Passive Loss Rules

1. Passive Loss Rules Matthew K. Becker, CPA BDO Douglas J. Patch, Godfrey & Kahn, S.C. November 4, 2010 mw5514693

2. History of Passive Loss Rules • Prior to TRA 1986, few limitations were placed on ability to use deductions from one activity to offset income from another activity. • Tax Shelters were designed to generate large deductions with minimal investment. • TRA 1986 addressed this situation with many lines of attack: expansion of AMT, extension of at-risk rules to real estate and passage of the passive loss rules.

3. Effect of Passive Loss Rules • Loss from passive activities can not offset active income or portfolio income. • Exceptions to general rule of disallowance: • Dispositions • Former passive activity rules • $25,000 Rental/Real Estate Activity Rule

4. Effect of Passive Loss Rules - Dispositions • Dispose of entire interest in activity in a fully taxable transaction allows utilization of suspended losses. • What is an activity? • What is a qualifying disposition?

5. Effect of Passive Loss Rules - Dispositions • Appropriate Economic Unit to determine “activity.” • Facts and circumstances relevant in grouping. • Decision made at entity level. • Limitations • Rental Activity/Non-rental activity • Real Property Rental/Personal Property Rental

6. Effect of Passive Loss Rules - Dispositions • Must dispose of entire interest in activity • Disposition must be fully taxable • Related Party Rule • Installment sales

7. Effect of Passive Loss Rules – Other Triggering Events • Activity ceases to be passive • Not a disposition • Can use suspended losses to offset income from the same activity • $25,000 Rental Real Estate Rule • Can treat $25,000 as active if active in the rental • Otherwise, real estate is per se passive

8. Determining Whether an Activity is Passive • Trade or Business in which the Taxpayer does not materially participate. • Rental Activity.

9. Material Participation Standard • Material Participation means involvement is regular, continuous and substantial. • Regulations provide Material Participation standard met if and only if one of seven tests met. • First six tests are narrowly quantitative, the seventh is a facts and circumstances test.

10. Material Participation – Test One • Taxpayer must participate more than 500 hours • Taxpayer must own activity at time of services for services to count • Certain hours disregarded: • Non-owner work done to meet 500 hour test • Work done in investor capacity unless taxpayer involved in day-to-day management

11. Material Participation – Test Two • Met if the taxpayer’s participation constitutes substantially all of the participation in the activity. • If test met, does not matter how few hours taxpayer spends participating in activity. • Services of non-owners is considered.

12. Material Participation – Test Three • Met if a taxpayer participates in an activity for more than 100 hours and his participation is not less than that of any other individual during the same year. • Work performed by non-owners is considered. • Not clear whether number of hours is sole determinant of who participates more.

13. Material Participation – Test Four • Met if aggregate participation in all “significant participation activities” exceeds 500 hours. • A SPA is a non-rental trade or business in which taxpayer participates for more than 100 hours and none of the other tests are met. • If fail the 500 hour aggregate test, income from SPAs is considered active, but loss is considered passive.

14. Material Participation – Test Five • If materially participated (based on other tests) in five of past ten years, then considered to materially participate in current year. • Test designed to prevent flip-flops, i.e., treatment of an activity as nonpassive when it generates losses and active when it generates income.

15. Material Participation – Test Six • Met if participated in a personal service activity for any three prior taxable years. • Personal service activity means any business where capital is not a material income-producing factor including, but not limited to, health, law, engineering, architecture, accounting, performing arts or consulting. • Several cases in the area.

16. Material Participation – Test Seven • Met if, based on all the facts and circumstances, a taxpayer establishes regular, continuous and substantial involvement in the activity. • Regulations specify this test cannot be met if taxpayer participates in an activity for 100 hours or less. • Management services are disregarded unless: (1) no other individual is compensated for providing management services and (2) no other individual performs a greater number of management hours.

17. Material Participation – Other Considerations • Distinction between investors and entrepreneurs • Treatment of limited partners • Material Participation by legal entities

18. Definition of Rental Activity • A rental activity is an activity where payments are for the use of tangible property. • Exception One: Average customer use period of seven days or less. • Exception Two: Average use of 30 days or less and significant personal services. • Exception Three: Extraordinary personal services.

