IRS takes narrow view of aggregation under the at-risk rules

By Grace Kim, J.D., LL.M., and Whit Cocanower, J.D., LL.M., Washington

Editor: Greg A. Fairbanks, J.D., LL.M.

In Chief Counsel Advice (CCA) 201805013, the IRS took a narrow view of the concept of "activity" for purposes of the at-risk rules and concluded that business activities conducted through a partnership and three separate S corporations could not be aggregated and treated as a single activity for purposes of Sec. 465. As a result, amounts for which the taxpayer was considered at risk for one entity could not be used to increase the amount deemed at risk for any other entity. Although the CCA is not binding on taxpayers, it does indicate that the IRS has a taxpayer-unfavorable interpretation of the provisions governing the aggregation of a taxpayer's activities in applying the at-risk rules.

The facts of the CCA state that the taxpayer, an individual, purchased a minority interest in three S corporations in exchange for nonrecourse promissory notes payable to the majority owner, who continued as a shareholder in each entity. The taxpayer also acquired an interest in a limited liability company classified as a partnership for U.S. federal income tax purposes and personally guaranteed a portion of the partnership's debt. The guaranteed debt was used to finance inventory and working capital in the partnership's business but was not available for use by any of the S corporations.

The partnership and the S corporations each had a similar line of business and operated in the same industry but operated their respective businesses at different locations. The four businesses also shared some expenses, such as advertising, information technology, and accounting services. However, the operations of each business were otherwise largely independent of the others.

The taxpayer sought to deduct losses flowing from the three S corporations. However, the deductibility of those losses was potentially limited under the at-risk rules of Sec. 465. Because the shareholder from whom the taxpayer borrowed to purchase its interests continued to hold interests in the S corporations (and thus was a person with an interest in the activities), the taxpayer was not considered "at-risk" for any of the purchase price promissory notes under Sec. 465(b)(3).

The taxpayer argued that he could combine the S corporations with the partnership into a single activity to determine the amount for which he was at risk. If such an aggregation were permitted, the amount for which the taxpayer was at risk with respect to the personal guaranty on the partnership debt would allow the taxpayer to deduct all the reported losses.

The IRS ultimately concluded that the taxpayer was not permitted to aggregate the S corporations with the partnership for the purpose of applying the at-risk rules of Sec. 465. Although the IRS's conclusion in the CCA is not precedential, several points in the IRS's analysis are instructive as to how the Service interprets the statutory provisions governing aggregation under the at-risk rules.

Aggregation provisions under the statute

Aggregation of activities under Sec. 465 is addressed in Sec. 465(c)(3). Sec. 465(c)(3)(B) provides that, except as provided in Sec. 465(c)(3)(C), for purposes of Sec. 465, activities described in Sec. 465(c)(3)(A) that constitute a trade or business shall be treated as one activity if (1) the taxpayer actively participates in the management of the trade or business, or (2) the trade or business is carried on by a partnership or an S corporation and 65% or more of the losses for the tax year is allocable to persons who actively participate in the management of the trade or business.

Sec. 465(c)(3)(C) provides that the Treasury secretary shall prescribe regulations under which activities described in Sec. 465(c)(3)(A) shall be aggregated or treated as separate activities. To date, no regulations have been promulgated under Sec. 465(c)(3)(C).

Definition of activity

As a starting point in applying the at-risk rules, the IRS concluded that an "activity," before any potential aggregation, is the smallest indivisible piece or parcel of property, business asset, or integrated business unit in which the taxpayer possesses an ownership interest. At most, the business activity of each entity comprises a separate activity for purposes of Sec. 465(c)(3)(A) (prior to the application of any aggregation rules contained or referred to in Sec. 465(c)(3)(B)).

The IRS then considered the taxpayer's argument that he should be able to aggregate the activities conducted by the partnership and the three S corporations into a single activity. Sec. 465(c)(3)(B) lays out aggregation rules (for activities other than those covered by Sec. 465(c)(1)) for activities that constitute a trade or business where: (1) the taxpayer actively participates in the management of the trade or business, or (2) the trade or business is carried on by a partnership or an S corporation and 65% or more of the losses for the tax year is allocable to persons who actively participate in the management of the trade or business.

Active participation

In the absence of a statutory definition or regulatory guidance, the IRS relied upon legislative history to describe what constitutes active participation in the management of a trade or business. Relevant facts that might indicate active participation include participation in decisions involving the operation or management of the trade or business, performing services for the trade or business, or hiring and discharging employees (versus the authority to do so only for the person who is in charge of the trade or business) (H.R. Rep't No. 95-1445, 95th Cong., 2d Sess. at 69 (Aug. 4, 1978)).

