Can a trade or business include activities conducted in a different entity?

Editor: Annette B. Smith, CPA   While the term “trade or business” is used widely in the Internal Revenue Code and Treasury regulations, it is largely undefined. For purposes of Sec. 162, the Supreme Court has said that an activity is a trade or business if the taxpayer is “involved in the activity with continuity and regularity and . . . the taxpayer’s primary purpose for engaging in the activity . . . [is] for income or profit” (Groetzinger, 480 U.S. 23 (1987)). This definition assumes an ongoing activity that is normal and customary (i.e., it is “regular”) as well as constant and not sporadic (i.e., it is “continuous”). Implicitly, then, any amount of activity below a certain threshold will not qualify as a trade or business. This discussion focuses on the narrow issue of whether a taxpayer’s trade or business can include activities conducted through a different entity.   A set of cases from the poultry industry illustrates the initial impact of entity lines on the trade or business determination. Under Sec. 446, a taxpayer with multiple trades or businesses may use a separate accounting method for each trade or business (e.g., the cash method for business one and the accrual method for business two). However, a taxpayer with a single trade or business generally may not use a mix of accounting methods.   In Peterson Produce Co., 205 F. Supp. 229 (W.D. Ark. 1962), aff’d, 313 F.2d 609 (8th Cir. 1963), a corporate taxpayer attempted to use the accrual method for its feed and hatchery operations while using the cash method for its broiler division, where the chickens were slaughtered and processed for sale. The feed and hatchery operations had some third-party customers, but the bulk of feed and young chickens were transferred to the broiler division at cost. The IRS objected on the grounds that those methods would create an overstatement of losses.   The U.S. District Court held that those accounting methods did not reflect the income of the business because the company’s broiler division was not a separate and distinct business from its feed and hatchery division. First, the court reasoned that although the general ledger accounts of the taxpayer’s three departments could be physically separated, the original and daily entries could not be separated “physically”:  

The feed and hatchery divisions continued to use the accrual method of accounting since they still were selling feed and chicks to the public at large on a limited basis. The bulk of their output, however, was transferred on their books at cost to the broiler division as accounts receivable. The broiler division in turn set up its account system on a cash method by which it made appropriate entries on its books in payment for the feed and chicks that were “sold” by the other two divisions to the broiler farming division. [Peterson Produce Co., 205 F. Supp. at 236]

Second, the court noted that the taxpayer created a “functional integration” of the three departments as illustrated by the fact that the volume of the outside sales of feed and chicks was small in comparison to the internal transfers (at cost) of feed and chicks to the broiler division by the other two departments.

The Tax Court reached a different conclusion in Rocco, Inc., 72 T.C. 140 (1979), where the corporate taxpayer had formed a new corporation to run its broiler operations separately. The Tax Court held that each business within the consolidated group was different and separate because the taxpayer conducted the chicken and turkey broiler businesses through separate and individual corporate entities, respectively. In other words, the functional result that the court disallowed in Peterson Produce Co. was permitted by the court in Rocco, Inc. The primary difference between the two cases appears to be that the taxpayer conducted the activities in Rocco, Inc. through different (though consolidated) corporations. This suggests that entity structure can significantly affect whether a taxpayer can include an activity as a part of its trade or business.

Peterson Produce Co. and Rocco, Inc. suggest that multiple entities can result in multiple trades or businesses. This was similar to the result reached in Madison Gas and Electric Co., 72 T.C. 521 (1979), aff’d, 633 F.2d 512 (7th Cir. 1980). In that case, Madison Gas and Electric Co., a partner of the deemed partnership, unsuccessfully asserted that the partnership should be treated as an extension of that partner, an existing utility company that already was producing energy for sale. Distinguishing Madison Gas and Electric Co. from the partnership itself, the Tax Court held that the taxpayer should capitalize expenses incurred by the newly formed partnership in the construction of a coal and nuclear power plant because the partnership itself had not started its production of electricity for sale. Thus, extending an existing operation through a new entity can run the risk that the operation would not be viewed as a continuation of the existing trade or business.

