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Passive Activity Loss ATG - Chapter 8, Activities (Grouping Rules)

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.

Chapter 8: Activities (Grouping Rules)

In a Nutshell

If related businesses form an appropriate economic unit, entities may be grouped as a single activity, making it easier to meet the 500-hour test. The taxpayer needs to show he materially participates in the grouped activity as a whole. A sole proprietorship (Schedule C or F), C or S Corporation, partnership or LLC may be grouped into one single activity if the businesses form an appropriate economic unit. See Reg. § 1.469-4.

An “activity” is not constrained by entity lines.  If the taxpayer spends 500 hours among the grouped businesses, even though in different entities, he materially participates in all.  The entire 500+ hours could be spent all in one business entity or could be spread among several related entities.  See checksheet at end of chapter.

It is important to note that Reg. § 1.469-4(a) only provides for grouping of businesses (or rentals).  Businesses generally may not be grouped with rentals.  Land or buildings held for investment may not be grouped.  And, of course, no personal activity or portfolio activity belongs in the grouping.

It is possible that several different activities may exist within a single entity.  Example:  two unrelated businesses or a business and a rental activity within a single partnership. 

The temporary regulations expired in 1992.  The Reg. § 1.469-4T cannot be relied upon for current years.  All rules and definitions for what constitutes an activity are in Reg. § 1.469-4, which is in final format.

Five Factors

The Reg. § 1.469-4 provides a facts and circumstances approach to determine whether two or more activities form an appropriate economic unit for the measurement of gain or loss.  Five factors[1] are given significant weight:

  1. Similarities and differences in the types of businesses.
  2. Extent of common control.
  3. Extent of common ownership.
  4. Geographical location.
  5. Interdependencies between or among the activities.

Not all factors are necessary.  The determination as to whether related entities form a single activity is made based on all the facts and circumstances.  In a realistic sense, are the entities interrelated, integrated businesses?

Audit Techniques

  • On examination, taxpayers may argue that, while they do not materially participate in an entity, it forms an economic unit with another business.  Early in the examination, it is important to determine what the taxpayer’s activities are.  In the initial Information Document Request (IDR), ask the taxpayer to explain any grouping under Reg. § 1.469-4, why the grouping is appropriate, what the nature of each entity or activity is, and when the grouping decision was made.  If each activity is a separate activity, request an affirmative statement in writing to that effect.
  • Look for any rentals in a grouping.  As discussed later in the chapter, a rental generally may not be grouped with a business (Reg. § 1.469-4(d)(1)).
  • Secure as many prior year returns as possible and peruse them for inconsistencies between passive and non-passive.  Particularly, in income years, some taxpayers classify the activity as passive.  At a minimum a three-year comparison of passive and non-passive income and losses is suggested.  The consistency requirement is discussed later.   The fluctuation between passive and non-passive could be due to the annual test for material participation.  However, it could also be a significant indicator that each entity was treated as a separate activity or of inconsistent treatment.


The Reg. § 1.469-4(d)(1) prohibits grouping a rental activity with a trade or business unless:

  • Either is insubstantial in relation to the other; OR,
  • The owner has the same proportionate interest in the rental as in the business[2].

Grouping real property and personal property rentals is also prohibited unless the personal property is provided in connection with the real property.  

Audit Techniques:

  • Ensure that the taxpayer is not erroneously mixing a rental with a business activity, i.e. using a rental loss to offset business income on Schedule C or F.
  • Look for rental losses which might have been erroneously entered on Schedule E in the non-passive column.  Even if owned via a partnership or S Corporation interest, rentals generally retain their passive taint.

Limited Partners

A limited partnership interest (or limited entrepreneur) generally may be grouped with other activities which form an appropriate economic unit.  However, a limited partnership interest in any of the following types of businesses may not be grouped with another business unless it is the same type of business and the two form an appropriate economic unit[3]:

  • Motion picture films or videotapes
  • Farming
  • Leasing IRC § 1245 property (personal property)
  • Exploring for or exploiting oil and gas
  • Exploring for or exploiting geothermal deposits

C Corporations

A personal service corporation or closely held C Corporation may be part of the grouping that forms an appropriate economic unit[4].

Partnerships and S Corporations

If an entity contains more than one business or rental activity, it must group or separate activities.  Once the entity groups its activities, the investor may group those activities with each other, with activities he conducts himself or with activities conducted through other entities – as long as the grouped businesses form an economic unit, i.e. they are integrated interrelated activities.   See Reg. § 1.469-4(d)(5). 

Consistency Requirement

The Reg. § 1.469-4(e) imposes a consistency requirement.  Once the taxpayer has selected his grouping, he must use that same grouping in future years unless the original group is clearing inappropriate or there is a material change in facts and circumstances. 

A decision not to group, i.e. to treat each activity separately, is a grouping decision.  This decision generally should have been made starting in 1994 when Reg. § 1.469-4 was finalized or, if subsequent to that date, at the time the activity was first reflected on a return. A taxpayer cannot pick and choose each year what his grouping is.  The taxpayer must maintain the grouping he originally chose under the consistency rules in Reg. § 1.469-4(e).

