Election to group activities for purposes of passive activity loss rules

Editor: Kevin D. Anderson, CPA, J.D.

In its decision in Hardy, T.C. Memo. 2017-16, the Tax Court held that a taxpayer had not elected to group two activities together under the passive activity loss rules simply by treating both activities as nonpassive. Notably, as the Tax Court pointed out, the IRS and the taxpayer each took tax positions more commonly argued by the opposing side, as the taxpayer, a surgeon, sought to be treated as a passive investor in a surgery center in which he performed surgeries.

General rules

Under Sec. 469, the deduction of losses from a passive activity is limited to the amount of passive income from all passive activities, until there is a fully taxable disposition of the taxpayer’s entire interest in the activity. A passive activity loss is generally the excess of the aggregate losses from all passive activities for the tax year over the aggregate income from all passive activities for that year. When a taxpayer’s passive activity loss deduction is disallowed, it is treated as a deduction for the next tax year and can be carried forward indefinitely.

In general, a passive activity is any trade or business in which the taxpayer does not materially participate. Temp. Regs. Sec. 1.469-5T provides seven general tests to determine whether an individual can classify participation as material. The application of the seven tests was not discussed in this case.

Sec. 469 does not define the term “activity” and a separation of activities based on separate legal entities is not required. Regs. Sec. 1.469-4(c)(1) provides for a grouping of legal entities if their activities constitute an appropriate economic unit for the measurement of gain or loss.

Regs. Sec. 1.469-4(c)(2) provides a facts-and-circumstances test for determining whether a grouping of activities results in an appropriate economic unit. Therefore, whether activities constitute an appropriate economic unit under this test and may be treated as a single activity depends on all the relevant facts and circumstances. A taxpayer may use any reasonable method of applying the relevant facts and circumstances in grouping activities. The factors given the greatest weight in the regulation are (1) similarities and differences in types of trades or businesses; (2) the extent of common control; (3) the extent of common ownership; (4) geographical location; or (5) interdependencies between or among the activities.

Regs. Sec. 1.469-4(e) provides that once a taxpayer has grouped activities, the taxpayer cannot regroup those activities unless “it is determined that a taxpayer’s original grouping was clearly inappropriate or a material change in the facts and circumstances has occurred that renders the original grouping clearly inappropriate.”

Facts in Hardy

The taxpayers in Hardy, Stephen Hardy and Angela Hardy, were married during tax years 2008 through 2010, the years at issue. Hardy, a plastic surgeon based in Missoula, Mont., specialized in pediatric reconstructive surgery. Hardy conducted his medical practice through Northwest Plastic Surgery Associates (PSA), a single-member professional limited liability company (LLC) of which Angela Hardy was the COO.

Hardy performed minor surgeries at his office and more complex procedures at two local hospitals. He explained to his patients the options for selecting a location for their surgery, and the practice manager provided a cost estimate for different locations. While his patients ultimately decided where to undergo surgery, availability of operating rooms at the local hospitals was limited.

Hardy’s services generally required three fee components: (1) a fee paid to PSA for his surgical services; (2) a fee for an anesthesiologist’s services; and (3) a fee paid directly to the surgical facility.

Because of the difficulty in scheduling operating rooms in the two local hospitals, Hardy considered opening his own surgery center. However, he eventually decided not to open his own surgery center and instead became a member of the already existing Missoula Bone & Joint Surgery Center LLC (MBJ).

MBJ, an LLC treated as a partnership for federal income tax purposes, had been formed by a group of physicians to operate a surgical center. MBJ’s facility was equipped for doctors to perform simple procedures that require local or general anesthesia without an overnight stay, and provided patients with a cost-efficient alternative to having procedures performed at a hospital.

MBJ was professionally managed, self-sufficient, and independent of PSA. Patients were directly billed by MBJ for facility fees. The LLC provided each member a cash distribution representing his or her share of the earnings less expenses. The LLC paid distributions to each member regardless of the number of procedures they performed at MBJ. Physicians performing procedures at MBJ were not paid any direct compensation. MBJ engaged a third-party accounting firm to prepare Schedules K-1 (Form 1065, U.S. Return of Partnership Income) for its members.

In 2006, Hardy purchased a 12.5% interest in MBJ. The following year, PSA built an office next to the MBJ facility. Hardy never managed MBJ, nor did he have any day-to-day responsibilities there. Although he met with the other members quarterly, he did not have any influence on management decisions, including decisions on hiring or firing employees. He performed surgeries on patients at MBJ strictly on Mondays, while performing surgeries at two other area hospitals on alternating Tuesdays. On the other days of the week, Hardy performed surgeries at his medical practice. He performed approximately 20% of all his procedures at MBJ.

