The Tax Reform Act of 1986 (TRA) brought about a large decline in tax-sheltered investments by instituting section 469 of the Internal Revenue Code, now known as the passive loss rules. These rules operated to disallow losses from activities in which the taxpayer did not “materially participate” as a current deduction against other sources of income.
In order for a taxpayer to “materially participate” in an activity, and use losses from those activities to offset non-passive income, one of seven tests spelled out in regulations must be satisfied. These tests generally examine the amount of time and/or effort the taxpayer spends in the activity.
In certain circumstances, the regulations allow a taxpayer to group activities into “appropriate economic units” for purposes of testing for material participation. This economic grouping concept requires an assessment of a taxpayer’s relevant facts and circumstances. The following are factors, not all of which are necessary, to be considered in determining whether multiple activities may constitute an appropriate economic unit:
- Similarities and differences in types of trades or businesses;
- The extent of common control;
- The extent of common ownership;
- The geographical location; or
- The interdependencies between or among the activities.
All of a taxpayer’s activities should be considered when determining what constitutes an appropriate economic unit for the measurement of income or loss for purposes of passive activity. Appropriate tax planning and groupings could allow utilization of past, current, and future losses.
Of course, limitations apply. A rental activity may not be grouped with a trade or business activity unless the activities being grouped together 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
- Each owner of the trade or business activity has the same proportionate ownership interest in the rental activity, in which case the portion of the rental activity that involves the rental of items of property for use in the trade or business activity may be grouped with the trade or business activity.
Baker owns passive activity rental partnerships and an S corporation that manages the rental property. The S corporation was created to provide services to the partnerships and to facilitate the taxpayer's active involvement in the rental activity. All of the S corporation's income is derived from managing the rental activity. The daily operations of both the S corporation and the rental partnerships are performed by a single group of employees under Baker's supervision. The S corporation's income is 10% of the gross income and 3% of the total market value of the combined activities. Based on all these factors, the S corporation's activities are considered insubstantial in relation to the rental activities and the activities may be grouped.
Jason and Paula are married and file a joint return. Jason is the sole shareholder of an S corporation that operates a grocery store. Paula is the sole shareholder of an S corporation that owns and rents a building, part which is rented to Jason's grocery store. The grocery store rental and the grocery store trade or businesses are not insubstantial in relation to each other. Because they file a joint return, Jason and Paula are treated as one taxpayer. Therefore, the sole owner of the trade or business activity is also the sole owner of the rental activity. Consequently, each owner of the trade or business activity has the same proportionate ownership interest in the rental activity. The grocery store rental and the grocery store trade or business activity may be grouped together into a single trade or business activity, if the grouping is otherwise appropriate.
In conclusion, with advance tax planning, the economic groupings can help reduce your tax liability by maximize your tax deductions and create nonpassive income or losses. In addition, the economic grouping provision can help alleviate the new Medicare tax on net investment income effective for tax years beginning January 1, 2013. Please see the prior Insight article regarding the 3.8% Medicare tax effect on net investment income and passive activity.
For more information, please contact Steven A. Barber at firstname.lastname@example.org.
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