Recharacterization of Income from Nonpassive to Passive Is Not a Change in Accounting Method

By James A. Beavers, J.D., LL.M., CPA

Tax Accounting

The IRS National Office ruled that the recharacterization of income from nonpassive to passive for purposes of the passive activity loss and credit limit rules of Sec. 469 is not a change of accounting method for purposes of Secs. 446(e) and 481(a).

Background

X owned a 1% general partner interest and X and Y (collectively, the taxpayers) owned a 99% limited partner interest, through their living trust, in a state limited partnership that developed a nursing home. The partnership hired a management company to operate the nursing home in exchange for a fee plus a portion of the profits. The nursing home became fully operational in 1990.

The taxpayers determined that they materially participated in the nursing home from 1990 through 1994, and therefore they treated the majority of the losses flowing from the partnership as not being subject to the passive loss limitation rules under Sec. 469. The taxpayers’ treatment of the losses for the tax years 1990–1994 as nonpassive resulted in their either carrying back the losses to prior years or offsetting them against other income in those years. This treatment allowed the taxpayers to offset their ordinary income with the losses from the nursing home on their tax returns from 1990 through 1994.

The IRS examined the taxpayers’ 1994 tax year, and the IRS examiner questioned whether the taxpayers were correct in deciding that their ownership of the nursing home was not a passive activity in 1994. Specifically, the examiner questioned whether the taxpayers were correct in claiming that they “materially participated,” as defined in Sec. 469(h), in the nursing home activity in 1994.

The examiner believed that the taxpayers did not materially participate in the activity in 1994 and that the nursing home ownership was a passive activity, which resulted in the taxpayers being subject to the passive activity loss and credit limit rules of Sec. 469 in 1994. The examiner requested guidance on whether a recharacterization of the taxpayers’ activities from nonpassive to passive for purposes of Sec. 469 is a change in a method of accounting for purposes of Sec. 446(e), requiring the computation of an adjustment under Sec. 481(a).

The taxpayers did not agree with the examiner’s Sec. 469 position. However, the taxpayers and the examiner agreed that only the change in method of accounting issue would be submitted to the National Office for consideration. Both the taxpayers and the examiner agreed that the National Office should assume for purposes of answering that issue that the examiner is correct about the taxpayers’ lack of material participation in the nursing home activity. Thus, for purposes of answering the question, the National Office assumed that the taxpayers did not materially participate in the nursing home activity in 1994 and were therefore subject to the passive activity loss and credit limit rules of Sec. 469 in that year.

The National Office’s Ruling

The National Office concluded that the actual question before it was whether a determination of whether a taxpayer materially participated in an activity was a method of accounting. It noted that under Regs. Sec. 1.446-1(e)(2)(ii), a change in accounting method includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such an overall plan. A material item is any item that involves the proper time for the inclusion of the item in income or the taking of a deduction. A change in accounting method does not include a correction of mathematical or posting errors, errors in the computation of a tax liability, or an adjustment of any item of income or deduction that does not involve the proper time for the inclusion of the item of income or the taking of a deduction. The National Office explained that a change in the characterization of the income was not a change in accounting method because

the taxpayers’ determination of whether they materially participate in their nursing home activity does not determine into which period an item of income or deduction will be placed. The taxpayers’ determination does not involve the treatment of a “material item.” Simply, determining whether the taxpayers materially participated in their activity for purposes of classifying the activity as passive or not is not an “item”—it is not a recurring incidence of income or expense. Instead, the taxpayers’ determination establishes the character of their activity for that year—it is either passive or it is not passive. Once the character of the activity is determined, then if the activity is passive, the taxpayers must apply the statutorily mandated rules of Sec. 469 to any existing loss.

Instead, according to the National Office, if the taxpayers did not actually materially participate in the partnership’s activities, their mischaracterization of their income as nonpassive was an error, and thus the recharacterization of the income as passive would be a correction of an error, not a change in a method of accounting.

The IRS examiner cited Knight-Ridder, 743 F.2d 781 (11th Cir. 1984), as support for the position that a recharacterization of the taxpayer’s income from the partnership would be a change in method. However, the National Office distinguished that case from the present case because the items at issue in Knight-Ridder were items of income and expense, whereas in the present case the issue was a factual determination of whether the taxpayers materially participated in an activity.

Reflections

This ruling saves the taxpayers from a potentially burdensome and expensive reporting requirement. As the National Office pointed out, if a change in the characterization of income had been treated as a change in method, the taxpayers could possibly have been required to calculate a Sec. 481(a) adjustment and file a Form 3115, Application for Change in Accounting Method, every year if their level of participation varied from year to year.

TAM 201035016

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