19. Definition of Rental Activity, cont. • Exception Four: Rentals incident to nonrental activities of taxpayer. • Exception Five: Property customarily made available for nonexclusive use by various customers. • Exception Six: Property rented to a pass through entity or joint venture in which the taxpayer owns an interest. • Exception Seven: Rental of taxpayer’s residence.

20. Real Estate Operators • Taxpayers who qualify as real estate operators must treat their rental activities as nonpassive upon a showing of material participation. • Definition of real estate operator: • Closely held C corporation with more than 50% of gross receipts from real property. • Individuals who perform more than 50% of services in a real property trade or business AND more than 750 hours in real property trades or businesses in which he materially participates.

21. Real Estate Operators • Must group all real estate activities together as a whole or treat separately. • Must still meet one of the seven activity tests for trade or business to be considered active.

22. Net Income from Nonshelterable Passive Activities (“NOPAs”) • Six situations in which net gain, but not net loss, from a passive activity is treated as nonpassive. • Can use suspended loss from NOPA to offset income from the NOPA. • NOPA #1: Significant Participation Passive Activities

23. NOPAs, cont. • NOPA #2: Rental of Nondepreciable Property. • NOPA #3: Equity-Financed Lending Activity. • NOPA #4: Property Rented Incidental to Development Activity

24. NOPAs, cont. • NOPA #5: Property Rented to a Nonpassive Activity of the Taxpayer. • NOPA #6: Certain Royalties Received Through a Pass Through Entity.

25. Self-Charged Interest Rule • Interest income is portfolio income generally not available to offset loss from a passive activity. • Self-charged interest rule allows offset of interest expense of debtor passive activity attributable to loan from owner.

26. Self Charged Interest Example X owns 50%; Y owns 50% of LLC. LLC conducts per se passive rental activity. X loans $1,000,000 to LLC at 10% interest rate. X can treat $50,000 of interest income as passive income. 26

27. Self Charged Interest Example, Cont. • What if $1,000,000 were contributed as preferred equity with a 10% priority return? • Economics between X and Y would be the same • Entire special allocation is passive income and could be offset with passive loss. • Must take care to avoid having the special allocation treated as a guaranteed payment. 27

28. Rev. Proc 2010-13 • Requires taxpayers to report their groupings and regroupings of activities. • Also requires reporting additions of activities to current groupings. • Effective for tax years beginning on or after January 25, 2010.

29. Reporting Requirements – New Groupings • The taxpayer must file a statement identifying the activities. • Statement must be attached to the original return for the first taxable year in which two or more activities are grouped.

30. Reporting Requirements – Existing Groupings • No disclosure is required for existing groupings that are unchanged. • Statement must be attached to the tax return in any year that an activity is added to an existing group. • When adding an activity, the entire group must be disclosed.

31. Regrouping Activities • Regrouping is required for groups that are clearly inappropriate or have a material change in facts and circumstances. • Failing to regroup inappropriate activities will cause each activity to be treated separately.

32. Special Rules –Partnerships and S-Corps • Partnerships and S Corporations must report groupings to partners and shareholders. • Grouping is reported by separately stating income and loss for each group on attachments to the entity’s Schedule K-1.

33. Reporting Requirements – Partners and Shareholders • Partners and shareholders are generally not required to report groupings disclosed by the entity. • Separate disclosure is required if the partner or shareholder: • Groups together activities that the entity does not group together, • Groups entity activities with activities conducted directly by partner or shareholder, and/or • Groups entity activities with activities conducted through other passive entities.

34. Partners & ShareholdersExample – Grouping Partnerships • Assume the taxpayer holds a partnership interest in a grocery distributor as well as a partnership interest in a separate entity that owns the warehouse rented to the distributor. • Assume both partnerships are under common control and that the warehouse is rented predominantly to the distributor.

35. Partners & ShareholdersExample – Grouping Partnerships cont. • Each partnership attaches a statement of activity to the partner’s K-1. • The taxpayer may elect to group these activities into a single activity. • If grouped, the taxpayer’s material participation is measured by testing both activities together as one activity.

