Mary E. Wood, J.D.
Meadows, Collier, Reed, Cousins, Crouch & Ungerman, L.L.P.
901 Main St., Suite 3700
Dallas, Texas 75202
214-744-3700
www.meadowscollier.com
[email protected]
Discussion will focus on the following:
 What is and is not a passive activity?
 Interplay between Section 469 and Section 1411
 Which taxpayers are subject to Section 469?
 Matching passive gains & losses
 Grouping activities
 Material Participation Tests and Related Issues
 Rental Activities and Real Estate Professional Exception
2
1
» Trade or business in which the taxpayer does not “materially
participate.”
˃ Trade or business activity is defined as an activity that:
• Involves the conduct of trade or business (within the meaning of IRC § 162);
• Is conducted in anticipation of starting a trade or business; or,
• Involves research & development expenditures that would be deductible
under IRC § 174.
» Rental activities.
• Except certain rental activities of qualifying real estate professional.
If a taxpayer does not materially participate in an activity, the losses from the
activity are limited by IRC § 469.
3
» Income and losses from the following activities are generally
passive:
˃ Rental real estate (except rentals in which a real estate professional
materially participates).
˃ Equipment leasing.
˃ Sole proprietorship or farm in which the taxpayer does not materially
participate.
˃ Limited partnership interest, with some exceptions.
˃ Partnership, S Corp, and limited liability company in which the owner
does not materially participate.
4
2
» Working interests in oil and gas well held directly or indirectly
˃ §469(c)(3) & (4)
˃ Taxpayer must have unlimited liability (e.g., no ownership through limited
partnership or S Corporation)
» The rental of a dwelling unit used as a residence if §280A(c)(5) applies.
˃ §280(c)(5) applies if the # of days the TP uses the dwelling unit as a residence
exceeds the greater of 14 days or 10% of the # of days during the year that the
home was rented at fair rental value.
» Activity of trading personal property
˃ §1.469-1(e)(6)
˃ Includes traders of stocks and bonds.
» Portfolio income and related deductions
˃ 1.469-2T(c)(3) & 1.469-2T(d)
5
» To define a passive activity that produces net investment income,
Section 1411 cross-references the rules of Section 469.
˃ As a result, the rules of Section 469 assume great importance in the
context of the NIIT.
» The preamble provides a list of Section 469 rules applicable to
Section 1411 (this list is not exhaustive):
˃ Material participation;
˃ Grouping rules;
˃ Rental Activity exceptions; and
˃ Real Estate Professional exception.
6
3
» Individuals – Schedule C, Schedule F and flow-through income/loss
from partnerships and S corporations (applied to distributive share
of partners’ and shareholders’ income/loss).
» Trusts and Estates (other than grantor trust where rules apply to
owner).
» Personal service corporations.
» Definition in §469(j)(2) adapted from §269A(b)(1) (with some
modification)
» Limited application to closely held C corporations.
˃ A corporation is closely held if, at any time during the last half of the
taxable year, more than 50% (by value) of its outstanding stock is
owned—directly or indirectly—by five or fewer individuals.
˃ CHCs can use passive losses and credits to offset net active income. Net
portfolio income is not “active income.” Reg. §1.469-1T(g)(4)(i)
7
» Once income is categorized, passive losses generated by passive activities
can offset only passive activity income.
˃ Unused passive losses are carried over to future years to be applied against later
passive income.
» Similar rules apply to credits from passive activity – passive credits are
generally allowed only to the extent of FIT otherwise payable on net
passive income.
» There are several exceptions to this approach:
˃ Up to $25,000 in rental real estate losses are permitted if MAGI is less than
$100,000.
˃ A real estate professional may deduct rental real estate losses, if materially
participates.
˃ The suspended losses and credits are allowed in full when the taxpayer disposes
of his entire interest in the passive activity that generated the losses.
§ 469(g)(1)(A).
8
4
» If related activities form an appropriate economic unit, they may be
grouped as a single activity, making it easier to meet the material
participation tests. See Reg. § 1.469-4(c)(1)
» The following may not be grouped per Reg. §1.469-4(d):
˃ A rental activity may not be grouped with a trade or business activity.
