Passive activity credits and recharacterized income

The Internal Revenue Code includes various tax incentives to encourage certain economic and social behavior. Depending on the investor’s participation level, however, the promised tax benefits might not arise. Passthrough owners that do not materially participate in a trade or business may find their tax credits suspended under the passive activity rules. This concern is particularly acute when the passthrough owner significantly participates in the business activity but does not materially participate.

Material participation: Under the regulations, a person is treated as materially participating in an activity for the tax year if:

1. The individual participates in the activity for more than 500 hours during the year;
2. The individual’s participation in the activity for the tax year constitutes substantially all of the participation in that activity of all individuals (including individuals who are not owners of interests in the activity) for the year;
3. The individual participates in the activity for more than 100 hours during the tax year, and the individual’s participation in the activity for the tax year is not less than the participation in the activity of any other individual (including individuals who did not own interests in the activity) for the year;
4. The activity is a significant participation activity (within the meaning of Temp. Regs. Sec. 1.469-5T(c)) for the tax year, and the individual’s aggregate participation in all significant participation activities during that year exceeds 500 hours;
5. The individual materially participated in the activity (determined without regard to this paragraph (5)) for any five tax years (whether or not consecutive) during the 10 tax years that immediately precede the tax year;
6. The activity is a personal service activity (within the meaning of Temp. Regs. Sec. 1.469-5T(d)), and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year; or
7. Based on all the facts and circumstances (taking into account the rules in Temp. Regs. Sec. 1.469-5T(b)), the individual participates in the activity on a regular, continuous, and substantial basis during the year.¹

Significant participation: An individual significantly participates in an activity if he or she participates for more than 100 hours during the year² and does not otherwise materially participate.³ The individual who significantly participates without achieving more than 500 hours in all significantly participating activities is a person involved with a significant participation passive activity.⁴ In this case, the amount of gross income that exceeds the passive activity deductions from all significant participation passive activities is recharacterized as income that is not from a passive activity⁵ (i.e., net income from a significant participation passive activity is nonpassive income).

Passive activity credit

The taxpayer’s tax credits may be fully or partially suspended and disallowed for the current tax year if the taxpayer has a passive activity credit for the year. A taxpayer’s passive activity credit is the amount by which the sum of all of the taxpayer’s credits that are subject to Sec. 469 for a tax year exceeds the taxpayer’s regular tax liability allocable to all passive activities for the year. If the taxpayer has a passive activity credit, a ratable portion of each credit from each passive activity of the taxpayer is treated as a passive activity credit. A credit suspended as a passive activity credit in a tax year is carried over to the next tax year and treated as a credit allocable to that activity.

A credit is subject to Sec. 469 if it “arises in connection with the conduct of an activity that is a passive activity for such taxable year”⁶ and is described in Subpart D of Part IV of Subchapter A or in Subpart B (other than Sec. 27(a)) of Part IV.⁷ Because the regulation describing the credits omits credits enacted after the regulations were promulgated, it is best to focus on the statutory provisions.⁸ Subpart D includes Sec. 38 (general business credit) through Sec. 46 (amount of credit). Subpart B includes Sec. 27 through Sec. 30. Sec. 38(b) enumerates 36 credits, some of which are not included in Subpart D but are passive activity credits because they are listed as general business credits. Practitioners should always check Sec. 38 before concluding that a credit is not within Subpart B or D.

The taxpayer’s regular tax liability allocable to all passive activities for the tax year is the excess of the taxpayer’s regular tax liability⁹ for that tax year over the amount of the taxpayer’s regular tax liability determined by reducing the taxpayer’s taxable income for the year by the excess of the taxpayer’s passive activity gross income over the taxpayer’s passive activity deductions.¹⁰ Consequently, a taxpayer can only take a passive activity credit against tax attributable to passive activity income. Some credits are allowed for taxpayers who have adjusted gross income below specific thresholds.¹¹

Passive activity versus passive income

Note that the regulation defining a passive activity credit refers to credits arising “in connection with a passive activity” and does not refer to whether the activity’s income is passive. “Passive activity” means “a trade or business activity . . . in which the taxpayer does not materially participate for such taxable year” or certain rental activities.¹²

Business owners are whipsawed if income is recharacterized as nonpassive when the activity itself remains classified as passive. Passive activity credits can only be used against tax attributable to passive income; thus, they do not appear to be creditable against recharacterized income. The credit of a former passive activity may offset the regular tax liability generated from the taxable income of the activity,¹³ but the recharacterization of income as nonpassive does not change the activity to a nonpassive activity.

Temp. Regs. Sec. 1.469-2T(f) “sets forth rules that require income from certain passive activities to be treated as income that is not from a passive activity (regardless of whether such income is treated as passive activity gross income under section 469 or any other provision of the regulations thereunder).” Note that the income is recharacterized, but the classification of the activity as a passive activity is not altered. An enumerated credit arising from the activity appears to remain passive. Since the activity is not a former passive activity, the credit is not freed up from suspension.

