Passive Activity Loss ATG - Exhibit 3.1: Passive Income
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.
Exhibit 3.1: Passive Income
Large amounts of passive income on Form 8582 line 1a and 3a should be scrutinized carefully. Passive income can be generated only by a rental or a business in which the taxpayer does not materially participate. Both are more apt to produce net losses than net income. If Form 8582 reflects significant income on line 1a or 3a, perform the following:
_____ Verify that income on Form 8582 is also reflected on Schedule E lines 22 & 28(a) Col (h), Form 4797 or elsewhere. Form 8582 is merely a computational form which figures the amount of allowable passive losses (Form 8582 line 11). Income on Form 8582 MUST also be reflected on the appropriate schedule to be properly reported. If income on Form 8582 is not reflected elsewhere on the return, the examiner has an adjustment for unreported income!
_____ Verify that income is not interest, dividends, royalties, or gains on the sale of stock. Portfolio income is not passive income and should not be entered on Form 8582.
Exception: self-charged interest income. See Reg. § 1.469-7.
_____ Verify that income is not flowing from a partnership or LLC which a trader or stocks, bonds or other securities. An activity involving trading of stocks and bonds is not a passive activity. Thus, income would be non-passive and should not be reflected on Form 8582. See Reg. § 1.469-1T(e)(6).
_____ Verify that income is not from rental of building to a partnership, corporation, or business where the taxpayer materially participates (unless there is written currently binding lease signed before 02/19/88). Rental income from businesses in which the taxpayer materially participates (i.e. works on a regular basis) is non-passive and does not belong on Form 8582 line 1a. See Reg. § 1.469-2(f)(6).
_____ Verify that income is not from leased of land or other non-depreciable property.
Example: leased field, parking lot, ground rents for trailers or mobile homes, leased land for cell towers. See Reg. § 1.469-2T(f)(3).
_____ Verify that income on Form 8582 line 1a or 3a is not from the sale of land. Investment income is not passive income. See IRC § 469(e)(1)(A)(ii)(II). Passive income must be generated by a passive activity.
_____ Verify that income is not from an activity in which taxpayer materially participates. See Reg. 1.469-5T(a). Review the worksheets of Form 8582 to see if income is coming from an in-state activity - an indicator that the taxpayer is possibly materially participating. Even if the taxpayer does nothing, in the current year, if losses/income were non-passive in any 5 of the prior 10 years, income is non-passive in the current year. Reg. § 1.469-5T(a)(5). Also if the activity is a personal service activity (doctors, attorneys, accountants, financial planners, actors, consultants, engineers, etc.), income is non-passive if the taxpayer materially participated any prior 3 years. See Reg. § 1.469-5T(a)(6).
_____ Verify that income is not from an investment such as lots, the sale of a building never rented or used in a business, or the sale of timber. Investment income is not passive income. See IRC § 469(e)(1)(a)(ii)(II). Passive income only comes from a passive activity, i.e. passive income must be generated either by a rental activity OR a business in which the taxpayer does not materially participate. If income on Form 8582 is from Schedule D, examiner should consider the possibility that it could be simply investment income. Some real estate developers have splintered their projects into many separate entities and entered net gains on Schedule D, limiting their tax rate to 20 percent. If income is treated as investment income (as opposed to business income), it cannot be passive income. The examiner should consider whether the motivation in creating multiple entities was to circumvent IRC § 469. If so, the examiner may want to invoke the anti-abuse rule in Reg. § 1.469-4(f) and regroup the entities as one single activity. Also consider whether the taxpayer should be treated as a dealer. Consequently, property would be inventory and taxed at ordinary rates versus capital gain.
_____ Verify that income is not compensation for personal services such as wages, guaranteed payments from a partnership or Form 1099-Misc commission income. See IRC § 469(e)(3), Reg. § 1.469-2T(c)(4).
_____ Verify income is not from a covenant not to compete. Reg. § 1.469-2(c)(7)(iv).
_____ If there is a Form 6252, Installment Sale Income, for an installment sale of a passive activity, verify that:
- Income entered on Form 6252 Line 24 ties to Form 8582; AND,
- Current and suspended losses are deducted in same ratio as gain is reported.
Note, however, that passive losses will be triggered up to the amount of gain reported in the current year. See IRC § 469(g)(3).
_____ Verify that neither husband nor wife materially participate in a business producing passive income. The husband's participation is attributed to the wife and vice versa. Even if one spouse does nothing, if the other spouse materially participates, income is non-passive. Participation of one spouse is treated as participation of the other spouse. IRC § 469(h)(5), Reg. 1.469-5T(f)(3), Reg. 1.469-1T(j)
_____ If there was a gain on disposition of a passive activity, verify that the Form 4797 gain and current and carryforward losses have been entered on Form 8582. If there was a gain on sale, but current and suspended operating losses exceed the gain, nothing should be entered on Form 8582. In both instances, the full gain should be entered on Form 4797. Reminder: passive income is not investment income under IRC § 163(d). The same type of income should never be entered on both Form 4952 and Form 8582.
_____ If income is generated by an oil & gas entity, ask the taxpayer if there were losses in prior years. If so, request prior year returns. If losses were claimed as non-passive under the working interest exception in any prior year, income in subsequent years is non-passive and should not be in Form 8582. See IRC § 469(c)(3)(B).
CONCLUSION: Passive income has/has not been correctly reflected on Form 8582. Passive losses in the amount of ____ have been allowed/disallowed.
ADJUSTMENT: Remove non-passive income from Form 8582 L1a, or 3a, and recompute. Adjustment to allowable passive losses is difference between Form 8582 L16 per return and Form 8582 L16 as corrected (without income determined to be non-passive).
Report: Disallowed Passive Losses.