Based on the facts described in the CCA, the taxpayer may have been able to demonstrate active participation in the management of the partnership and S corporations. However, the IRS did not reach a definitive conclusion on this issue. Rather, the analysis turned to whether the taxpayer could apply the Sec. 465(c)(3)(B) aggregation rules where the business activities to be aggregated were conducted through a partnership and multiple S corporations, rather than directly.

Component activities constituting a trade or business

The IRS noted that while Sec. 465(c)(3)(B) may allow component activities that constitute a trade or business to be aggregated, the aggregation provisions allow aggregation only within a single trade or business. The IRS's view in the CCA is similar to its conclusion in Technical Advice Memorandum (TAM) 9035005, which was not discussed in the CCA. TAM 9035005 concluded that aggregation of the activities of two partnerships was not permitted. In the TAM, the taxpayer was a 50% partner in two separate partnerships, one operating an oil and gas operation and one operating a restaurant business. The taxpayer and the other 50% partner actively participated in the management of both partnerships. In response to the taxpayer's effort to aggregate the activity of the oil partnership with that of the restaurant partnership, the IRS held that the aggregation was allowed only within a single trade or business, not between two or more trades or businesses. The taxpayer had argued that Secs. 465(c)(2)(B) and 465(c)(3)(B) permitted him to aggregate the activity of the oil-and-gas partnership with the restaurant partnership so long as he and his partner actively participated in the management of both activities. In the TAM, the IRS explained that "under certain circumstances, sections 465(c)(2)(B) and 465(c)(3)(B) permit taxpayers to aggregate activities 'which constitute a trade or business,' and treat them as one activity for at risk purposes," but "these aggregation provisions allow aggregation only within a SINGLE trade or business" and "there is no provision in section 465 that would permit aggregation of activities between two or more trades or businesses."

Scope of the aggregation rules

The taxpayer in CCA 201805013 asserted that he was permitted to aggregate all four entities under Secs. 465(c)(3)(B)(i) and (ii). For Sec. 465(c)(3)(B)(ii), the IRS expressed doubt that the taxpayer could demonstrate that 65% of the relevant losses flowed through to active participants in the management of the businesses, given the presence of a passive majority owner from whom the taxpayer had purchased his interests. The IRS asserted that Sec. 465(c)(3)(B)(i) cannot be applied to activities conducted through partnerships and S corporations at all.

On its face, Sec. 465(c)(3)(B)(i) appears to set forth only two requirements for aggregation: that the activities constitute a trade or business and that the taxpayer materially participate in the management of that business. However, the IRS, relying on legislative history describing the aggregation provisions, concluded that the Sec. 465(c)(3)(B)(i) aggregation rule only applies to activities that are conducted directly by a taxpayer (see Staff of the Joint Comm. on Taxation, General Explanation of the Tax Reform Act of 1978, H.R. 13511, 95th Cong., 29, 131 (Jt. Comm. Print 1979)). In the IRS's view, activities conducted through a partnership or S corporation have the possibility of being aggregated under only Sec. 465(c)(3)(B)(ii) and not under Sec. 465(c)(3)(B)(i).

The IRS's interpretation significantly limits the scope of Sec. 465(c)(3)(B)(i). Applying Sec. 465(c)(3)(B)(i) to activities conducted through partnerships and S corporations would allow any taxpayer who is an active participant in the management of a trade or business to aggregate the activities comprising that trade or business. If 65% of the losses from a partnership or S corporation flowed through to active participants, then, under Sec. 456(c)(3)(B)(ii), all of the partners or S corporation shareholders would be permitted to aggregate the activities of the trade or business, without regard to whether the particular partner or shareholder was an active participant. If Sec. 465(c)(3)(B)(i) cannot be applied to trade or business activities conducted through partnerships or S corporations, as the IRS concluded in the CCA, then even active participants in the management of a trade or business conducted through a partnership or S corporation may not aggregate unless the 65% requirement of Sec. 465(c)(3)(B)(ii) is satisfied.

Aggregation of multiple legal entities

The IRS also concluded that, as a general rule, the aggregation rules provided by Sec. 465(c)(3)(B) do not permit aggregation of activities that are conducted across more than one partnership or S corporation. The IRS seems to have based its conclusion on the phrase in Sec. 465(c)(3)(B)(ii) allowing aggregation where a trade or business "is carried on by a partnership or an S corporation" (emphasis added).