This observation holds true for significant participation activities:

An amount of the taxpayer’s gross income from each significant participation passive activity for the taxable year equal to a ratable portion of the taxpayer’s net passive income from such activity for the taxable year shall be treated as not from a passive activity if the taxpayer’s passive activity gross income from all significant participation passive activities for the taxable year . . . exceeds the taxpayer’s passive activity deductions from all such activities for such year [emphasis added].¹⁴

Any enumerated credit associated with a significant participation activity would appear to be a passive credit that a taxpayer cannot use to offset tax on that activity’s income that year. When the income is recharacterized as nonpassive, there is no passive income on which tax liability is generated. Without tax liability from passive income, the passive credit is not available to offset the tax.¹⁵

The analysis above appears to be confirmed by reading Form 8582-CR, Passive Activity Credit Limitations, in which the taxpayer calculates allowable passive credits, allowing the credits only against tax on passive income shown on Form 8582, Passive Activity Loss Limitations. Net income from significant participation activities is not reported on Form 8582.¹⁶

Note, however, that passive credits are suspended, not lost. If a passive credit is not allowable one year, it is suspended and carried to the next year.¹⁷ Consider a taxpayer with income and credits from a significant participation activity. If sufficient amounts of suspended passive credits accumulate, the taxpayer might consider intentionally flunking the significant participation test one year and paying net investment income tax¹⁸ but generating passive income against which the taxpayer may take current and suspended credits.

Whether such a strategy provides a tax benefit depends on the characteristics of the particular credit and the taxpayer’s tax posture for that year—­factors that would need to be analyzed in each situation. Alternatively, the taxpayer could increase participation to meet one of the material participation tests for the year. If the taxpayer materially participates, some or all of the suspended passive activity credit may offset the tax liability the activity generates because the activity is a former passive activity.¹⁹

The discussion of passive activity credits would not be complete without addressing the disposition of the entire interest in a passive activity. Upon a disposition in which all gain or loss realized on the disposition is recognized, the passive loss from the activity in excess of the net income or gain for the year from all other passive activities is treated as a loss that is not from a passive activity.²⁰ The suspended passive loss from the disposed activity is released from suspension. However, Sec. 469(g) does not address passive activity credits. As a consequence, due to its treatment as a passive activity credit, a credit might expire unused if the taxpayer has insufficient tax liability generated from passive activities before the end of the credit’s carryover period. The taxpayer, however, may elect to increase the basis of property immediately before the transfer. The amount of the basis increase is the portion of any unused credit that reduced the basis of the property for the year in which the credit arose.²¹

Taxpayers and practitioners should be aware that either materially participating in an activity or intentionally flunking the significant participation test would prevent these issues from arising and should consider stepping up or decreasing their participation to avoid this result.  

Footnotes

¹Temp. Regs. Sec. 1.469-5T(a).

²Temp. Regs. Sec. 1.469-5T(c)(2).

³Temp. Regs. Sec. 1.469-5T(c)(1)(ii).

⁴Temp. Regs. Sec. 1.469-2T(f)(2)(ii).

⁵Temp. Regs. Sec. 1.469-2T(f)(2)(i).

⁶Temp. Regs. Sec. 1.469-3T(b)(1)(i)(A).

⁷Sec. 469(d)(2)(A).

⁸Sutton and Howell-Smith, Federal Income Taxation of Passive Activities ¶3.01[1] “Credits Subject to Limitation” (WG&L) (detailed commentary).

⁹Temp. Regs. Sec. 1.469-3T(d)(2) refers to the definition of “regular tax ­liability” in Sec. 26(b), which in turn refers to tax determined under Chapter 1, subject to some exceptions from Chapter 1. Chapter 1 includes Code sections numbered from 1 to 1400.

¹⁰Temp. Regs. Sec. 1.469-3T(d)(1)(ii). Temp. Regs. Sec. 1.469-2T(c)(1) provides: “Except as otherwise provided in the regulations under section 469, passive activity gross income for a taxable year includes an item of gross income if and only if such income is from a passive activity.”

¹¹See Sec. 469(i). A discussion of the use of these credits is beyond the scope of this article.

¹²Temp. Regs. Sec. 1.469-1T(e)(1)(i).

¹³Sec. 469(f)(1).

¹⁴Temp. Regs. Sec. 1.469-2T(f)(2)(i).

¹⁵The Tax Court came to this conclusion in Sidell, T.C. Memo. 1999-301, a case involving income recharacterized as nonpassive under the self-rented property rule in Regs. Sec. 1.469-2(f)(6).

¹⁶IRS Publication 925, Passive Activity and At-Risk Rules, p. 10 (2016).

¹⁷Sec. 469(b). The suspended credit is then retested each year. Temp. Regs. Sec. 1.469-3T(b)(1)(ii), referring to Temp. Regs. Sec. 1.469-1T(f)(4), which refers to Regs. Sec. 1.469-1(f)(4). Regs. Sec. 1.469-1(f)(4)(i) provides: “In the case of an activity of a taxpayer with respect to which any deductions or credits are disallowed for a taxable year under § 1.469-1T(f)(2) or (f)(3) (the loss activity)—(A) The disallowed deductions or credits [are] allocated among the taxpayer’s activities for the succeeding taxable year in a manner that reasonably reflects the extent to which each activity continues the loss activity; and (B) The disallowed deductions or credits allocated to an activity under paragraph (f)(4)(i)(A) of this section shall be treated as deductions or credits from the activity for the succeeding taxable year.”

¹⁸Regs. Sec. 1.1411-5(b)(2). Income from a significant participation passive activity recharacterized as nonpassive due to Temp. Regs. Sec. 1.469-2T(f)(2) is excluded from net investment income.

¹⁹Sec. 469(f)(1).

²⁰Sec. 469(g)(1).

²¹Sec. 469(j)(9).