While Madison Gas and Electric Co. may represent the predominant approach, other cases treat a new entity’s operations as extensions of an existing trade or business. For example, in Baltimore Aircoil Co., 333 F. Supp. 705 (D. Md. 1971), the court held that the parent corporation, Baltimore Aircoil Co. Inc. (Aircoil), could deduct the expenses it paid in 1965 for opening its wholly owned subsidiary’s manufacturing and assembly plant, because the subsidiary, Baltimore Aircoil of California Inc., with which Aircoil, the parent corporation, filed a consolidated return, was in substance a mere branch or division of Aircoil. The court noted that during 1965, after its incorporation, Baltimore Aircoil of California Inc., had no income, cash, or bank accounts.

A district court reached a similar decision in Playboy Clubs International Inc., No. 73 C 1559 (N.D. Ill. 3/31/76). In this case, the parent corporation, Playboy Clubs International Inc., deducted the “pre-opening” expenses incurred by six subsidiaries in its consolidated group. The court held that the taxpayer could deduct those expenses because it reported the revenues attributable to the membership at its six subsidiaries. Baltimore Aircoil Co. and Playboy Clubs International Inc. illustrate that the facts and circumstances of a case can determine whether a taxpayer can treat certain business expenses incurred by a newly formed entity as expenses related to a historic and ongoing activity. Phrased slightly differently, these cases allow for the possibility that a taxpayer can treat activities within one entity as part of a larger trade or business activity.

A similar issue can arise under the at-risk loss limitation rules of Sec. 465. Generally, losses are allowed only to the extent a taxpayer is “at-risk” in an activity. Sec. 465(c)(3)(B) allows taxpayers to aggregate activities that constitute a trade or business for purposes of the at-risk rules. However, the IRS historically has not allowed taxpayers to aggregate the activities conducted through different partnerships. In Technical Advice Memorandum 9035005, the IRS rejected the taxpayer’s argument that Secs. 465(c)(2)(B) and 465(c)(3)(B) allowed him to aggregate the activities of an oil partnership and a restaurant partnership, because the aggregation provision only allowed aggregation within a “SINGLE trade or business,” and the two partnerships were separate trades or businesses because they kept a separate set of books and records and used a different method of accounting.

The IRS recently repeated a similar argument in CCA 201805013, but also acknowledged that there could be compelling cases where the facts and circumstances indicate that the activities conducted through separate entities do constitute a single integrated trade or business for Sec. 465 purposes. (The CCA offers, as an example, a situation in which the multiple entities are owned and managed by the same persons that share the same lenders and creditors who may have legal claims against the assets of all the entities and their owners.) In the next sentence, however, the IRS wrote that “such compelling situations would be rare.” However, the search for a “compelling situation” seems to be consistent with the judicial approach in Baltimore Aircoil Co. and Playboy Clubs International Inc.

A similar judicial approach to such “compelling situations” can be found in Campbell, 868 F.2d 833 (6th Cir. 1989), rev’g in part and aff’g in part T.C. Memo. 1986-569. In that case, the IRS challenged the expenses claimed in a partnership’s airplane leasing activity on the basis that the activity could not produce profits. Viewing it differently, the Sixth Circuit held the airplane leasing activity was a trade or business because it was integrated with the business of its primary customer, a medical corporation. Each partner of the leasing partnership also was a shareholder of the medical corporation. On that basis, the court noted that although these partners did not receive a direct profit from the medical corporation’s use of the plane, they indirectly benefited through the medical company’s dividends and the increase in its stock value. Therefore, the profits generated by the medical corporation’s use of the planes convinced the court to characterize the plane operations of the partnership as an activity engaged in for profit and, ultimately, as a trade or business.

What constitutes a trade or a business has been a major focus of multiple sections of the Code. The significance of this issue will increase as tax practitioners attempt to apply new Secs. 199A, which requires determining the amount of qualified trade or business income, and 163(j), which limits the amount of deductible business interest. Since there has been no guidance on these new sections yet, it is worth noting that there is an existing entity-specific preference for identifying a trade or business. Rocco, Inc. and Madison Gas and Electric Co. expressed that preference by concluding that a trade or business does not extend past entity lines. However, cases such as Baltimore Aircoil Co., Playboy Clubs International Inc., and Campbell direct taxpayers’ attention toward the principle of economic integration to incorporate multiple entities’ activities as one trade or business. Thus, given the proper facts and circumstances, the IRS and the courts may be willing to accept the aggregation of activities operated through different entities into a single trade or business.

EditorNotes

Annette B. Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.

For additional information about these items, contact Ms. Smith at 202-414-1048 or annette.smith@pwc.com.

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