1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law,...

41
1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules
  • date post

    19-Dec-2015
  • Category

    Documents

  • view

    217
  • download

    2

Transcript of 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law,...

Page 1: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

1

IRC §469 – Passive Activities

Part 1Background, purpose, basics, relevance

in the tax law, some considerations in properly applying the rules

Page 2: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

2

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%.

Page 3: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

3

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.

Page 4: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

4

§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)

Page 5: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

5

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).

Page 6: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

6

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.

Page 7: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

7

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.”

Page 8: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

8

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

Page 9: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

9

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

Page 10: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

10

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

Page 11: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

11

§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 ---

Page 12: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

12

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)?

Page 13: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

13

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.”

Page 14: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

14

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.

Page 15: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

15

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)

Page 16: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

16

Who is subject to §469

Individuals Estates Trusts Closely-held C corporations Personal Service Corporations

Page 17: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

17

What is a passive activity?

Either:

1. A trade or business in which the taxpayer does not materially participate, or

2. A rental activity (exception for real estate professionals at §469(c)(7))

Page 18: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

18

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).”

Page 19: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

19

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).”

Page 20: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

20

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

Page 21: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

21

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.

Page 22: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

22

“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

Page 23: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

23

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.

Page 24: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

24

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?

Page 25: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

25

EX – Construction of rental property T was constructing and developing what

would become rental property. Q – how to characterize the construction

activity? TAM 9251003

Page 26: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

26

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

Page 27: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

27

Material Participation TestsQuantitative Tests1. > 500 hours2. 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

3. 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;

4. Significant participation activity (SPA) and aggregate participation in all SPAs during year > 500 hours

Prior Year MP Tests5. MP in any 5 prior tax years (whether or not consecutive) during prior

10 years6. Personal service activity and individual materially participated in the

activity for any 3 prior tax years (whether or not consecutive) Facts and Circumstances Test7. Based on all of facts and circumstances, individual participates in the

activity on a regular, continuous, and substantial basis during the year

Page 28: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

28

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.

Page 29: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

29

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

Page 30: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

30

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.

Page 31: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

31

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)

Page 32: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

32

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

Page 33: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

33

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

Page 34: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

34

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.”

Page 35: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

35

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?

Page 36: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

36

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.

Page 37: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

37

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?

Page 38: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

38

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

Page 39: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

39

Q – can < 100 hours of participation ever be MP?

Yes “substantially all” test Prior years’ MP tests

Page 40: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

40

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).”

Page 41: 1 IRC §469 – Passive Activities Part 1 Background, purpose, basics, relevance in the tax law, some considerations in properly applying the rules.

41

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!