Reporting income and losses

On their 2006 and 2007 joint tax returns, the Hardys’ tax preparer reported their MBJ income as nonpassive, based on the Schedule K-1 from the LLC, and paid self-employment tax on the income. However, starting with the 2008 tax year, after learning Hardy was not involved in the management of MBJ, the tax preparer concluded that the MBJ income should be classified as passive. Thus, for the 2008 through 2010 tax years, the Hardys’ tax returns reported their MBJ income as passive, allowing Hardy to use current and carried over suspended passive activity losses from other passive activities to offset the MBJ income.

For all tax years 2006 through 2010, the Hardys’ individual income tax return did not include any statement electing to group the MBJ activity with the activity of PSA.

Tax Court opinion

The IRS asserted that the Hardys had made an election to group the activities of MBJ and PSA, because they had classified income from both sources as nonpassive in 2006 and 2007. However, the Tax Court disagreed, citing Regs. Sec. 1.469-4(e). The IRS was not able to produce any evidence to support a grouping of the taxpayer’s ownership interest. The court found that the mere fact that income from two sources was reported as nonpassive was insufficient to conclude that the activities were grouped for purposes of Sec. 469.

The IRS also cited Regs. Sec. 1.469-4(f)(1), which gives the IRS the authority to regroup a taxpayer’s activities if any of the activities resulting from the taxpayer’s grouping are not an appropriate economic unit and a principal purpose of the taxpayer’s grouping is to circumvent the underlying purposes of Sec. 469.

The IRS stated that Hardy’s facts and circumstances were almost identical to those described in the example in Regs. Sec. 1.469-4(f)(2). The example concludes that a business activity of acquiring and operating X-ray machines should be grouped with a doctor’s medical practice. However, the taxpayer successfully differentiated his ownership interest in MBJ, a rental surgical facility, as a separate economic unit from PSA, an active medical practice. In addition, Hardy’s acquisition of his interest in MBJ was driven by a valid business purpose, i.e., Hardy’s intent to find additional facilities in which to perform procedures; thus, the court concluded that Hardy did not become a member of MBJ for the purpose of artificially creating income from a passive activity.

Passive vs. nonpassive: Self-employment tax considerations

The tax preparer’s initial classification of MBJ income as nonpassive was based on the Schedule K-1 Hardy received, which reported the income as “net earnings from self-employment” under Sec. 1402. However, later, after investigating the nature of Hardy’s involvement in the day-to-day operations of MBJ, the preparer concluded that the activity could properly be classified as passive and began treating the income from MBJ as passive.

Under Sec. 1402(a), a taxpayer generally includes in self-employment income his or her distributive share (whether or not distributed) of income or loss described in Sec. 702(a)(8) from any trade or business carried on by a partnership of which he is a member. Sec. 1402(a)(13) provides an exception to permit the exclusion of the distributive share of any item of income or loss of a limited partner, other than guaranteed payments to that partner for services actually rendered to or on behalf of the partnership, to the extent that those payments are established to be in the nature of remuneration for those services. This exception was enacted before limited liability entities taxed as partnerships were contemplated, and the term “limited partner” is undefined by the Code for these purposes.

While the IRS argued that the performance of medical procedures at the facilities of MBJ tainted Hardy’s classification as a limited partner, the court disagreed, citing Renkemeyer, Campbell & Weaver, LLP, 136 T.C. 137 (2011), which established criteria to determine whether a partner/member’s involvement exceeds that of a limited partner. In Renkemeyer, the Tax Court held that attorney-partners in a law firm operating as a limited liability partnership were subject to self-employment tax on their income from the partnership because the income they derived from the firm was for legal services the partners provided to the firm.

In Hardy, the Tax Court affirmed the possibility that an LLC member may be treated as a passive investor who should not be subject to self-employment tax. The court noted that Hardy received a distribution from MBJ based on the net taxable results from the operations of the facility, independent of fees collected by PSA for the services he provided at the MBJ facility. Hardy had no management or day-to-day responsibilities at the facility, and his share of the MBJ income was not tied to surgeries that he performed but was related to the fees that patients paid for the use of the facility. Thus, the court concluded that Hardy was an investor in MBJ and held that the income he received from MBJ qualified for the exception from self-employment tax under Sec. 1402(a)(13).

K-1 classification not always controlling

The Tax Court’s decision in Hardy provides some insight into how the court will interpret the Sec. 469 regulations and when the IRS has authority to change or regroup activities. Moreover, this decision in favor of the taxpayer reminds practitioners to maintain professional skepticism about the proper characterization of passive income or losses when receiving documents used in connection with the preparation of income tax returns.

EditorNotes

Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.

For additional information about these items, contact Mr. Anderson at 202-644-5413 or kdanderson@bdo.com.

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.