IRC §469 – Passive ActivitiesPart 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules
Background • Widespread tax shelter investments by middle to high income taxpayers in 1980s • Bluebook to TRA’86 page 210 – Per Treasury, “in 1983, out of 260,000 tax returns reporting “total positive income” in excess of $250,000, 11% paid taxes equaling 5% or less of total positive income, and 21% paid taxes equaling 10% or less of total positive income. Similarly, in the case of tax returns reporting total positive income in excess of $1 million, 11% paid tax equaling less than 5% of total positive income, and 19% paid tax equaling less than 10% of total positive income.” • In 1981, top individual rate was dropped from 70% to 50%.
Purpose of the §469 rules • Per TRA’86 Blue Book (pages 209-214) • Curb expansion of tax shelters. • Only allow taxpayers with substantial and bona fide involvement in certain activities to deduct losses for the activity. • Other taxpayers (passive ones) can only use losses against passive activity income or upon disposition when the “true” economic benefit can be determined • Prevent taxpayers from offsetting wage and investment income with passive losses. • Provide limited relief to moderate income taxpayers with rental real estate activities. • Prevent investment capital from being diverted from productive activities to tax shelter activities.
§469 Guidance • IRC and legislative histories • Final and temporary regulations • A few rulings and court cases • Forms 8582 and 8801 and instructions are also helpful, as is IRS Pub 925 (but not primary authority)
What does §469 do? • Only allows current year use of a deduction or credit from a “passive activity” to be used against passive activity income or tax on such income. • Any disallowed loss or credit for the year is carried forward to the next year and subject to the same PAL and PAC limitations. • It is suspended. • Generally, PAL “triggered” if activity disposed of in a fully taxable transaction. • So – prevents use of passive activity loss against non-passive income (such as wages and investment income).
Key to application of the rules … • Activity is “passive” if: • T or B in which taxpayer does not materially participate. • Any rental activity. • Exceptions and special rules • Rental real estate with active participation and AGI < $150,000. • Real estate professional (added in 1993) • Important – • Meaning of: • “activity” • “trade of business” • “rental” • “material participation” • Tracking of income, losses and suspended losses (and credits) of passive activities. • Recordkeeping.
Early reaction to §469 and initial guidance • Is somewhat complicated due to length of rules, lots of definitions and special rules, and the grouping and recordkeeping needed to determine each passive activities PAL and PAC • Letter reprinted in DTR 6/30/99 – letter signed by “Disgusted” called the temporary regulations “boring and incomprehensible” and suggested that IRS should “throw them out altogether as unworkable and unenforceable.”
And more … • Friends of Oregon, et al v. Sec. of Treasury and IRS Comm’r (DC Or 1988) – brought action to require IRS to prepare environmental impact study and to obtain court approval before adopting the §469 regs. Were concerned with the MP tests. Noted that regs encourage timber owners to convert timber lands to non-timber uses to get better tax result. • Court disallowed claim for lack of subject matter jurisdiction
More reactions • Concerns that the rules hurt the real estate industry, such as • Price declines (which also hurt local governments due to drop in property tax collections) • Some say the rules helped fuel the subsequent S&L crisis
Economic consequences • Testimony of Bill Archer, now with PWC, but formerly member and chair (1995-2001) of the House Ways & Means Committee • 9/23/10 SFC hearing on lessons learned from TRA’86 • “The 1986 Act made a significant change to real estate investments on a retroactive basis, causing serious adverse consequences. I am referring to the passive loss rules that imposed restrictions on the deduction of losses from existing real estate investments. A number of economists and the Federal Reserve have cited this change as adversely impacting real estate values, which in turn contributed to the U.S. savings and loan crisis during the late 1980's and early 1990's.” • http://finance.senate.gov/hearings/hearing/?id=1d2a7636-5056-a032-5282-4bb7cf0d5078
§469 is in Subchapter E • Accounting method? • Notice 94-49 – “the passive activity rules may be viewed as character rules because they limit absorption of losses, or as timing rules because the losses ultimately will be absorbed” • St. Charles Investment Co. v. Commissioner, 110 T.C. 46 (1998), rev’d on appeal • Noted that while Congress did place §469 in Subchapter E, in the legislative history, it is explained under topic of “tax shelters” rather than accounting methods (such as where §448 is discussed). • TAM 201035016 ---
TAM 201035016 • T says was MP in partnership in 1990 – 1994. • IRS auditing 1994 and says did not MP in 1994. • Asked National Office if “a recharacterization of the taxpayers' activities from nonpassive to passive for purposes of the passive activity loss and credit limit rules of §469 was a change in a “method of accounting” for purposes of §§446(e) and 481(a)?