Exception: The activities may be grouped if they are owned in the same
percentage or one is insubstantial to the other.
˃ Real property rentals may not be grouped with personal property rentals.
˃ Limited partners or limited entrepreneurs involved in activities specified in
§465(c)(1) may group with another activity only if it is in the same line of
business.
•
Limited entrepreneur – person other than a limited partner who does not actively
participate in the management of the enterprise.
9
» Reg. § 1.469-4(c)(2) provides a facts and circumstances test to
determine if two or more activities constitute an appropriate
economic unit.
» Five factors are given the greatest weight under §1.469-4(c)(2):
˃ Similarities and differences in the types of businesses.
˃ Extent of common control.
˃ Extent of common ownership.
˃ Geographical location.
˃ Interdependence between or among the activities.
» No one factor is determinative; the taxpayer can use any reasonable
method given the facts and circumstances to group.
10
5
» Example: Taxpayer has a significant ownership interest in a bakery
and a movie theater in Baltimore and in a bakery and a movie
theater in Philadelphia.
˃ Possible permissible groupings under the 5-factor test are:
• A single activity.
• A movie theater activity and a bakery activity.
• A Baltimore activity and a Philadelphia activity.
• Four separate activities.
˃ Reg. §1.469-4(c)(3), Ex. 1.
11
» An entity may consist of several different activities.
» If an entity groups its activities, an investor may group those
activities with each other, with activities he conducts himself or
with activities conducted through other entities – as long as the
entities satisfy the appropriate economic unit standard.
» Investor may not treat activities as separate if grouped at entity
level.
12
6
» A decision to group or not to group is a grouping decision and the
taxpayer must maintain the grouping he originally chose under the
consistency rules. Reg. §1.469-4(e)(1).
» The taxpayer may change his grouping only if the original grouping
was clearly inappropriate or there has been a material change in the
facts and circumstances that makes the original grouping
inappropriate. Reg. §1.469-4(e)(2).
» The IRS may regroup the taxpayer’s activities if the grouped
activities do not form an appropriate economic unit and a principal
purpose of the taxpayer’s grouping is to circumvent the underlying
purpose of Section 469. Reg. §1.469-4(f).
13
» Grouping disclosure pursuant to Rev. Proc. 2010-13 (effective for
groupings made on or after January 25, 2010)
˃ Requires TPs to file a disclosure statement in the taxable year that a
grouping is first made, when a new activity is added to an existing
group, and when a clearly inappropriate grouping is regrouped.
˃ Failure to comply will result in each activity in a purported grouping
being treated as a separate activity.
˃ Partnerships and S Corps generally satisfy the disclosure requirements
by separately stating the income/loss for each grouping conducted by
the entity on attachments to the entity’s annual Schedule K-1.
Practice Tip: Rev. Proc. 2010-13 provides relief for untimely disclosure if
consistently reported and disclosed upon learning of obligation. If IRS
makes discovery of untimely disclosure, relief only provided if reporting
consistent and TP proves reasonable cause.
14
7
» In light of the impact of the Section 1411 tax, the IRS issued Reg.
§1.469-11(b)(3)(iv) allowing a taxpayer to make a“fresh start” and
elect to regroup their activities for tax years beginning after December
31, 2013 if they are subject to the 3.8% Medicare tax on net investment
income.
» This “fresh start” for Section 469 groupings allows taxpayers to
reevaluate grouping decisions that may have been made as many as 20
years ago under the consistency rules of Reg. § 1.469-4(e).
» A regrouping under the “fresh start” Regulations may only be utilized
once.
» Furthermore, the regrouping must be appropriate under Reg.
§ 1.469-4(e) (appropriate economic unit) and disclosed as required by
Rev. Proc. 2010-13.
» The Regulations do not propose to allow regrouping for pass-through
entities.
