The Passive Loss Rules
In general, if a taxpayer’s aggregate losses from passive activities exceed the taxpayer’s aggregate income from passive activities for the taxable year, the excess losses may not be deducted against other income for that taxable year. Such excess losses are suspended and are carried forward, to be treated as deductions from passive activities in succeeding years, at which point they may offset passive income from such activities.
An activity is generally treated as a passive activity if it involves the conduct of a trade or business, and if the taxpayer does not materially participate in the activity. An individual taxpayer materially participates in an activity only if he or she is involved in the operations of the activity of a regular, continuous, and substantial basis. This standard applies regardless of whether the individual owns an interest in a trade or business activity directly (as a sole proprietorship), or owns an interest in an activity conducted at the entity level by a pass-through entity such as a general partnership or S corporation.
In general, a passive activity is defined to include any rental activity, whether or not the taxpayer materially participates in the activity. Thus, losses from rental activities are allowed against income from other passive activities, but not against other income.
Portfolio income, which encompasses interest, dividends, royalties and certain other items not derived in the ordinary course of a trade or business, is not treated as income from a passive activity. However, if borrowed funds are used in a passive activity, the interest expense is treated as a passive activity deduction. Consequently, in certain lending transactions, a taxpayer may have interest income that is characterized as portfolio income, and interest expense that is characterized as a passive activity deduction.
An issue with respect to portfolio income arises where an individual receives interest income on the debt of a pass-through entity in which the individual owns an interest. The interest may essentially be “self-charged” and, thus, lacks economic significance. For example, assume that the taxpayer charges interest on a loan to an S corporation in which the taxpayer is the sole shareholder. In form, the transaction could be viewed as giving rise to offsetting payments of interest (portfolio) income and pass-through interest (passive) expense, although in economic substance the taxpayer has paid the interest to himself.
Under these circumstances, it is not appropriate to treat the transaction as giving rise both to portfolio interest and to passive interest expense. Rather, to the extent that a taxpayer receives interest income with respect to a loan to a pass-through entity in which he or she has an ownership interest, such income should be allowed to offset the interest expense passed through to the taxpayer from the passive activity for the same taxable year.
Congress anticipated that the IRS would issue regulations to provide for the above result. It also contemplated that such regulations might also identify other situations in which such netting would be appropriate with respect to the payment to a taxpayer by an entity in which he or she has an ownership interest.
In a recent decision, the Fifth Circuit considered a taxpayer’s challenge of one such regulation.
Self-Charged Rental Rule
In general, the Code treats earned income (such as a salary) differently from passive activity income (including many types of rental income). This distinction is important because the passive loss rules only allow a taxpayer to deduct “passive activity losses up to the amount of passive activity income”; the taxpayer may not deduct passive activity losses from earned income. Thus, to gain any benefit from passive activity losses, a taxpayer must have passive activity income. The regulation at issue, the so-called “self-rental rule,” provides as follows:
An amount of the taxpayer’s gross rental activity income for the taxable year from an item of property equal to the net rental activity income for the year from that item of property is treated as not from a passive activity if the property . . . is rented for use in a trade or business activity . . . in which the taxpayer materially participates . . . for the taxable year. Essentially, the regulation provides that when a taxpayer rents property to the taxpayer’s own business, the income is not passive activity income.
Taxpayer’s Real Estate Activity
During the relevant tax years, the Taxpayer owned 100% of two companies: Real Estate, an S corporation, and Medical, a C corporation. During that time, Taxpayer worked full time for Medical and materially participated in the trade or business activities of Medical for purposes of the passive loss rules. The Taxpayer did not materially participate in the activities of Real Estate (including the rental of commercial real estate to Medical) or otherwise engaged in a “real property trade or business.”
During the years in issue, Real Estate leased to Medical the commercial real estate that Medical used in its trade or business activities. Real Estate had net rental income during those years from the rental of commercial real estate to Medical. Taxpayer reported these amounts as passive income on Schedules E, Supplemental Income and Loss, attached to his federal income tax returns for those years. Taxpayer offset these amounts with passive losses from other S corporations, partnerships, and personally owned rental properties. The IRS reclassified Real Estate’s rental income as non-passive income pursuant to the self-rental rule, and disallowed Taxpayer’s passive losses that were claimed in excess of their adjusted passive income for the tax years in issue.
