469(h)(4)(B):  For closely held C Corporations that are not personal service corporations, they can also materially participate if they meet the requirements of IRC § 465(c)(7)(C)(i), (ii), and (iii).
  • IRC §465(c)(7)(C) requires that
    • For the entire 12 months;
    • A full-time employee spends all his time managing the activity AND the corporation has 3 or more non-owner employees  performing services directly related to the  activity; AND,
    • The C Corporation’s expenses[9] exceed 15 percent of gross income (excluding interest, taxes and depreciation).

If the corporation meets the above criteria, it will be deemed to materially participate.

Personal Service Corporations

  • IRC § 469(a)(2)(C):  The passive loss limitations apply to PSCs.
  • IRC § 469(j)(2):  A PSC is defined via reference to IRC §269(A)(b)(2)

Examples:  doctors, veterinarians, accountants, engineers, attorneys, actuaries, actors, consultants, financial planners, etc.

  • IRC §469(i)(1) The $25,000 offset is available only to natural persons.

Trusts In a Nutshell

There is no provision in either Subchapter J or IRC § 469 for passive losses to flow out of a simple or complex trust[10].  Passive losses generally remain suspended at the trust level until there is passive income.  Thus, rental losses or losses from a business in which the trustee does not materially participate may not be deducted in the absence of passive income.  See checksheet at the end of the chapter.

Losses from partnerships and S Corporations in which the trustee does not materially participate are not deductible against portfolio income of the trust.  Passive losses go on Form 8582 line 3b (2b prior to 2002) and must be carried forward until there is passive income or a disposition to an unrelated party in a fully taxable transaction.

Estates are similar to complex trusts.  The same tax rules that apply to trusts also generally apply to estates.  In this Chapter, we have used the  term “trustee”.  If you are examining an estate, substitute executor or administrator for trustee.

Trusts Rental Issues

Since rentals are defined as passive activities in IRC § 469(c)(2), losses from rental real estate or equipment leasing activities are passive[11] and are generally not deductible in absence of passive income. 

While an individual receives a special allowance of up to $25,000 in rental real estate losses, no such allowance is available to trusts since they are not natural persons[12].   An estate may, however, use the $25,000 offset for two years[13] if there was active participation by the decedent and to the extent that the surviving spouse does not use it.

Also, while relief is provided for taxpayers with rentals who spend the majority of their time in real property businesses (real estate professionals) under IRC § 469(c)(7), this provision does not address trusts.

Issue Identification:

  • Passive business losses or rental losses on Form 1041, U.S. Income Tax Return for Estates & Trusts, lines 5 and 6 may not have been entered on Form 8582.
  • Unless there is sufficient passive income to absorb all passive losses, the absence of Form 8582 on a trust return with losses on lines 5 and 6 is an indicator the passive loss limitations may have been ignored.
  • Losses on Form 1041 lines 8 and 15a labeled as net operating losses may actually be generated by a rental activity or business in which the taxpayer does not materially participate.  In other words, they may be passive losses, which, unlike an NOL, cannot offset portfolio income and cannot be carried back.

Examination Techniques:

  • Read the trust instrument or will for details on who manages the businesses, partnerships or S Corporations.
  • Verify that rental real estate losses have not been entered on Form 8582 line 1b, thereby permitting the $25,000 offset in error.  Other than estates, rental losses should be entered on line 3b (2b prior to 2002) of Form 8582.
  • Review Schedule K-1s to determine if any rental losses were improperly passed through to the beneficiary returns.

Documents to Request:

  • Trust instrument or will including any amendments and codicils.
  • Detailed description of any rental activities.
  • List of activities, nature of the business, and amounts that comprise any NOL.

Supporting Law:

  • IRC § 469(a)(2)(A) & Reg.  § 1.469-1T(b)(2):  Passive loss rules apply to trusts and estates.  Since neither IRC § 469 (passive activities) nor § 641-692 (trusts and estates) contain any provision for a pass through of passive activity losses, disallowed passive losses generally remain suspended at the estate or trust level and do not flow out to beneficiaries[14].
  • IRC § 469(i):  A trust is not a natural person; it is an artificial entity.  Thus, rental losses are generally disallowed in the absence of passive income, and the $25,000 rental real estate offset is not applicable.
  • IRC § 469(i)(4)(A): An estate may use the $25,000 offset for two years after the decedent’s death.  However, IRC § 469(i)(4)(B) requires that the portion used by the surviving spouse reduce the $25,000 offset.