15
» Amended Return Regrouping Elections:
˃
The final Regulations allow a taxpayer to regroup under §1.46911(b)(3)(iv) on an amended return, but only if the taxpayer was not
subject to Section 1411 on his or her original return.
˃
Similarly, if a taxpayer regroups on an original return (or previously
amended return), and then subsequently determines that the
taxpayer is not subject to Section 1411 in that year, such regrouping
is void in that year and all subsequent years until a valid regrouping
is done.
16
8
» General Rule: A taxpayer materially participates in an activity if he
or she works on a regular, continuous and substantial basis in
operations.
» Material participation is a year-by-year determination.
17
Quantitative Tests
1.
The TP works 500 hours or more during the year in the activity.
˃ If the TP qualifies, this is the strongest defense to a passive activity
reclassification.
2.
The TP does substantially all the work in activity.
˃ No specific hour test and “substantially” not defined.
3.
The TP works more than 100 hours in the activity during the year
AND no one else works more than the TP.
4.
The activity is a significant participation activity (SPA), and the
sum of SPAs in which the TP works 100-500 hours exceeds 500
hours for the year.
18
9
Prior Year MP Tests
5.
The TP materially participated in the activity in any 5 of the prior 10
years.
Example: TP retired and his children now run business, but he stills owns an interest in
the partnership.
6.
The activity is a personal service activity and the TP materially
participated in that activity in any 3 prior years.
Facts and Circumstances Test
7.
Based on all the facts and circumstances, the TP participates in the
activity on a regular, continuous, and substantial basis during such year.
19
» SPA defined:
˃ The taxpayer participated more than 100 hours in the activity during the
year.
˃ The activity must be a trade or business activity.
˃ The business must be a passive activity (i.e. the taxpayer would not
meet material participation test without regard to SPA rule)
˃ The taxpayer CANNOT do most of the work in the activity (performing
substantially all the work qualifies for material participation).
20
10
» John owns the following activities and participates as follows for
2013:
˃ A – Engineering business – 1600 hours
˃ B - Rental Property – 120 hours
˃ C – Fast Food S Corp – 300 hours
˃ D – Video Rental S Corp – 250 hours
» Analysis:
˃ A – not SPA because another MP test met (500 hour)
˃ B – not SPA because not a trade or business (rental)
˃ C and D – SPA because > 100 hours and no other MP test met (assuming prior
years’ MP test not met for either) AND total hours in SPA > 500
» CONCLUSION – John is MP in A, C and D
21
» Involves performance of personal services in:
˃ Fields of health, law, engineering, accounting, actuarial science,
performing arts, or consulting; or
˃ Any other trade or business in which capital is not a material incomeproducing factor. Reg. §1.469-5T(d).
Practice Tip: This test applies if the taxpayer participated in any
3 prior years, not just the 3 immediately preceding taxable years.
22
11
» “Facts and circumstances” – reserved
» Participation must exceed 100 hours
» Managerial activities do not count unless:
˃ No other person who acts in a managerial capacity receives
compensation, AND
˃ No other person spends more time than the taxpayer performing the
managerial services.
23
» If the taxpayer participates more than 500 hours during the year in a
business, income or loss from the activity will be non-passive.
» This is the test most often applicable to taxpayers in IRS
examination.
24
12
» Participation of both spouses is counted, but not participation of
children or employees.
» Contemporaneous records are not required – Taxpayers are allowed
to prove the requisite number of hours to constitute material
participation by any reasonable means. See Treas. Reg. 1.4695T(f)(4).
˃ Appointment books, calendars, narrative summaries, cell phone logs,
credit card statements, etc.
– Montgomery v. Commissioner, T.C. Memo 2013-151 (no contemporaneous
records but court satisfied by credible witness testimony).
˃ Logs that are not contemporaneous should be supported by other
documentation or corroborated testimony.
– Newhart v. Commissioner, T.C. Memo 2001-289 (Taxpayer’s log that was
created after the fact was not credible and was contradicted by other
supporting documentation).
