Maximizing the use of losses from passive business activities requires an in-depth understanding of IRC section 469. The rules that govern passive activities and prohibit the use of passive activity losses to offset nonpassive income are among the most complex, ambiguous, and burdensome in the area of taxation. Revenue Procedure 2010-13 provides some additional guidance in applying the activity grouping rules, but there continues to be considerable disagreement among practitioners and the IRS over the correct application of these rules.
Ambiguities notwithstanding, the IRS is intent on strict compliance. Failure to correctly group activities and sufficiently document the taxpayer’s active participation in individual business activities can result in disallowed losses and substantial penalties.
This article provides insights and recommendations aimed at helping taxpayers comply with section 469 rules to best minimize their tax liability.
Aimed at curbing tax shelter activity prior to 1986, section 469 prohibits taxpayers from using losses derived from passive activities to offset income earned on activities in which the taxpayer materially participates. In other words, passive losses can be used only to offset passive income. To the extent passive losses exceed passive income, they can be carried forward and used to offset passive losses in subsequent years.
Because losses from passive activities cannot be used to offset nonpassive income, taxpayers generally are interested in maximizing the number of business activities that qualify as nonpassive—that is, activities in which the taxpayer materially participates.
In determining material participation, section 469 allows taxpayers to group separate activities together and treat them as a single activity as long as the group constitutes an appropriate economic unit. Section 469 defines an appropriate economic unit on the basis of facts and circumstances, particularly the extent of common control or ownership, geographic location, and the interdependence among activities.
The IRS is adamant about the correct application of this rule. If the IRS determines that grouped activities do not constitute an appropriate economic unit, or that the principal purpose of a grouping is to circumvent section 469’s prohibition against the use of passive losses to offset nonpassive income, the IRS will separate or regroup activities.
Complying with section 469 rules
Among the most important things taxpayers can do to ensure compliance with section 469 rules and maximize the use of passive losses is to group activities correctly. To this end, we offer the following recommendations:
- Consistent ownership: Keep ownership percentages of individual businesses consistent from year to year. The IRS is more likely to question and regroup activities with significant percentage ownership changes from one year to the next.
- Geographic location: To the extent possible, group activities by location. Although the IRS has become more willing to accept groupings of geographically diverse businesses, it is less likely to challenge groupings of activities in close physical proximity to each other.
- Interdependence of activities: The IRS is more likely to accept the taxpayer’s groupings—and, thus, less likely to regroup—if the business activities are interdependent. Take, for example, an activity group consisting of a bakery and a restaurant. The IRS is more likely to accept the grouping if the bakery provides baked goods to the restaurant.
Once activities are grouped, they are not easily regrouped. The consistency requirement of section 469 says once a taxpayer has grouped activities, the taxpayer may not regroup in subsequent tax years unless the taxpayer can show that the original grouping was clearly inappropriate or that there is a material change in facts and circumstances that makes the original grouping inappropriate.
The burden of proving a material change in facts and circumstances lies with the taxpayer, and experience suggests the IRS doesn’t easily accept taxpayer regroupings. The best way to circumvent this potential problem is to get groupings right in the first place. The role of long-term business planning in correctly grouping passive and nonpassive activities becomes even more critical in light of the new 3.8 percent Medicare contribution tax on investment income, which takes effect in 2013. This incremental tax on passive income creates an additional incentive for taxpayers to analyze their groupings and document their participation in their business activities so that nonpassive income subject to new Medicare tax is minimized.
Taxpayers must also keep in mind that if a single activity is left ungrouped the IRS considers that activity a "group of one." There is disagreement among practitioners over the IRS’s position that reporting a single activity constitutes the grouping of that activity and whether that activity can later be inserted in another activity group. To avoid a situation in which the taxpayer is unable to regroup an activity, taxpayers generally will not want to leave activities ungrouped. Besides, in many circumstances, taxpayers will benefit from grouping activities.
Section 469 requires taxpayers to disclose activities added to or removed from existing groups during the tax year. However, we recommend disclosing all activity groupings every year. Repeating the same groupings year after year is the best way to establish a track record of grouping documentation that is required in an IRS exam.
Documenting material participation
Besides correctly grouping activities, taxpayers must also document their material participation in the grouped activities. Detailed, contemporaneous documentation of time devoted to each activity will provide invaluable proof of material participation in an IRS exam. We believe it is essential for taxpayers to maintain a contemporaneous calendar, documenting on a daily basis the following items:
- Dates and time spent on each business activity
- Business purpose of all meetings and work sessions
- Names of individuals present in all meetings and work sessions
We cannot overstate the importance of maintaining a contemporaneous record of time spent on all business activities. Reliance on after-the-fact documentation in an audit almost inevitably results in significant disallowed losses and additional tax liabilities.
If you have questions or would like more information on this topic, please contact a member of your Baker Tilly service team or e-mail our tax team at firstname.lastname@example.org.