Trusts Material Participation

If a business activity is owned by a trust, the examiner will need to determine if the material participation standard is met in order for losses to be fully deductible.  Businesses may be conducted via Schedules C or Form, partnerships, S Corporations or LLCs. 

The IRC § 469(h) requires regular, continuous and substantial participation in the operations of the business to meet material participation and for losses to be fully deductible.  There is no guidance in the regulations at this time for material participation of trusts and estates[15]

As an administrative proxy, we look to the seven tests in Reg. § 1.469-5T(a) for material participation, and generally will not raise an issue if the trustee meets one of the tests.  However, as a technical matter the tests apply to individuals, not to a trust or trustee.  Thus, as a legal matter, the trustee must prove he works on a regular basis in operations, on a continuous basis, and on a substantial basis in operations, i.e. rise to the requirements of IRC § 469(h).

Grantor Trusts:  Since tax law does not recognize a grantor trust as a separate taxable entity, the examiner should ignore the trust entirely and look to the grantor (individual taxpayer) to determine material participation.

Qualified Subchapter S Trust[16] (QSST):  The QSSTs are generally grantor trusts in which the grantor is frequently a parent and the beneficiary is a child.  The examiner should look to the beneficiary (child) to determine material participation.

Exceptions:  There are two major exceptions to the passive loss rules: 

  1. Partnerships which are traders in stocks and bonds;[17] and,
  2. Working interests in oil and gas activities[18].  Losses or income from these activities are excepted from the passive loss limitations and are not entered on Form 8582.

Issue Identification: Does the trustee materially participate in the following:

  • Schedule C or F activities with losses.
  • Partnership or S corporation with losses.
  • Entity with an EIN and address a long distance from the trust or trustee.
  • Entity in which the trust is a limited partner or the ownership percentage is low.

Examination Techniques:

  • Secure the trust instrument or will and read it.
  • Determine who the trustee is and what his other responsibilities are.  If the trustee is a busy bank officer or attorney, material participation may be questionable in businesses or entities in which the trust owns an interest.

Documents to Request:

  • Trust instrument or will including any amendments and codicils.
  • Copies of Schedule K-1s from related entities.
  • Detailed description of business activities conducted on Schedule C or F or by any partnerships, or S Corporations.
  • Explanation of the duties and responsibilities of the trustee for each  business, whether conducted as a Schedule C, partnership or S Corporation.
  • Completion of the log at the end of Chapter 4 for any activity in which material participation is questioned.

Supporting Law

  • The Senate Report[19] clearly provides that an estate or trust would be treated as materially participating if the executor or fiduciary/trustee materially participates.
  • Reg.  § 1.469-1T(b)(2)  Passive loss rules apply to trusts other than trusts described in IRC § 671 (grantor trusts).  Also see Rev. Rul. 85-13, 1986-1 CB 184.
  • QSSTs:  The General Explanation of the Tax Reform Act of 1986 by the Staff of the Joint Committee on Taxation, Note 33, page 242, explains, “Similarly, in the case of a qualified electing Subchapter S trust (§ 1361(d)(1)(B)) that is treated as a grantor trust (i.e., the beneficiary is treated as the owner for tax purposes), the material participation of the beneficiary is relevant to the determination of whether the S Corporation’s activity is a passive activity with respect to the beneficiary.”

Trusts Dispositions, Distributions and Gifts

Under IRC § 469(g), when a passive activity is sold or otherwise disposed of in a fully taxable transaction to an unrelated party, current and suspended losses are triggered[20].  Changes in the form of the entity and likekind exchanges are not qualifying dispositions under IRC § 469(g), as they are not fully taxable.  Thus, losses remain suspended on Form 8582 at the trust level.

As a practical matter, passive activities are often sold to a beneficiary or trustee, i.e. related party.  Thus, losses remain suspended by the trust[21].  Furthermore, even without the provisions of IRC § 469 regarding sales to related parties, IRC § 267 prohibits the deductibility of losses on dispositions to related parties.  Losses will be triggered only to the extent of any net taxable income from the sale.

When a trust distributes a passive activity (rental or passive partnership interest, etc.) to a beneficiary, current and suspended passive losses are added to the basis immediately before the distribution[22].  The distribution is not, under any circumstances, a triggering event which would allow deductibility of losses by either the trust or the beneficiary.