Audit Technique:

In the IDR, ask:

  • Has each activity on the return been treated as a separate activity under Reg. § 1.469-4 [appropriate economic unit rules]?   If so, please provide a statement to that effect.
  • If the Schedule C business or partnership interest or S Corporation interest has been grouped with another business OR rental activity under Reg. § 1.469-4, please provide a written explanation of the grouping and why it is appropriate.   If activities or entities were grouped under Reg. § 1.469-4, in what year were they grouped?
  • If there are tax workpapers or other documentation supporting your grouping, please provide them.  If you have no documentation from prior years on your grouping decision, please state so.

Anti-Abuse Provision

The anti-abuse provision in Reg. § 1.469-4(f) permits the Commissioner (examiner) to regroup businesses if:

The taxpayer's grouping is not an appropriate economic unit; and,

One of the primary purposes of the taxpayer's grouping is to circumvent the underlying purposes of IRC § 469.

To illustrate, the regulations provide an excellent example in Reg.1.469-4(f)(2).  In this example, a limited partnership (formed by five doctors, each of whom were limited partners) produced net income.  Because it formed an economic unit with the doctors’ practices and the purpose was to circumvent IRC §469, the Government could group the two businesses as a single activity, with the result that income from the partnership was deemed non-passive. 

Practical Note:  If the examiner wishes to regroup the taxpayer's activities under the anti-abuse rule, document the following facts as fully as possible:

  • The factors indicating the two businesses form an economic unit:  related businesses, same customers, etc.
  • All facts indicating an attempt to circumvent IRC § 469.  Probably the most common factor is that, in the absence of the purported passive income, passive losses would be nondeductible.

Supporting Law

  • IRC § 469(c):  The term passive activity means any business in which the taxpayer does not materially participate.  It also generally includes any rental or leasing activity, regardless of the taxpayer’s participation.
  • IRC § 469(c)(2) & (4):  In general, all rentals are passive whether or not the taxpayer materially participates.
  • IRC § 469(h):  A taxpayer must work on a regular, continuous and substantial basis in the operations of an activity in order to meet the material participation standard.  If the taxpayer can group two or more businesses as a single activity, it will be easier to meet the 500-hour test for material participation.
  • Reg. § 1.469-4T:  Contains the temporary grouping rules for related businesses and rentals.  These regulations expired on 5/11/92.  If the taxpayer cites any provision in Reg. § 1.469-4T, he is citing old law which has no applicability for years after 1992.
  • Reg. § 1.469-4:  Contains the final regulations for grouping businesses and/or rentals.  Reg. § 1.469-4 governs current years and was effective for 1994 and subsequent years.  Sole proprietorships, farms, partnerships, S Corporations, personal service corporations and closely held C Corporations may be grouped as a single activity if they form an appropriate economic unit, i.e. they form integrated interrelated business activities.  Grouping makes it easier for the taxpayer to meet 500 hour test for material participation.  An activity is not an entity.  It is an integrated interrelated economic unit, which could be comprised of more than one entity.  A single entity also may contain more than one activity, i.e. several different and distinct activities.
  • Reg. § 1.469-4(c):  Entities may be grouped as a single activity if the form an appropriate economic unit.  Factors:  similarities; common control; common ownership; geographic location; interdependencies.
  • Reg. § 1.469-4(d)(1):  Rental real estate or equipment leasing activities may not be grouped with a business unless insubstantial or owned in the same proportionate ownership interest.
  • Reg. § 1.469-4(d)(3):  Limited partners involved in motion pictures, videotapes, farming, exploring or exploiting oil and gas, and exploring or exploiting geothermal deposits may group with another activity only if it is in the same line of business.
  • Reg. 1.469-4(d)(5)(ii):  A C Corporation may be grouped with another activity only for purposes of determining whether the taxpayer materially or significantly participates in the other activity.
  • Reg. § 1.469-4(e)(2):  The taxpayer may change his grouping only if the original grouping was clearly inappropriate or there has been a material change in the facts and circumstances that makes the original grouping inappropriate.    If the taxpayer wants to change his grouping, he must prove that the grouping in prior years was clearly inappropriate.
  • Reg. § 1.469-4(f)  The Commissioner may regroup the taxpayer’s activities if they do not form an appropriate economic unit and a principal purpose is avoidance of the  passive loss limitations. 


  • The five factors indicating that activities form an economic unit are:  similarities, common control, common ownership, location, and interdependencies.
  • A rental may not be grouped with a business unless it is owned in the same percentage as the business or it is insubstantial in relation to the business.
  • Limited partners in IRC § 465(c)(1) activities may not group with other activities, unless in the same line of business.
  • The PSCs and closely held C Corporations may be grouped with other businesses, but only to determine material participation.
  • An examiner may regroup business acts, including treating income producing activities as separate activities, to prevent abuse of the grouping rules.

[1] Reg. § 1.469-4(c)(2) 

[2] A rental is permitted to be grouped under the same ownership rule only if it is leased to the business activity in the grouping.  See Reg. § 1.469-4(d)(1). 

[3] Reg. § 1.469-4(d)(3)  and IRC § 465(c)(1)  

[4] Reg. § 1.469-4(d)(5).  Note that Reg. § 1.469-4(d)(5)(ii) permits a C Corporation to be grouped only for the purposes of determining whether the taxpayer materially or significantly participates.  

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