The Code provides various rules that may limit the ability of an individual taxpayer, who owns an interest in a closely held business, to deduct losses that are attributable to such business.
Under the passive activity loss (“PAL”) rules, for example, the losses realized by a taxpayer from passive activities that exceed the income realized by the taxpayer from such passive activities are disallowed for the current year, though the taxpayer can carry forward the disallowed passive losses to the next taxable year.
Any passive activity losses that have not been allowed (including current year losses) generally are allowed in full in the tax year the taxpayer disposes of his entire interest in the passive activity in a transaction in which all realized gain or loss is recognized.
Passive activities include business activities in which the taxpayer does not materially participate. A taxpayer materially participates in a business activity for a tax year if he satisfies any of the following tests:
- He participated in the activity for more than 500 hours.
- His participation was “substantially all” the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.
- He participated in the activity for more than 100 hours during the tax year, and he participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year.
- The activity was a “significant participation activity,” and he participated in all significant participation activities for more than 500 hours.
- He materially participated in the activity for any 5 of the 10 immediately preceding tax years.
- The activity was a personal service activity – for example, one which involved the performance of personal services in the field of health – in which he materially participated for any 3 preceding tax years.
- Based on all the facts and circumstances, he participated in the activity on a regular, continuous, and substantial basis during the year.
A taxpayer can treat one or more business activities as a single activity if those activities form an “appropriate economic unit” for measuring gain or loss under the PAL rules.
Grouping is important for a number of reasons. If a taxpayer groups two activities into one larger activity, he need only show material participation in the one larger activity as a whole to avoid the limitations of the PAL rules. But if the two activities are separate, the taxpayer must show material participation in each one. On the other hand, if the taxpayer groups two activities into one larger activity and he disposes of one of the two, then he has disposed of only part of his entire interest in the activity. But if the two activities are separate and he disposes of one of them, then he has disposed of his entire interest in that activity and may use the passive losses therefrom in full.
Generally, to determine if activities form an appropriate economic unit, the taxpayer must consider all the relevant facts and circumstances. He can use any reasonable method of applying the relevant facts and circumstances in grouping activities. The following Grouping Factors are assigned the greatest weight in determining whether activities form an appropriate economic unit; all of the factors do not have to apply to treat more than one activity as a single activity:
- The similarities and differences in the types of businesses,
- The extent of common control,
- The extent of common ownership,
- The geographical location, and
- The interdependencies between or among activities, which may include the extent to which the activities:
- Buy or sell goods between or among themselves,
- Involve products or services that are generally provided together
- Have the same customers
- Have the same employees, or
- Use a single set of books and records to account for the activities.
Generally, when a taxpayer groups activities into appropriate economic units, he may not regroup those activities in a later tax year.
However, if the original grouping is clearly inappropriate, or if there is a material change in the facts and circumstances that makes the original grouping clearly inappropriate, the taxpayer must regroup the activities and comply with any disclosure requirements of the IRS.
If any of the activities resulting from the taxpayer’s grouping is not an appropriate economic unit, and one of the primary purposes of his grouping (or failure to regroup) is to avoid the PAL rules, the IRS may regroup the activities.
A recent ruling by the IRS Office of Chief Counsel (“OCC”) considered the IRS’s authority to regroup a physician’s various business interests into a single activity.
IRS: “What’s Up Doc?”
Doctor was an employee/shareholder of X, an S corporation, through Date1, when Doctor left X and became an employee/shareholder of Y, also an S corporation, through Date2.
Doctor also held a small ownership interest in P partnership during Year1 and Year2. In turn, P owned a partnership interest in R, which provided outpatient surgery facilities for qualified licensed physicians. P was established by a group of local City area physicians to acquire an interest in R. These physicians saw a benefit to having a surgical facility in City area which would give patients a lower-cost choice for their surgical needs as opposed to Hospital being the only available surgical facility.
The majority of the equity in R was owned by Q partnership, which had ownership interests in similar facilities throughout the country.
Physicians were not required to be owners of R or be in practice with an owner of R in order to use its facilities. R was used extensively by non-owner physicians or surgeons in City area.
Under applicable local law, physicians were not permitted to refer patients to an entity in which they had a financial interest. Instead, patients had to be given a choice in surgery location. However, patients often chose R over Hospital due to its lower cost.
The income generated from Doctor’s indirect ownership in R (through P) was not tied to the number of surgeries he performed at R’s facility or to the revenue generated by those surgeries. Moreover, even if Doctor did not perform any surgeries at R, he would still receive the same proportionate share of R’s profits allocable to his ownership interest in P.
Prior to the opening of R, the surgeries that could not be performed in Doctor’s office were performed at Hospital. The opening of R did not affect Doctor’s income from his medical practice, but his patients were given a choice as to where to have the surgery performed. Moreover, there were no interdependencies between X, Y, and R. Doctor was compensated for his surgical services to patients through medical charges made by X or Y. The revenue generated by R through facility charges were separate from the charges for medical services rendered by Doctor to his patients.