25
» The following time is considered non-qualifying time pursuant to
the regulations:
˃ Investor-type activities:
– Studying and reviewing financial statements or reports on operations of the
activity;
– Preparing or compiling summaries or analyses of the finances or operations
of the activity for the individual’s own use; and
– Monitoring the finances of the operations of the activity in a non-managerial
capacity.
– BUT, this time is allowed if the individual is directly involved in the
day-to-day management or operations of the activity. Treas. Reg.
§ 1.469-5T(f)(2)(A); see also Shaw v. Commissioner, T.C. Memo 2002-35.
Practice Tip: To rebut an argument that certain time spent is disallowed as
“investor time,” present evidence that the taxpayer was participating in the
day-to-day management or operations of the activity. Otherwise, show that
the time is not an investor-type activity as contemplated by the Regulations.
26
13
» The following time is considered non-qualifying time (cont’d):
˃ Work not ordinarily done by an owner – this is work normally done by
an employee.
–
The IRS must also show that this work was included solely in an attempt to
avoid disallowance of the losses. Treas. Reg. § 1.469-5T(f)(2)(i).
˃ Travel time.
˃ Time before taxpayer owned the activity. Treas. Reg. § 1.469-5T(k),
Ex. 6.
˃ Time performed by individual other than the taxpayer. Treas. Reg.
§ 1.469-5T(a).
27
» IRC § 469 (h)(2) presumes that limited partner interests are per se
passive.
» Limited partners can rebut this presumption through 3 of the 7
material participation tests:
˃ 500-hour test.
˃ Taxpayer materially participated in the activity in any 5 of the prior 10
years.
˃ The activity is a personal service activity and the taxpayer materially
participated in that activity in any 3 prior years.
28
14
»
After a series of court losses, IRS issued proposed Regulations
(Prop. Reg. § 1.469-5(e)(3)) regarding treating LLC and LLP
interests as limited partner interests. The proposed Regulations
focus on the following:
˃
Whether the entity is taxed as a partnership for FIT purposes and
˃
Whether the individual has the right to manage the entity under state
law and the entity agreement.
˃
But, the limited partnership limitation is not applicable if the
individual also holds another interest in the entity that is not akin to a
limited partnership interest as defined by the proposed regulations.
29
» The final Regulations do not provide any guidance on determining the
material participation of trusts.
» Until recently, the only court opinion suggested that the collective efforts
of the trust’s fiduciaries, employees, and agents should be used to
determine if the trust’s participation is regular, continuous and
substantial. See Mattie K. Carter Trust, 256 F. Supp. 2d 536 (N.D. Tex.
2003)
˃ The court, however, also noted that the actions of the trustee alone (IRS
position), satisfied the material participation test.
» IRS issued TAM 201317010 which is consistent with its opinion that only
trustee’s participation may be considered. The TAM, however, involved
the participation of a special trustee.
30
15
»
On March 27, 2014, the Tax Court issued its long-awaited ruling in Frank Aragona
Trust v. Commissioner, 142 T.C. No. 9 (2014).
˃ Tax Court Holding:
•
A trust can qualify for the real estate professional exception under §469(c)(7).
•
The trustees’ participation as employees of a trust-owned LLC should be
counted for MP purposes.
•
Court determined that trustees’ participation counted even where trustees also
owned a minority interest in some of the trust’s real estate assets.
•
Court reasoned that under Michigan law, a trustee is required to act prudently
with respect to the trust assets at all times (note: most states follow the same or
similar requirement).
•
Court found no need to determine whether the activities of the trust’s nontrustee employees should be considered for MP purposes.
Note: It is unclear if the court would rule the same way if the trustee owned a
majority interest in an asset also owned by the trust.
31
»
Rental Activity = any activity where payments are principally for
the use of tangible property.
»
Rental activities are automatically passive under §469(c)(2) unless:
˃
Falls under rules of §280A(c)(5)
•
˃
So loss would be limited under that rule rather than 469
Is real estate owned by a real estate professional
32
16
»
Exceptions to treatment as a “Rental Activity” – Regs. §1.4691T(e)
»
Average customer use period of 7 days or less
»
Average customer use period of 30 days or less and significant personal
services are provided by or on behalf of the owner of the property in
connection with making property available for use by customers
»
Providing extraordinary personal services (e.g., in-patient healthcare
facilities, student dormitories, etc.)