A rental property, partnership interest or other passive activity which is given to a charitable organization is not an event which triggers deductible losses for the trust on line 5 or Schedule E.  Instead, current and suspended losses are added to the donee's basis[23].  Losses are not deductible by either the trust or the beneficiaries.

Issue Identification:  Watch for:

  • Final returns with losses on disposition but no Form 4797
  • Form 4797 with a zero in the selling price column.

Examination Techniques:

  • Ask who purchased the property.  Was it a beneficiary or a business (corporation, partnership, LLC) of the beneficiary?  Even though there may have been a sale at fair market value, current and suspended losses from the passive activity remain suspended at the trust level until the activity is ultimately sold to an unrelated party.
  • Review losses triggered on a disposition to verify that it was indeed a sale and not merely a distribution to a beneficiary.  If there is a loss on disposition yet no F4797, it is an indicator that there was merely a distribution to a beneficiary.  Final returns should be scrutinized carefully for this issue.
  • Inquire whether the passive property or activity was sold, distributed or gifted to a beneficiary, trustee or other related party

Documents to Request:

  • Secure appraisals to determine if the property was sold at fair market value.
  • Copy of the settlement statement or other documents verifying the amount of the sales price and the parties involved in the sale.
  • Basis computations.

Supporting Law

  • IRC § 469(g)(1)(B):   If the disposition involves a related party, passive losses stay with the trust.  They are not triggered until the activity is acquired by an unrelated party.
  • IRC § 267(b)(6):  A trustee (fiduciary) and a beneficiary are related parties.
  • IRC § 469(j)(6):   If a passive activity (rental or passive business) is gifted, losses are added to the recipient’s (donee’s) basis.  They are not deductible by the trust or estate.
  • IRC § 469(j)(12):   If a passive activity is distributed to a beneficiary by a trust or estate, losses are added to the basis of the asset immediately before the transfer.  No loss is deductible by the trust or estate.

LLCs In a Nutshell

The LLCs combine features of both partnerships and corporations.  The most notable characteristics of LLCs are contractual freedom and limited liability for all investors.  An LLC with more than one owner is treated as partnership and files Form 1065 unless the LLC elects to be treated as a corporation.  Single member LLCs are generally disregarded, and gain or loss is reported on the single member’s return (Form 1040 for an individual).

Since each member of an LLC has limited liability, investors are analogous to limited partners under IRC § 469.  For purposes of passive loss rules, LLC members are treated as limited partners, even if the taxpayer is a member-manager.

See LLC checksheet at the end of the chapter.

Material Participation for LLCs

When looking at an LLC, the very first step is to determine whether you are dealing with a rental/leasing activity or a business activity.  If the LLC is a rental activity, all member losses are generally passive[24], even if a member materially participates.  The IRC § 469(c)(2)&(4) hold that rentals are passive regardless of the level of participation.

If the activity is a trade or business, a member must prove material participation[25].  The IRC § 469(h) requires regular, continuous and substantial basis in operations.  Reg. § 1.469-5T(e)(3)(i)(B) holds that a partnership interest will be treated as a limited partnership interest if the liability of the holder is limited under the law of the State.  Under most state laws, an LLC member has limited liability.  Therefore, LLC members are treated as limited partners[26].   The Reg. 1.469-5T(e)(2) holds that only three tests are available to limited partners (LLC members):

  • The taxpayer must prove he worked more than 500 hours during the year.
  • The taxpayer must prove he materially participated any 5 of the last 10 years.
  • If a personal service activity (doctor, accountant, engineer, architect, consulting, etc), the taxpayer must prove he materially participated any 3 prior years.

Refer to Chapter 5 for more detail on Material Participation.

Self-Charged Interest In a Nutshell

The self-charged interest income rule in Reg. § 1.469-7[27] is the sole exception where portfolio income is recharacterized from non-passive to passive income.  Interest income may be treated as passive income if it results from a loan between a taxpayer and a passthrough entity in which he has a direct or indirect ownership interest.   See checksheet at the end of the chapter.  Interest income may be treated as passive income only if:

  • The activity involved is a passive activity.  (The taxpayer does not materially participate in the activity, or it is a rental activity)
  • It is from a pass-through entity, i.e. partnership or S Corporation.
  • It is from a lending transaction.

