Thursday, April 19, 2018
It is not uncommon for a farmer or a higher-income taxpayer to invest in various activities in which they do not materially participate (as determined by a seven-factor test under Treas. Reg. §1.469-5T(a). Examples of passive investments for farmers include rental activities, “condominium” grain storage LLCs and interests in ethanol and bio-diesel plants. These investments generate either passive income or passive losses. Passive income is subject to ordinary income tax and may also be subject to an additional 3.8 percent passive tax. I.R.C. §1411. When a passive activity generates losses, however, the passive activity rules limit the ability to deduct the losses to the extent the taxpayer has passive income in the current year. Otherwise, they are deducted in the taxpayer’s final year of the investment.
When a farmer (or other taxpayer) has investments in which they don’t materially participate and, hence, potentially face the impact of the passive activity rules can those investment activities be combined with an activity in which the taxpayer materially participates so that the limitation on deducting losses can be avoided? There might be. It might be possible to group activities. A recent case shows how the grouping rules work.
That’s the topic of today’s post – grouping activities under the passive loss rules.
An election can be made on the tax return to group multiple businesses or multiple rentals as a single activity for purposes of the passive loss restrictions. Treas. Reg. §1.469-4. Grouping multiple activities is permitted if the activities constitute an “appropriate economic unit.” But, how is an appropriate economic unit determined? The Treasury Regulations state that a taxpayer may use any reasonable method to make the grouping determination, although the following factors set forth in Treas. Reg. 1.469‑4(c)(2) are given the greatest weight:
- Similarities and differences in types of business;
- The extent of common control;
- The extent of common ownership;
- Geographical location; and
- Interdependence between the activities
Grouping disclosure. The IRS has issued final guidance on the disclosure reporting requirements of groupings (and regroupings). Rev. Proc. 2010-13, 2010-1 C.B. 329. A grouping statement is to be filed with the tax return stating that the taxpayer is electing to group the listed activities together so that they are treated as a single activity for the tax year, and all years thereafter. The taxpayer should also represent in the grouping statement that the grouped activities constitute an appropriate economic unit for the measurement of gain or loss for the purposes of I.R.C. §469.
A failure to properly group activities may result in passive status for an activity. This can be particularly detrimental because a passive loss from a business (lacking material participation by the taxpayer) or a rental activity loss is suspended and, since 2013, a 3.8 percent net investment income tax applies to net rental income and other passive business income of upper income taxpayers.
Under the guidance, a written tax return statement is required for:
- New groupings, such as in the first year of grouping two activities;
- The addition of a new activity to an existing grouping; and
- Regroupings, such as for an error or change in facts.
However, no written statement is required for:
- Existing groupings prior to the effective date of the guidance, unless there is an addition of an activity;
- The disposition of an activity from a grouping; and
- Partnerships and S corporations (because the entity’s reporting of the net result of each activity as separate or as combined to each owner serves as the grouping election.
If a taxpayer is engaged in two or more business activities or rental activities and fails to report whether the activities have been grouped as a single activity, then each business or rental activity is treated as a separate activity.
Despite the default rule that treats unreported groupings as separate activities, a taxpayer is deemed to have made a timely disclosure of a grouping if all affected tax returns have been filed consistent with the claimed grouping, and the taxpayer makes the required disclosure in the year the failure is first discovered by the taxpayer. However, if the IRS first discovers the failure to disclose, the taxpayer must have reasonable cause. The practical implication of this relief rule is that where proper disclosure has not yet occurred, the taxpayer “needs to win the race with the IRS” in completing proper disclosure.
Special Grouping Rules
A rental activity ordinarily cannot be combined with a business activity, although such grouping is allowed if either the business or rental activity is insubstantial in relation to the other, or each owner of the business activity has the same proportionate ownership interest in the business activity and rental activity. Treas. Reg. §1.469-4(d)(1).
An activity conducted through a closely-held C corporation may be grouped with another activity of the taxpayer, but only for purposes of determining whether the taxpayer materially participates in the other activity. For example, a taxpayer involved in both a closely-held C corporation and an S corporation could group those two activities for purposes of achieving material participation in the S corporation. However, the closely-held C corporation could not be grouped with a rental activity for purposes of treating the rental activity as an active business. Treas. Reg. §1.469-4(d)(5)(ii).
An activity involving the rental of real property and an activity involving the rental of personal property may not be treated as a single activity, unless the personal property is provided in connection with the real property or the real property in connection with the personal property. Treas. Reg. §1.469-4(d)(2).
A recent case illustrates the how the factors for grouping are applied. In Brumbaugh v. Comr. T.C. Memo. 2018-40, the petitioner owned 60 percent of a C corporation that was engaged in developing real estate. The balance of the stock was owned by two others. The business had its headquarters in southern California and the plaintiff participated in the business for more than 500 hours in 2007, the year in issue. The business had a development project in 2007 in northern California several hundred miles away. The shareholders discussed buying an airplane for the trips to the project and back to southern California.
Ultimately, instead of the corporation buying the plane, the plaintiff bought it personally through his LLC. In 2006, the plaintiff had formed and LLC (taxed as a partnership) in which he owned 51 percent and his wife owned 49 percent. The LLC entered into a management agreement with an aviation company that provided that the aviation company was responsible for all managerial duties related to the plane and had the exclusive right to charter the plane for commercial flights by third parties whenever the petitioner did not need to use the plane. The plaintiff was also given access to other planes when his was being chartered. In 2007, the plaintiff used the plane on only one occasion. On four other occasions he used a different plane because his was being chartered. On petitioner’s 2007 return, he reported a $683,000 loss. Upon audit, the IRS recharacterized the loss as a passive loss on the basis that the plaintiff had not materially participated in the LLC’s activities.
The Tax Court agreed with the IRS and also concluded that the petitioner could not group the airplane activity with the real estate development activity because none of the Treas. Reg. §1.469-4(c)(2) factors favored grouping the two activities together. There was no functional similarity between the two activities and the plane was not integrated into the real estate activity in any way. While the factors for extent of common ownership and common control were neutral (the petitioner held controlling interests in both entities, but the interests were very different), there was no interdependence between the two businesses. In addition, the court noted that the petitioner did not materially participate in the aviation activity because there was no evidence to support the petitioner’s contention that he participated for at least 100 hours including no contemporaneous logs, appointment books, calendars or narrative summaries. In any event, the petitioner did not devote 500 or more hours in the aggregate to “significant participation activities.” In addition, the real estate development activity did not qualify as a significant participation activity (another issue not discussed in this post).
Farmers, ranchers and other taxpayers often engage (invest) in passive activities in addition to their business activity in which they materially participate. While it is possible to group the investment activities with a farming business, for example, the factors set forth in the regulations for grouping must be satisfied. The recent Tax Court case illustrates that it can be rather difficult to satisfying those factors.