»
Rental incidental to a non-rental activity
»
Property available during defined business hours for nonexclusive use by
various customers
»
Property rented to a pass-through entity or joint venture in which the
taxpayer owns an interest
»
Rental of taxpayer’s residence
33
»
$25,000 Rental Loss Allowance
˃ TP may deduct up to $25,000 in rental real estate losses as long as the taxpayer
actively participates and MAGI is less than $100,000.
˃ The activity must consist of rental real estate (not an equipment lease).
˃ The taxpayer must have “actively participated” in the rental real estate
activity.
• As long as a taxpayer participates in management decisions in a bona fide
sense, he actively participated in the real estate rental activity (no hour
requirement).
34
17
»
$25,000 Rental Loss Allowance
˃ The following taxpayers do not meet the standard of active participation and
therefore do not qualify:
• A limited partner in an activity (IRC § 469(i)(6)(c)).
• A taxpayer who has less than 10 percent ownership (IRC § 469(I)(6)(A)).
• A trust or corporation. The $25,000 is available only to natural persons.
– Exception: Grantor trust owned by a natural person because it is not
deemed a separate entity.
• A taxpayer whose rental activity consists of a net lease. Under a net lease,
the tenant pays most of the expenses.
35
»
»
Although rental activities are per se passive, they may nonetheless
avoid passive classification if the taxpayer:
˃
Qualifies as a real estate professional AND
˃
Materially participates in each rental activity.
Under §469(a)(c)(7)(B), a taxpayer is a real estate professional if
two tests are satisfied:
˃
More than one-half of the personal services the taxpayer performs in
trades or businesses during the tax year are performed in real property
trades or businesses in which the taxpayer materially participates, and
˃
The taxpayer performs more than 750 hours of services during the tax
year in real property trades or business in which the taxpayer
materially participates.
36
18
37
»
Real property trades or businesses are defined as:
»
»
“any real property development, redevelopment, construction, reconstruction,
acquisition, conversion, rental, operation, management, leasing or brokerage
trade or business.” §469(c)(7)(C).
Definition of “Personal services”:
»
Any work performed by an individual in connection with a trade or business
(as defined for §469(c)(7) purposes to include §212 activities).
»
Does not include:
»
Any work performed by an individual in the individual’s capacity as
investor
»
Personal services performed as an employee do not count as performed
in real property trades or businesses unless the employee is 5% owner
of the employer.
Practice Tip: On a joint return if either spouse individually satisfies the two-part test
then all rental real estate activities of both spouses qualify for the exception. But the
spousal attribution rules can still be used to prove MP.
38
19
»
Material participation must be satisfied with regard to each
separate interest in rental real estate unless the taxpayer has made
an election to treat all interests in rental real estate as a single
rental activity.
»
Aggregation election must be affirmatively made by filing a
statement with the taxpayer’s original tax return containing a
declaration that the taxpayer is a qualifying taxpayer and is making
the election under IRC §469(c)(7)(A).
»
If the election is made, the 750 hours of material participation may be
satisfied by looking at all of the rental properties in aggregate.
Practice Tip: The IRS may accept a late aggregation election pursuant
to Rev. Proc. 2011-34 if returns have been filed timely, filed consistent
with the proposed aggregation and the failure to timely file the election
is due to reasonable cause.
39
» Be prepared to address the following items the IRS considers as
indicators that the taxpayer did not materially participate in the
activity:
˃ The taxpayer was not compensated for services.
˃ The taxpayer’s residence is hundreds of miles from the activity.
˃ The taxpayer has a W-2 wage job requiring 40+ hours per week for which he
receives significant compensation.
˃ There is paid on-site management, foreman, supervisor and/or employees who
provide day-to-day oversight and care of the operations.
