Passive Activity Loss ATG - Exhibit 8.1: Activities (Grouping Entities)
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 8.1: Activities (Grouping Entities)
ISSUE: Does the grouping form an appropriate economic unit? In other words, in a realistic sense, does the grouping form an interrelated, integrated economic unit? Taxpayers may group related business entities into one single activity in order to meet the 500 hour test for material participation in Reg. § 1.469-5T(a)(1). Conversely, some taxpayers may attempt to separate inherently related activities in an attempt to create purported passive income which would trigger otherwise unallowable passive losses. In abusive situations, particularly with passive income, the Government may regroup activities to prevent the taxpayer from circumventing IRC § 469.
LAW: Under Reg. § 1.469-4, if businesses form an economic unit, the taxpayer may group Schedule C/F, C or S Corporation and partnerships/ LLCs into a single activity. Rentals may not be grouped with a business unless owned in identical percentages as the business or insubstantial in relation to the business.
_____ At the initial appointment or first IDR, ask if entities were grouped. Request statement as to how activities are grouped, which entities or undertakings are grouped, and why they form an appropriate economic unit.
_____ If the taxpayer states that he has grouped activities, ask when the grouping decision was made and request tax workpapers or other documents addressing the entities grouped. While not absolutely critical to the issue, the failure to provide any written documentation generated at the time of return filing (either in current or prior years) is an indicator that taxpayer did not group his activities. In other words, each activity is separate. The decision to group or not group is not made at the time of an audit. It is a decision which generally should have been made in 1994 or in the year the interest in the activity was acquired, whichever is later. The Reg. § 1.469-4(e) contains a consistency requirement from year to year and provides that taxpayer may not regroup (unless original grouping was inappropriate or there is a material change). The Reg. § 1.469-4(g) does not permit losses to be deducted under the "substantially all" provision unless the taxpayer can establish amount of deductions and credits allocable to that part of the activity. Obviously, in both instances, it is critical to know what constitutes the "activity".
_____ Separate businesses from:
- Any rental or leasing activity
- Portfolio activities (stocks, bonds, securities, etc.)
- Land held for investment (IRC § 469(e)(1)(A)(ii)(II))
_____ Verify the grouping forms an appropriate economic unit based on:
__Similarities __Location __Ownership __Common control and
__Interdependencies (purchase or sell goods between themselves, involve products or services that are generally provided together, the same customers, the same employees, or use a single set of books and records to account for the activities).
Not all factors are necessary, and there is no factor which is required to be present. Instead, the appropriateness of the grouping should be based on all the facts and circumstances. It is important that examiner address the 5 factors and anything else that points to the appropriateness or inappropriateness of the grouping
_____ Ensure the taxpayer has not grouped rentals with businesses unless:
- Insubstantial; OR,
- Owned in the same percentage and the rental is leased to the business.
_____ Verify that limited partners in IRC § 465(c)(1) activities (equipment leasing, farming, etc.) have not been grouped unless in the same line of business.
_____ Ensure that the grouping was not to circumvent the passive loss limitations. Have similar businesses been treated as separate activities in order to create passive income? If so, under the anti-abuse provisions, the Commissioner can regroup. Scrutinize carefully any entity which produces purported passive income, but is related or in the same line of business as other non-passive activities. See example in Reg. § 1.469-4(f)(2).
_____ Review prior and subsequent year returns for passive and non-passive losses and income to verify that the same grouping has been used consistently. Do a comparative analysis of three years (or more) on an entity by entity basis. Reg. § 1.469-4(e) provides that once the taxpayer has grouped activities he cannot regroup in subsequent years unless the original grouping was clearly inappropriate or a material change makes the original grouping inappropriate.
_____ To verify material participation, request written documentation, explaining the activities performed and hours the taxpayer applied to each entity. Also, inquire how much time the taxpayer applies to his rental activities, on portfolio activities, on hobbies, on vacation, etc. See Log at end of Chapter 4.
_____ Always inquire whether the spouse is involved in business activities, which ones, and how much time. Both spouses’ time counts. Furthermore, one spouse's participation is attributed to the other spouse. Even if the spouse does nothing, if the other spouse materially participates, income or losses are non-passive. See IRC § 469(h)(5) and Reg. § 1.469-5T(f)(3)
_____ If the taxpayer argues on audit that he is grouping entities, some which were listed as passive and some which were listed as non-passive, check the Form 8582 worksheets to see if each entity was listed separately. If so, it is an indicator that taxpayer did not group. Page 8 of the Instructions for Form 8582 advise the taxpayer to enter income and losses for each activity for columns (a), (b) and (c). The instructions clearly state that each activity should be entered (not each entity). Proper allocations are important to determine the correct gain on disposition and because there is a consistency requirement for groupings.
CONCLUSION: In accordance with Reg. § 1.469-4, the taxpayer's businesses have/have not been properly grouped.
NOTE: If the taxpayer is a real estate professional as defined in IRC § 469(c)(7), to group rentals, he MUST file a timely written election with his return. See Reg. § 1.469-9(g) and Reg. § 1.469-11(a)(3).