TAM 201035016 - more • “Each year the taxpayers review their facts and decide whether during that year they materially participated in their nursing home activity. If the taxpayers did not materially participate, their nursing home activity must be classified as passive under the §469 rules. Based on the facts present in one year, the activity may be nonpassive in that year, while in another year, under the facts present in that year, the activity may be passive. Under the argument advocated by the examiner, each year that the activity changed from nonpassive to passive, or vice versa, the taxpayers would be required to file a Form 3115, Application for Change in Accounting Method. In each year of change, the taxpayers would be required to compute an adjustment under §481(a). If, for example, a taxpayer materially participated in an activity in 1997, but did not in 1998, the examiner would have the taxpayer file a Form 3115 for 1998. Any amounts that were properly deducted in 1997 because the activity was nonpassive, that would have been deferred had the activity been passive would be included in the computation under §481(a). Similarly, in the instant case, the examiner believes that if the taxpayers did not materially participate in 1994, the examiner may bring into income in 1994 any amounts that were deducted in prior years, that would not have been deductible in those years if the taxpayers had not materially participated in those years. The examiner believes that this may be done, by virtue of §481(a), without regard to whether the taxpayers materially participated in the nursing home activity in the prior years. The examiner notes that this is because, if a change from determining that a taxpayer materially participated in an activity to determining that it did not materially participate in the activity is a change in method of accounting, §481(a) authorizes necessary adjustments to prevent amounts from being duplicated or omitted.”
TAM 201035016 – conclusion • “We do not believe that a determination of whether a taxpayer materially participates in an activity is a method of accounting. In this case, the taxpayers' determination of whether they materially participate in their nursing home activity does not determine into which period an item of income or deduction will be placed. The taxpayers' determination does not involve the treatment of a “material item.” Simply, determining whether the taxpayers materially participated in their activity for purposes of classifying the activity as passive or not is not an “item“—it is not a recurring incidence of income or expense. Instead, the taxpayers' determination establishes the character of their activity for that year—it is either passive or it is not passive. Once the character of the activity is determined, then if the activity is passive, the taxpayers must apply the statutorily mandated rules of §469 to any existing loss.” • So, if improperly applied MP in 1994, that is an error.
TAM 201035016 - comments • Odd ruling • Statute is clear that MP is an annual determination, so whether an activity is passive or not can change from year to year. • What is benefit of change from non-passive to passive being a method? • Better question would be: • T thought it met a MP test for past 6 years, but turns out did not. If method, §481(a) adjustment would bring past improperly claimed losses back into income. • Notice 94-49 and St. Charles Investment Co. v. Commissioner, 110 T.C. 46 (1998)
Who is subject to §469 • Individuals • Estates • Trusts • Closely-held C corporations • Personal Service Corporations
What is a passive activity? Either: • A trade or business in which the taxpayer does not materially participate, or • A rental activity (exception for real estate professionals at §469(c)(7))
Activities specifically excluded from §469 loss limitation rules • Working interests in oil and gas well • §469(c)(3) & (4) and §1.469-1 • t/p must have unlimited liability • Rental of dwelling unit subject to §280A(c)(5) limitations • §469(j)(10) and §1.469(e)(5) and §1.469-2(d)(2)(xii) • Activity of trading personal property §1.469-1(e)(6) • “(i) In general. An activity of trading personal property for the account of owners of interests in the activity is not a passive activity (without regard to whether such activity is a trade or business activity (within the meaning of paragraph (e)(2) of this section)). • (ii) Personal property. For purposes of this paragraph (e)(6), the term “personal property” means personal property (within the meaning of section 1092(d), without regard to paragraph (3) thereof).”
T or B versus Rental Activity • 1.469-4(b) • “(1) Trade or business activities. Trade or business activities are activities, other than rental activities or activities that are treated under §1.469-1T(e)(3)(vi)(B) as incidental to an activity of holding property for investment, that— • (i) Involve the conduct of a trade or business (within the meaning of section 162); • (ii) Are conducted in anticipation of the commencement of a trade or business; or • (iii) Involve research or experimental expenditures that are deductible under section 174 (or would be deductible if the taxpayer adopted the method described in section 174(a)). • (2) Rental activities. Rental activities are activities that constitute rental activities within the meaning of §1.469-1T(e)(3).”