˃ The taxpayer has numerous other investments, rentals, business activities, or
hobbies that absorb significant amounts of time.
˃ The taxpayer is elderly or has health issues.
˃ Business operations would continue uninterrupted if the taxpayer did not perform
the services claimed.
40
20
»
Spend time compiling evidence that supports the taxpayer’s claim
of time spent working in the activity. Evidence may include:
˃
Receipts, notes, cell phone records, etc.;
˃
Recreated logs;
˃
Narratives;
˃
Witness testimony.
•
A knowledgeable taxpayer is a valuable asset in a passive
activity audit.
»
Maintain documents/records and analysis that supports groupings.
»
Also, consider whether to proceed to appeals through tax court to
lessen the likelihood of referral back to examiner.
41
» Pro-Taxpayer
˃
Al Assaf v. Commissioner, T.C. Memo 2005-14 – Tax Court concluded that taxpayer materially
participated in her office building activity despite the absence of contemporaneous logs or
calendars. The taxpayer provided testimony and evidence of her current involvement in the activity
and testified credibly that her degree of participation had not changed.
˃
Harrison v. Commissioner, T.C. Memo 1996-509 – In connection with a treasure hunting activity,
the court accepted the post-event narrative of the taxpayer and taxpayer co-venturer, along with
corroborating testimony, in determining that the taxpayer materially participated.
» Pro-Government
˃
Bogus v. Commissioner, T.C. Summary 2009-160 – Taxpayer failed to prove material participation
through his own uncorroborated testimony. He did not any objective evidentiary corroboration of
his participation in the activity. The court also noted that after being in the dog racing business for
over 25 years, it was likely that he had found qualified professionals to handle the day-to-day
activities and that his involvement was probably less than if he were just starting out in the activity.
˃
Iversen v. Commissioner, T.C. Memo 2012-19 – Taxpayer owned company in Minnesota and
worked more than 40 hours per week in W-2 position at the company. The ranch at issue was
located in Colorado. The Tax Court noted that much of the time spent at the ranch was personal or
related to Taxpayer’s other business and that a portion of the time claimed was investor time. Due
to these facts and the lack of substantiating documentation, the court concluded that the taxpayer did
not materially participate in the ranch activity.
42
21
» Examine passive investment holdings
˃
Determine if it is worthwhile for your clients to become a material
participant in any of their passive activities;
•
˃
Carefully consider SE tax implications.
Consider regrouping your clients’ activities under the “fresh start”
Regulations.
43
The information included in these slides is for
discussion purposes only and should not be relied on
without seeking individual legal advice.
IRS Circular 230 Disclosure
Information included in these slides is not intended or
written to be used, and cannot be used, for the purpose
of (i) avoiding any penalties under U.S. federal tax
law, or (ii) promoting, marketing or recommending to
another party any transaction or matter addressed
herein.
44
22
Mary E. Wood
Partner
phone (214) 744-3700
toll-free (800) 451-0093
fax (214) 747-3732
[email protected]
Ms. Wood’s practice areas are Income Tax Litigation, Estate and Gift Tax
Litigation, Commercial Litigation, State Tax Planning and Litigation, and
White Collar and Government Regulatory Litigation. She concentrates on
resolving federal and state tax controversies. She represents individuals,
closely-held businesses and large corporations in IRS audits, appeals and
litigation in the United States Tax Court, Federal District Courts and United
States Court of Federal Claims. Ms. Wood also represents taxpayers in
disputes with the Texas Comptroller of Public Accountants and other state
tax agencies. Ms. Wood represents individuals and entities in business
disputes and lawsuits involving fraud, breach of contract, breach of
fiduciary duty, deceptive trade practices act violations, non-compete
violations, business torts, and other commercial disputes.
Prior to joining the firm in 2006, she was a litigation associate with a Texas
law firm.
She received her J.D. from The University of Texas School of Law, with
honors, in 2004 and her B.B.A. in Accounting from Texas A&M University
in 2001. Ms. Wood was admitted to practice in Texas in 2004.
#441369v2
23