36. Partners & ShareholdersExample – Grouping at Entity Level • Assume the same facts as the previous example except that the distributor activity and the warehouse activity are part of one partnership. • Further assume that the partnership chooses to group the activities. • Assume the taxpayer materially participates in the distribution activity but not the warehouse activity.

37. Partners & ShareholdersExample – Grouping at Entity Level cont. • The activities must remain grouped on the partner’s return. • If the taxpayer’s material participation in the distributor activity is not enough to make him a material participant in the entire economic unit, both activities become passive.

38. Grouping Factors • Any reasonable method can be used to group activities. • Grouped activities must constitute appropriate economic units. • Similarities and differences in types of trades or businesses. • The extent of common control and/or ownership. • Geographical location. • Interdependencies between or among the activities.

39. Grouping Factors cont. • Business interdependencies can arise from: • Having the same customers, • Having the same employees, and/or • Having a single set of books or records. • Interdependencies among activities can also arise when: • Activities purchase or sell goods to each other, or • Products or services are normally provided together.

40. Grouping Factorscont. • Taxpayers may not combine or separate activities each tax year. • Regrouping is only allowed in circumstances where the initial grouping was: • “clearly inappropriate or there has been a material change in the facts and circumstances that makes the original grouping inappropriate.” • Commissioner can regroup a taxpayer’s activities when clearly inappropriate.

41. Grouping FactorsExample – Appropriate Economic Unit • Taxpayer owns a bakery and a movie theater in a mall located in Chicago, IL. • He also owns a bakery and a movie theater in a mall located in Houston, TX. • Depending on other circumstances, the taxpayer may: • Group all the activities into a single activity, • Group them as a movie theater activity and a bakery activity, • Group them as a Chicago activity and a Houston activity, or • Treat them as four separate activities.

42. Benefits of Grouping • Taxpayers can potentially combine passive rental activities with profitable active trade or business activities. • Activities can only be combined if the activities constitute an appropriate economic unit and: • The rental activity is insubstantial in relation to the trade or business activity, • The trade or business activity is insubstantial in relation to the rental activity, or • They have the same proportionate ownership.

43. Benefits of GroupingExample – Proportionate Ownership • Husband is the sole owner of an S corporation that conducts a grocery store trade or business activity. • Wife is the sole owner of an S Corporation that owns and rents out a building. • Part of the Wife’s building is rented to the Husband’s grocery store. • Both activities are reported on a joint tax return. • The activities can be combined as if the grocery store S Corporation owned the portion of the rented building used by the grocery store.

44. Regrouping ActivitiesExample – Material Change • Assume the same facts as the previous example except that the grocery store business was moved to an unrelated location. • The rental property is now rented to an unrelated party. • A material change in facts and circumstances has occurred and the activities must be regrouped separately.

45. Suspended Losses – General Rules • Losses can generally be suspended for two reasons: • Passive activity loss rules • At-Risk Basis Rules • Passive losses can only offset passive income. • Passive losses are carried forward until used or activity is disposed. • All losses are limited to amount investor has “at risk”.

46. Suspended Losses – Combined Passive Activities • Total losses from combined passive activities are allocated among each separate activity. • The ratable portion of each separate activity’s deductions that are suspended are determined as follows:

47. Suspended LossesExample – Allocation • Assume these are treated as a single passive activity with the following results: • The loss would be allocated as follows:

48. Suspended Losses – Example – Allocation (cont.) • Assume that the taxpayer disposed of the movie theater the next year. • The taxpayer can elect to treat the movie theater as a separate activity in the year disposed. • The $12,000 suspended loss would be deductible in full to offset non-passive income upon disposition.

49. At-Risk Basis • In general, limits losses to what the taxpayer actually has “at risk”. • At-risk losses are suspended until the taxpayer increases at-risk basis through income or contributions. • Suspended at-risk losses are subject to the passive loss rules in the year in which the loss is allowed.

50. At-Risk BasisExample – Suspended Losses (Year 1) • Assume the taxpayer purchased an interest in a passive activity with the following transactions in Year 1. • The taxpayer has a $15,000 suspended loss due to the passive activity rules and a $5,000 suspended loss due to the at-risk rules.