Rental Activity • Generally, per §469(j)(6) and §1.469-1T(e): • Involves tangible property used by customers or held for use by customers; and • The gross income generated is from “amounts paid or to be paid principally for the use of such tangible property (without regard to whether the use of the property by customers is pursuant to a lease or pursuant to a service contract or other arrangement that is not denominated a lease).” • 6 exceptions exist
6 Rental Exceptions §1.469-1T(e) and -1(e) • Average period of customer use < 7 days • Average period of customer use < 30 days AND significant personal services provided • Average period of customer use > 30 days and extraordinary personal services provided • Rental incidental to a non-rental activity • Property available during defined business hours for nonexclusive use by various customers • Property provided by its owner for use in an activity of a p/s, S corp or joint venture in which the owner has an interest Exceptions must be applied each year.
“Average period of customer use” • Original definition was changed by a later reg to avoid abuse. • OLD definition: Aggregate # days in all period of customer use during TY # such periods of customer use • NEW: weighs difference in rental value of the activity’s property causing higher rental value property to have greater effect than lower rental value property • Prevents t/p from lowering a longer rental period by short-term rentals of low value property
Example of formula Old formula: 3000 ÷ 2,035 = 1.47 average days New formula: 8.41 average days So new formula prevents t/p from converting something that meets the definition of a rental to a non-rental by also renting out a small value item for a very short time period. Taxpayer in example still needs to see if Rental Exception #2 is met.
Example – Residential Care Center • TAM 9247003 – retirement center owned by ltd p/s. • Q – rental or T or B? • Centers provided all meals, maid service, laundry, recreational activities and transportation. • Rental charge exceeded 2X cost of a luxury apt due to the services provided • IRS Auditor – rental activity • IRS National Office – what do you think?
EX – Construction of rental property • T was constructing and developing what would become rental property. • Q – how to characterize the construction activity? • TAM 9251003
Material Participation • §469(h) – exists when t/p “is involved in the operations of the activity on a basis which is— (A) regular, (B) continuous, and (C) substantial.” • Ltd p/s – “Except as provided in regulations, no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates.” • Married taxpayers • Include participation of each spouse to determine if either participates. • Can be beneficial when want to be a MP, but detrimental when trying to not be a MP • Regs. §1.469-5 and -5T
Material Participation Tests Quantitative Tests • > 500 hours • Participation constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year • Participation > 100 hours and is not less than participation of any other individual (including individuals who are not owners of interests in the activity) for such year; • Significant participation activity (SPA) and aggregate participation in all SPAs during year > 500 hours Prior Year MP Tests • MP in any 5 prior tax years (whether or not consecutive) during prior 10 years • Personal service activity and individual materially participated in the activity for any 3 prior tax years (whether or not consecutive) Facts and Circumstances Test • Based on all of facts and circumstances, individual participates in the activity on a regular, continuous, and substantial basis during the year
MP definitions - SPA • Trade or business activity (§1.469-1T(e)(2)) in which individual significantly participates for the year • Would be an activity in which individual does not materially participate for the year if material participation for the year were determined without regard to the SPA rule. • MP must exceed 100 hours for the year.
Example • Jessica owns following activities and participates as follows for 2010 • A – Engineering business 1,600 hours • B – Rental property 120 hours • C – Fast food S corp 300 hours • D – Video rental S corp 350 hours • Analysis: • A – not SPA because another MP test met • B – not SPA because not a T or B (is a rental) • C and D – SPA because > 100 hours and no other MP test met (assuming prior years’ MP test met for neither) AND total hours in SPAs > 500 • Conclusion – Jessica is MP in A, C and D
MP Definitions – Personal Service Activity • Involves performance of personal services in— • (1) fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting; or • (2) any other trade or business in which capital is not a material income-producing factor.
