IRS recently came out with new rules regarding how taxpayers must elect to group passive and active business and rental activities together. Grouping a passive activity with an active one can help taxpayers avoid the dreaded “material participation rules” – designed to blur your eyes and make you sleepy and irritable. Oddly, the passive activity rules upon which this new required grouping election is based were enacted back in 1987 with the infamous Tax Reform Act. Um…that was 25 years ago.
Importantly, for tax years 2011 and forward, the new guidance from IRS makes it necessary for all business owners with more than one “activity” to consider whether and how to apply these rules to their undertakings. Here is an overview of how the rules work:
- You can group rental or other passive activities with trade or business activities where one is insubstantial to the other and if they constitute an “appropriate economic unit.” This involves analyzing factors identified in Regulation 1.469-4: similarities and differences among the business activities, extent of common ownership, geographic location, and interdependence. (However, you cannot group rental real estate activities with personal property rental activities.) Example: a manufacturing S corporation produces waste metals that can be recycled or sold for scrap. For business reasons, the corporation’s owners form a separate S corporation to handle the recycled material, either selling it or ensuring its proper disposal. The recycling company’s revenues are miniscule compared to the manufacturing company, and it tends to generate losses. The owners don’t spend much time managing the recycling company, but if they elect to group the two companies together, they can treat the recycling company as active, never again worrying about the passive activity rules.
- You can group a rental activity with a trade or business activity if the rental is to the business, and all the owners have the same ownership percentages in each entity. Example: an LLC owns a building, rented out to a printing company, also an LLC. The owners of the printing company own the rental LLC in the same proportions as their ownership in the printing company. Each individual owner can decide whether or not to group the two activities together, which results in converting LLC rental losses and income to active status, and avoids suspended rental losses where the owner’s incomes are too high to take advantage of the losses.
- You can’t change or revoke your grouping election unless there is a material change in the underlying facts, or unless the original grouping was clearly erroneous. You can, however, add to the group.
- If you don’t decide which activities to group for 2011 by attaching the required statement, IRS will take the position that nothing has been grouped (but you may carry on with prior groupings and are not required to disclose prior groupings to IRS.) Grouping elections can be made in future years, but they cannot be retroactive. Groupings made prior to 2011 will not be disturbed, so long as the taxpayer consistently maintains the grouping.
- You must disclose to IRS, by attaching the required statement from Rev. Proc. 2010-13 all: new groupings for 2011; additions to prior groupings; changes to ANY groupings. You do not have to disclose grouping elections made prior to 2011.
- Grouping elections can be made first at the entity level and then at the individual level, but an owner in an S corporation or partnership cannot un-group an activity that has already been grouped at the entity level.
Generally, there is no good reason to group rental activities together into one passive group. Doing so would mean that passive activity losses would remain suspended until each property in the group is finally sold.
Unfortunately, there is neither a bright line test, nor a safe harbor, to help taxpayers determine which activities can be grouped. So, it’s a good idea to carefully review the rules with your CPA firm to evaluate the best course of action.