In other words, the IRS’s conclusion that Real Estate’s lease of commercial real estate to Medical fell under the self-rental rule carried the following consequences: (a) Taxpayer’s rental income was deemed non-passive; (b) the Taxpayer could not deduct from it any of his passive activity losses; and, (c) thus, he owed income tax on it. The Taxpayer challenged the deficiencies assessed by the IRS, raising two arguments. First, he argued that because the passive loss rules do not define “taxpayer” to include S corporations, the IRS lacked the authority to define “taxpayer” to include S corporations in the associated regulations. Second, he argued that the self-rental rule did not apply because the lessor, Real Estate, did not materially participate in the trade or business of the lessee, Medical.
The Tax Court rejected both of those arguments, and the Court of Appeals concluded that the Tax Court had reached the right result.
The Court Disagrees
The Court acknowledged that the passive loss rules do not refer to S corporations at all. They specifically apply to “taxpayers” who are individuals, estates, trusts, closely-held C corporations, and personal service corporations. An associated regulation defining certain passive activities, including rental activities, specifies:
This section sets forth the rules for grouping a taxpayer’s trade or business activities and rental activities for purposes of applying the passive activity loss and credit limitation rules of [the passive loss rules]. A taxpayer’s activities include those conducted through C corporations that are subject to[the passive loss rules], S corporations, and partnerships.
The Court concluded, however, that the Code did not need to specifically refer to S corporations because S corporations were merely pass-through entities, and their individual shareholders were the ultimate taxpayers.
Because S corporations do not pay taxes, there was no need for the passive loss rules to include S corporations in their list of potential “taxpayers.” Likewise, the regulations referring to a “taxpayer’s activities . . . conducted through . . . S corporations” did not conflict with the passive loss rules. Rather, they merely recognized the pass-through nature of S corporations and did not state that an S corporation was itself a taxpayer. Thus, the Court concluded that the regulation was valid. Next, the Court addressed the Taxpayer’s claim that the self-rental rule did not apply because the lessor S corporation, Real Estate, did not materially participate in the trade or business of the lessee C corporation, Medical. Again, the Court agreed with the Tax Court. The regulation classified rental income as non-passive if the property “[i]s rented for use in a trade or business activity in which the taxpayer materially participates.” As explained above, the S corporation, Real Estate, was not the taxpayer for purposes of the passive loss rules. Rather, Real Estate was only a pass-through entity; the Taxpayer was the taxpayer. It was undisputed, the Court stated, that the property leased to Medical was rented for Medical’s use in a trade or business activity, and it was likewise undisputed that Taxpayer materially participated in Medical’s business. Thus, the self-rental rule applied and operated to classify the rental income from that lease as non-passive income, as the IRS had determined.
Starting with the obvious, self-charged rental may present an issue for taxpayers whose activities are subject to the passive loss rules.
Beyond that is one of several recurring themes of this blog, of which every tax adviser needs to be mindful when reviewing the tax and economic consequences, and the associated risks, of a transaction.
The policy underlying the “self-charged” rules is to discourage – or at least not reward – transactions that lack economic significance. In form, the transaction could be viewed as giving rise to offsetting payments of income and expense, but in economic substance the taxpayer has only paid himself.
There are many situations in which a taxpayer is effectively paying himself. It happens every time a taxpayer transacts business with a related party as if the latter were not related to the taxpayer; for example, by charging an arm’s-length rate for the services rendered, the property used, or the products purchased. Indeed, that is how related parties should treat with one another, and when they do so, it is almost always the case that the IRS will respect the resulting tax consequences (tax will follow economics).
That being said, there are often other policy goals at work, as in the case of the passive loss rules described above. The tax adviser’s responsibility is to be aware of these “exceptions” that, notwithstanding the parties’ having acted on an arm’s-length basis, may produce unexpected – and undesirable – tax consequences.