MP – facts & circumstances test • “Facts and circumstances” – reserved • Hours must exceed 100 • Certain management activities - individual's services performed in management of an activity are ignored in determining if he is material participant for F & C test UNLESS, for the year— • “(A) No person (other than such individual) who performs services in connection with the management of the activity receives compensation described in section 911(d)(2)(A) in consideration for such services; and • (B) No individual performs services in connection with the management of the activity that exceed (by hours) the amount of such services performed by such individual.” • 1.469-5T(b)
MP – limited partners • §1.469-5T(e) • Can be MP if meet Test 1, 5 or 6 • If also holds general partner interest: • Don’t treat as ltd partner for MP measurement purposes, so can meet any MP test
MP and LLCs • Garnett v. Commissioner, 132 T.C. No. 19 (2009) • Generally, interest held as limited partner is passive unless provided otherwise in regs. • Regs allow ltd partner to meet material participation test if also GP or can use 3 of the 7 MP tests of 1.469-5 (> 500 hours, prior MP in 5/10 years, or personal service activity and MP in any prior 3 years) • §469 enacted 1986; LLPs not around until 1991 • IRS – owners of LLPs and LLCs have limited liability so should be treated similar as limited partners under §469 • Court noted that §469(h)(2) is not that broad – says, ““interest in a limited partnership as a limited partner” – so, specific to ltd partnerships • Conclusions: • Partners did not hold their interests in certain LLPs and LLCs as “limited partners.” Therefore, not subject to rule of presumed passive activity at §469(h)(2). • Also, because partners' “interests in the tenancies in common are not interests in limited partnerships, these interests also are not subject to the rule of sec. 469(h)(2)” • Basically, legislative purpose of §469 better served by treating the LLP and LLC members as general partners. Thus, they can apply any of the 7 MP tests. • Similarly – Thompson v. U.S., 104 AFTR 2d 2009-5381, (Ct Fed Cl), acq
AOD on Thompson case • “On July 20, 2009, the Court of Federal Claims issued a summary judgment opinion in Thompson v. U.S., 87 Fed. Cl. 728 (Fed. Cl. 2009), concluding that LLC interests are not “limited partnership interests” for purposes of §1.469-5T(e)(3)(i). Thompson joined Garnett v. Commissioner , 132 T.C. 19 (2009) and Gregg v. U.S., 186 F. Supp. 2d 1123 (D. Or. 2000) as the third case to rule against the position that an interest in an LLC is a limited partnership interest under §1.469-5T(e)(3)(i). • The taxpayer in Thompson directly owned 99% of an LLC that was in the airplane charter business. The taxpayer indirectly owned the remaining 1% interest through a wholly-owned S corporation. The Service disallowed losses that the taxpayer claimed arguing that the taxpayer failed to meet the restricted material participation requirements that applied to limited partners under §1.469-5T(e)(3)(i). Both parties stipulated that if the taxpayer's LLC interest was not characterized for purposes of §469 as a limited partnership interest then the taxpayer could establish material participation using any of the seven tests in §1.469-5T(a). The Court in Thompson held that the taxpayer's interest was not a limited partnership interest for purposes of §469, and that even if the interest was treated as an interest in a limited partnership, the taxpayer's interest would best be categorized as a general partnership interest under §1.469-5T(e)(3)(ii). Consequently, the Court held that the taxpayer could establish material participation using any of the seven tests in §1.469-5T(a). See also, Garnett and Gregg , supra. • Recommendation Acquiesce in result only.”
Different Tax Years & MP • §1.469-2T(e)(1) • Partnership has 9/30 year end • Partner Tom wants to know if he meets a MP test. • Q – does he look at calendar year or year ended 9/30/10?
MP Reminders • Must check each year • No prorating in quantitative tests for short years • Participation of spouse counts – always ask what spouse does in the activity • -5(f) and -5T(f): • Must be work customarily done by an owner of such an activity; and • One of the principal purposes for the performance of such work must not be to avoid the 469 rules • Generally, work done in individual's capacity as an investor (studying financial statements, preparing financial analyses, monitoring finances or operations in a non-managerial capacity) in an activity is not counted unless the individual is directly involved in the day-to-day management or operations of the activity.
MP Question • Jane provides legal services to partnership X as employee of law firm. Jane is also a 5% owner of X which manufacturer widgets. • Q – Should Jane include her law firm hours serving X as part of her hours in determining if she is a material participant in X?
Proving MP • 1.469-5T(f)(4) – “Methods of proof. The extent of an individual's participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.” • Practical application? • Have client keep records, particularly if close to an hour cut off point or has other full-time employment
Q – can < 100 hours of participation ever be MP? • Yes • “substantially all” test • Prior years’ MP tests
Q – are MP regs valid? • Mordkin, et ux., TC Memo 1996-187 • Challenged the regs as invalid because applied quantitative measures when statute implied a qualitative measure. • Court upheld the reg noting it was appropriate interpretation whether viewed as an interpretive reg or a legislative reg • “a review of other portions of the legislative history of section 469 confirms that the material participation test implicates the amount and extent of the time spent by a taxpayer in connection with the operations of an activity. For instance, that legislative history indicates that a taxpayer is most likely to participate materially in an activity if involvement in that activity is the taxpayer's principal business and the taxpayer devotes most of his or her time to that business and does not devote a comparable amount of time to another business (principal business factor).”
Next • Quiz on Desire 2 Learn • Then … • Podcast going over the examples in regs on rental exceptions and material participation • Powerpoint presentation on more rules in 469 including definition of “activity,” measurements of PAL and PAI, recharacterization rules, and more!