Editor: John L. Miller, CPA
The passive activity loss and credit limitation rules in Sec. 469 apply to individuals, trusts, estates, personal service corporations, and closely held C corporations. The rules prevent taxpayers subject to them from applying losses or credits generated by rental activities and activities in which they do not materially participate against investment income, compensation, or income from activities in which they do materially participate. In order to be treated as materially participating in an activity, a taxpayer must be involved in the operations of the activity on a regular, continuous, and substantial basis.
Taxpayers who are involved in multiple separate but related trade or business activities may find it difficult to meet the stringent material participation requirements of Sec. 469 for each activity. In addition, activities that involve property rental are treated as passive activities regardless of whether the taxpayer materially participates. As a result, the application of the passive activity rules could produce harsh results were it not for provisions in Regs. Sec. 1.4694(c)(1) that allow taxpayers to treat separate activities as a single activity for the purposes of Sec. 469. Generally, a taxpayer may treat multiple trade, business, or rental activities as a single activity if the facts and circumstances indicate that they constitute an appropriate economic unit.
The rules in Regs. Sec. 1.4694 place limits on which activities may be aggregated and limit the ability of taxpayers to change groupings from year to year. Once a taxpayer has grouped activities for a tax year, changes to groupings are generally not allowed. Changes are required, however, when it is determined that the taxpayer’s original grouping was clearly inappropriate or becomes inappropriate as a result of a material change in the facts and circumstances.
Grouping Disclosure Statements
Except for a special provision in Regs. Sec 1.4699(g) that applies only to certain real estate professionals, taxpayers have not been required to file grouping election forms or disclosure statements. As a result, it is difficult for the IRS to determine whether groupings are appropriate or whether prohibited changes have been made to groupings.
In 2008, the IRS issued Notice 200864, in which it proposed rules to require the filing of written statements with tax returns to disclose the grouping of activities under the passive activity regulations. After considering comments on the proposed rules, the IRS recently issued Rev. Proc. 201013, which provides final rules pertaining to the filing of passive activity grouping disclosure statements.
The new rules require written disclosure statements to be filed for activities that are grouped for the first time for tax years that begin on or after January 25, 2010. The statements must:
- Be filed with the tax return;
- Disclose the names, addresses, and EINs of trade, business, or rental activities that are grouped; and
- Include an attestation that the activities together form an appropriate economic unit for the purposes of Sec. 469.
Groupings that were made before the effective date of the revenue procedure are not required to be disclosed. However, when additions or changes are made to groupings, a disclosure statement must be filed with the required information for each activity within the resultant groupings, including the attestation that the grouped activities form an appropriate economic unit. The disclosure must also include an explanation of the justification for the change—specifically, why the taxpayer’s original grouping was inappropriate or what material change in the facts and circumstances makes the original grouping inappropriate.
Partnerships and S Corporations
Rev. Proc. 201013 does not require additional disclosures by partnerships and S corporations. Groupings of activities for the purposes of Sec. 469 are already required to be disclosed on statements filed with Forms 1065, U.S. Return of Partnership Income, and 1120S, U.S. Income Tax Return for an S Corporation. The new rules do not require partners and shareholders to make separate disclosures of groupings that were reported by passthrough entities. However, partners and shareholders must separately disclose when:
- They group together activities of an entity that were not grouped together by the entity;
- They group an entity’s activities with activities conducted directly by the partners or shareholders; and
- They group an entity’s activities with activities conducted by other entities.
Failure to File a Grouping Disclosure Statement
The failure to file a required disclosure statement with a tax return will generally result in the activities’ being treated as separate activities for the application of the passive activity loss and credit limitations unless the taxpayer can establish good cause for the failure to disclose. However, Rev. Proc. 201013 includes a relief provision for taxpayers who discover the error before the IRS discovers it, treat the groupings consistently, and file the required disclosure statement with the return for the year in which the error was discovered.
John Miller is a faculty instructor at Metropolitan Community College in Omaha, NE. John Slatten is with Slatten and Company, LLC, in Indianapolis, IN, and is a member of the AICPA Tax Division’s IRS Practice and Procedures Committee. For further information about this column, contact Mr. Miller at email@example.com.