Sec. 469 generally provides that losses from passive trade or business activities are disallowed and carried forward to the extent they exceed income from all such passive activities during the tax year. Similar limitations apply to credits generated by passive activities.
Regs. Sec. 1.469-4 sets forth rules for grouping a taxpayer’s trade or business activities and rental activities for purposes of applying the passive activity loss and credit limitations. In general, those regulations provide that one or more trade or business or rental activities may be treated as a single activity if the activities constitute an “appropriate economic unit” for the measurement of gain or loss for purposes of Sec. 469.
Taxpayers are generally allowed to use any reasonable method in determining the appropriate grouping of their activities based on all the relevant facts and circumstances. However, the regulations impose specific limits on the grouping of rental with nonrental activities, real property rental activities with personal property rental activities, and activities engaged in as a limited partner or limited entrepreneur with any other activity. Factors a taxpayer must consider in determining whether two or more activities represent an appropriate economic unit include similarities and differences in types of trades or businesses; the extent of common control; the extent of common ownership; geographical location; and interdependencies between or among the activities.
Grouping is relevant for a number of reasons, and it is not always readily apparent what groupings will be most favorable to the taxpayer. For example, if a taxpayer engages in two activities and treats them as separate, he or she must establish material participation in each activity separately to avoid passive loss limitations. If instead the taxpayer groups the two activities into one larger activity, the taxpayer may combine his or her participation in both activities to establish material participation. Thus, if nonpassive treatment is preferable, it may be advantageous for the taxpayer to group the activities.
On the other hand, grouping activities may limit a taxpayer’s ability to claim suspended losses upon disposition. Sec. 469(g) generally permits a taxpayer to claim suspended passive losses against nonpassive income when the taxpayer disposes of his or her entire interest in the activity in a fully taxable transaction. If the taxpayer groups two activities and later disposes of only one, Sec. 469(g) generally does not apply. But if the taxpayer does not group the activities, a disposition of either activity will generally free up its share of any suspended losses. Thus, it may sometimes be advantageous not to group activities.
Unfortunately, hindsight is not helpful in determining the most favorable groupings. Once a taxpayer has grouped activities, he or she may not generally regroup those activities in subsequent tax years. Regrouping is allowed only if the taxpayer’s original grouping was clearly inappropriate or a material change in the facts and circumstances has occurred that makes the original grouping clearly inappropriate.
The regulations require taxpayers to comply with any disclosure requirements that the IRS may prescribe with respect to both their original groupings and the addition and disposition of specific activities within those chosen groupings in subsequent tax years. Prior to the publication of Rev. Proc. 2010-13, no disclosure requirements were prescribed other than the filing of Form 8582, Passive Activity Loss Limitations, in accordance with its instructions. The information reportable on Form 8582 is often insufficient for the IRS to determine whether a taxpayer has grouped activities consistently from year to year.
Rev. Proc. 2010-13
Under Rev. Proc. 2010-13, a taxpayer is required to file a statement with his or her income tax return for the first tax year in which the taxpayer originally groups two or more trade or business activities or rental activities as a single activity. The statement must identify the names, addresses, and employer identification numbers (if applicable) of the activities being grouped and must contain a declaration that the grouped activities constitute an appropriate economic unit. A similar statement is required if the taxpayer adds a new trade or business activity or a rental activity to an existing grouping for a tax year, or regroups activities upon determining that the original grouping was clearly inappropriate or that a material change in facts and circumstances has occurred. No statement is required for the disposition of an activity within a chosen grouping.
The new disclosure requirements do not generally apply to partnerships and S corporations. Such entities must comply with the disclosure instructions for grouping activities on Forms 1065, U.S. Return of Partnership Income, and 1120S, U.S. Income Tax Return for an S Corporation, which require the entity to separately state the amounts of income and loss for each grouping conducted by the entity on attachments to the entity’s annual Schedule K-1. However, if the partnership or S corporation makes the disclosures required by Rev. Proc. 2010-13, a partner or shareholder will not be required to make a separate disclosure of the entity’s groupings unless he or she groups together activities that the entity does not group together or groups the entity’s activities with other activities. A shareholder or partner may not treat activities grouped together by his or her S corporation or partnership as separate activities.
If a taxpayer fails to report whether the activities have been grouped in accordance with the revenue procedure, each such trade or business or rental activity will be treated as a separate activity for purposes of applying Sec. 469. However, a taxpayer will be deemed to have made a timely disclosure if he or she has filed all affected income tax returns consistent with the claimed grouping of activities and makes the required disclosure on the income tax return for the year in which the taxpayer first discovers the failure to disclose. If the IRS first discovers the failure to disclose, however, the taxpayer must also have reasonable cause for not making the required disclosures.
The revenue procedure is effective for tax years beginning on or after January 25, 2010. Thus, most individuals will not be subject to the new reporting requirements until preparing income tax returns for the year ending December 31, 2011. Taxpayers will not be required to file disclosure statements for groupings of activities made before the effective date until there is an addition to an existing group or activities are regrouped.
Editor: Kevin D. Anderson, CPA, J.D.
EditorNotes
Kevin Anderson is a partner, National Tax Services, with BDO Seidman, LLP, in Bethesda, MD.
For additional information about these items, contact Mr. Anderson at (301) 634-0222 or kdanderson@bdo.com.
Unless otherwise noted, contributors are members of or associated with BDO Seidman, LLP.