The Reg. § 1.469-7(c)(3) provides that a taxpayer must use an “applicable percentage”.   Generally, this means the taxpayer’s ownership interest in the partnership or S Corporation is multiplied by the amount of interest income received.  Thus, if the taxpayer received $1,000 in interest, but had only a 10 percent ownership interest in a partnership, only $100 of the interest income can be used as passive income on Form 8582. 

Issue Identification:

  • Look for self-charged interest income on Form 8582, which might have been entered on Form 4952 as investment income, erroneously triggering deductions for investment interest expense.  Passive income is not investment income and should not be on Form 4952[28].
  • Verify that self-charged interest income has been reported on Schedule B in the same dollar amount as on Form 8582 line 1a or 3a.   Form 8582 does not report income.  It merely calculates the allowable passive loss for the year.  Taxpayers sometimes reflect self-charged interest on Schedule E.  If the income is not on Schedule B or E, it is possible that some other self-charged item has been recharacterized as non-passive.  There is no provision in law for recharacterization of any item as passive income other than interest.  If rents, guaranteed payments or any other self-charged item (other than interest income) is on Form 8582, it should be removed and an adjustment made.
  • Verify that a passive loss (from the same activity as self-charged interest) has also been entered on Form 8582.  For self-charged interest to be on Form 8582, it must be from a passive activity (a rental/leasing activity or business in which taxpayer does not materially participate).

Summary

  • The PSCs are fully subject to passive loss limitations, even if closely held.
  • For closely held C Corporations, other than PSCs, corporate income, other than portfolio income, generally may offset passive losses.
  • The passive loss limitations apply to trusts.  For trusts, there is no $25,000 offset for rental real estate.  For business activities held by the trust, the trustee must materially participate for losses to be non-passive and offset portfolio income.
  • Members of LLCs are treated as limited partners for purposes of the passive loss rules.  If the LLC member works more than 500 hours in the business, he is non-passive.
  • The self-charged interest rule treats interest income from a loan to a related entity as passive income.  No other self-charged item may be recharacterized as passive income and entered on Form 8582.

[1]IRC § 469(c)(2)&(4)

[2]IRC § 469(i)

[3]IRC § 469(b)

[4] IRC § 469(c)(2)&(4) and Reg. § 1.469-1T(e)(3) 

[5] See Chapter 2 and Reg. 1.469-1T(e)(3) for what is and is not a rental activity.

[6] See IRC § 469(e) and Reg. § 1.469-2T(c)(3)   

[7] IRC § 469(j)(1)

[8] IRC 469(b)

[9] IRC § 162 and § 404 business expenses

[10] On distribution of a passive activity, however, the basis of the activity is increased by suspended losses.  The increased basis will give the beneficiary the benefit of the loss when he eventually disposes of the activity.  See IRC § 469(j)(12)(A)

[11] See Chapter 2 and Reg. § 1.469-1T(e)(3) for a discussion of what is and is not a rental activity.

[12] IRC § 469(i)

[13] For estate tax years ending less than two years after the death of the decedent.

[14] See Reg. § 1.1398-1 for bankruptcy estates for individuals. 

[15] Note that Reg. § 1.469-5T(g) is “Reserved”.

[16] See IRC § 1361(d) where the beneficiary elects to be treated as the owner of the trust for purposes of IRC § 678.

[17] Reg. § 1.469-1T(e)(6) 

[18] IRC § 469(c)(3), Reg. § 1.469-1T(e)(4)(v)

[19] S. Rep. No. 313, 99th Cong., 2d Sess., Reprinted in 1986-3 C.B. (Vol. 3)1, at 735.

[20] See Chapter 5 for much more information on dispositions.

[21] IRC § 469(g)(1)(B)

[22] IRC § 469(j)(12)

[23] IRC § 469(j)(6)

[24] See Chapter 2 and Reg. § 1.469-1T(e)(3) for a discussion of what is and is not a rental activity.

[25] See Chapter 4 for additional information on material participation.

[26] Single member LLCs are disregarded entities.  Since they are not recognized by federal tax law, the taxpayer will have all seven tests in Reg. § 1.469-5T available to him.  He will not be subject to the limited partner taint.

[27] Final Regulation § 1.469-7 was issued on 08/21/2002.

[28] IRC § 163(d)(4)(D)


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