Challenging the Grouping
On his tax returns, Doctor did not treat X and Y as passive activities. He treated P as a separate activity from X and Y, and reported his income from P as passive income.
Doctor incurred a passive loss on rental condo Z in Year1, which was deducted against the passive income reported from P. In Year2, Doctor incurred another passive loss on condo Z, but again reported passive income from P, allowing him to deduct the entire Z loss in Year2.
The IRS challenged Doctor’s treatment of his interest in P as a separate activity. The IRS asserted that P should have been grouped with Doctor’s interests in X and Y, thereby re-characterizing his income from P as non-passive.
In reviewing the IRS’s challenge, OCC noted that, generally, one or more business activities may be treated as a single activity if the activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of the PAL rules.
Whether activities constitute an appropriate economic unit and, therefore, may be treated as a single activity depends on all the relevant facts and circumstances. According to OCC, a taxpayer may use any reasonable method of applying the relevant facts and circumstances in grouping activities, but OCC also stated that the Grouping Factors were to be given the greatest weight in determining whether activities constitute an appropriate economic unit.
OCC illustrated the intended application of these rules with the following example:
F, G, and H were doctors who operated separate medical practices. The doctors intended to invest in real estate that would generate passive losses.
In order to circumvent the underlying purposes of the PAL rules, the doctors converted a portion of their practices into a single passive income generator. They formed a partnership to engage in the business of acquiring and operating X-ray equipment. In exchange for equipment contributed to the partnership, the taxpayers received limited partnership interests. The partnership was managed by a general partner selected by the taxpayers; the taxpayers did not materially participate in its operations.
Substantially all of the partnership’s services were provided to the taxpayers or their patients, roughly in proportion to the doctors’ interests in the partnership. Fees for the partnership services were set at a level equal to the amounts that would be charged if the partnership were dealing with the taxpayers at arm’s length and were expected to assure the partnership a profit.
The taxpayers treated the partnership’s services as a separate activity from their medical practices and offset the income generated by the partnership against their passive losses.
For each of the taxpayers, the taxpayer’s own medical practice and the services provided by the partnership constituted an appropriate economic unit, but the services provided by the partnership did not separately constitute an appropriate economic unit. Accordingly, OCC stated, the IRS could require the taxpayers to treat their medical practices and their interests in the partnership as a single activity.
OCC contrasted the above example with the present case. An unrelated entity, Q, was the majority owner of R and controlled the day-to-day management of the surgical facility. Doctor and the other partners of P did not have any control over the day-to-day operations of R, unlike Doctor’s clear control over X or Y. In addition, the services provided by R to patients of P’s partners did not comprise substantially all of R’s patient services, and the services provided by R to the patients of P’s partners were not in proportion to the partners’ interests in P or their indirect interests in R.
Thus, while the above example concluded that the partnership’s activities did not separately constitute an appropriate economic unit, it was not necessarily inappropriate for Doctor to treat P’s activity as a separate economic unit in the present case.
While the business activities of X, Y, and R (held by Doctor through P) were similar in that they were all in the medical industry and involved the provision of medical services to patients, X, Y, and R provided different types of medical services. Certain surgeries could not be performed at X’s or Y’s office, and diagnostic and post-operative care was not provided through P or R. Doctor did not have the same kind of management control over R that Doctor exercised over his own medical practice conducted through X or Y. Doctor had different ownership interests among X, Y, and P. It also appeared that X, Y, and R were in different locations and did not share employees or recordkeeping.
Applying the Group Factors to the facts and circumstances of this case, OCC concluded that there may be more than one reasonable method for grouping Doctor’s activities into appropriate economic units. It also concluded that the facts and circumstances did not support a determination that Doctor’s grouping of the interests in X, Y, and P as separate activities was clearly inappropriate. Thus, the IRS did not have authority to regroup Doctor’s interests in X, Y, and P as a single activity.
Planning for Grouping?
It may be difficult, but not impossible.
The above ruling confirms that taxpayers have some flexibility in determining the grouping of their business activities for purposes of the PAL rules. This flexibility may enable a taxpayer to achieve a desired tax result.
For example, the taxpayer may be able to group certain activities in order to ensure satisfaction of the material participation test, thereby “converting” an otherwise passive activity to non-passive. Alternatively, if he has suspended losses, the taxpayer may decide to treat a particular activity, in which he is not active, as separate from other related non-passive activities in order to generate passive income from the separate activity.
Depending upon the facts and circumstances, a broad grouping may be beneficial to the taxpayer in some cases, while a narrower grouping would be preferred in others.
Unfortunately, it may be difficult to predict whether a taxpayer will realize income or loss from a particular business activity. In addition, a taxpayer may not accurately foresee the level of his participation in an activity.
The best that a taxpayer can do is to speak to his advisers and, based, upon his and their respective experiences, and the economic forecasts for the business, arrive at a strategy that is reasonable under the circumstances and that preserves a measure of flexibility.