The IRS also discussed language contained in the legislative history to the Tax Reform Act of 1986, P.L. 99-514, which could be viewed as contrary to its conclusion that aggregation should generally not be permitted across multiple partnerships or S corporations. The Tax Reform Act of 1986 expanded the scope of the at-risk rules to include real estate activity. The Senate report to that bill noted that the present aggregation rules contained in Sec. 465(c)(3)(B) would also apply to these newly covered real estate activities. The report notes that "[u]nder these rules, it is intended that if a taxpayer actively participates in the management of several partnerships each engaged in the real estate business, the real estate activities may be aggregated and treated as one activity with respect to that partner for purposes of the at-risk rules" (S. Rep't No. 313, 99th Cong., 2d Sess. 750 (1985), 1986-3 (Vol. 3) C.B. 750).

The language contained in the Senate report likely reflects Congress's contemporary understanding of the operation of the Sec. 465(c)(3)(B) aggregation rules, and could be viewed as support for the aggregation of trades or businesses conducted through multiple partnerships or S corporations. The report's statement that active participation in the trade or business supports aggregation, and the absence of any statement regarding the allocation of losses, also might support the argument that Sec. 465(c)(3)(B)(i) can be applied to activities conducted through partnerships and S corporations, in contrast to the IRS's conclusion in CCA 201805013. However, the IRS concluded that this language likely represented a suggestion that special aggregation rules might be appropriate for real estate activities and was not inconsistent with its conclusions regarding the scope of Sec. 465(c)(3)(B)(i) or the ability to aggregate activities conducted across multiple entities.

Although the IRS took the position that the presence of multiple legal entities would generally weigh heavily against aggregation, it did not rule out aggregation of multiple partnerships or S corporations altogether. The IRS stated:

[T]here may be compelling cases where the facts and circumstances clearly indicate that the activities conducted through separate entities do comprise a single integrated trade or business for § 465 purposes (such as situations where 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 of the entities and their owners). [CCA 201805013, p. 13]

The IRS stated that it believes such compelling situations would be rare.

Ultimately, the IRS concluded that the taxpayer was not permitted to aggregate the partnership with the three S corporations under Sec. 465(c)(3)(B). The IRS explained that there were few interdependencies among the various entities. The IRS cited nonidentical ownership, sales of product from different manufacturers, the use of separate franchise agreements and financing arrangements, the maintenance of separate books and records, and operations in different states, among other factors.

While the CCA confirms the IRS's rigid opposition to the aggregation of activities between two or more trades or businesses, similar to the view that was expressed in TAM 9035005, the CCA acknowledges that there could be compelling facts and circumstances for aggregating activities conducted in separate entities. Thus, the CCA signals a narrow opening toward limited aggregation, citing as reasons the lapse of time and substantial changes in the fundamental nature of how taxpayers conduct business that have occurred since the enactment of Sec. 465(c)(3)(B).

Implications

CCA 201805013 illustrates some of the challenges taxpayers may face in navigating the aggregation rules of Sec. 465(c)(3)(B). The application of the aggregation rules is made all the more challenging by the lack of regulatory guidance over the 40 years since the rules were enacted. Further, the CCA suggests that taxpayers may be limited in their ability to borrow aggregation concepts from the passive-activity loss rules to plug gaps in the statutory and regulatory framework for purposes of the at-risk rules. The IRS may challenge taxpayers who attempt to aggregate activities conducted through a partnership or S corporation unless they can show that the requirements of Sec. 465(c)(3)(B)(ii) are satisfied. Finally, the CCA demonstrates the IRS's reluctance to allow aggregation of activities conducted across multiple partnerships or S corporations. However, the CCA does explicitly leave an opening for rare compelling situations in which the facts and circumstances clearly indicate that the activities conducted through separate entities do constitute a single integrated trade or business for Sec. 465 purposes.

EditorNotes

Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington..

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

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

Newsletter Articles

TECHNOLOGY

2018 tax software survey

Among CPA tax preparers, tax return preparation software generates often extensive and ardent discussion. To get through the rigors of tax season, they depend on their tax preparation software. Here’s how they rate the leading professional products.

DEDUCTIONS

Qualified business income deduction regs. and other guidance issued

The package includes final regulations, guidance on how to calculate W-2 wages, a safe-harbor rule for rental real estate businesses, and new proposed rules on the treatment of previously suspended losses.