Activity grouping: the impact of recent developments.

• Author: Rowe, Daniel

It has been over 25 years since the last major overhaul of the tax code, but the Tax Reform Act of 1986 ('86 Act) (1) continues to affect the manner in which taxpayers structure and conduct their business activities, particularly through the passive activity loss (PAL) rules introduced under Sec. 469.

In the years since this legislation was enacted, the Code has become more cumbersome, layered, and complex with many smaller bills that have added their own marks of differing sizes. Rather than accomplishing large-scale permanent reform, these bills have lately been very focused, addressing short-term revenue and expenditure goals, lasting for a precise number of years, and targeting specific populations and industries. In addition, regulations have expanded on some of the central aspects of the '86 Act, and a quarter century of litigation, revenue rulings, and revenue procedures has added to the available interpretations, strategies, and considerations in arranging one's affairs for tax purposes.

The interplay of specific components of recent and previously existing legislation provides opportunities for reducing tax exposure and the ability to avoid planning traps. This article addresses the specific interactions of Sec. 469 and its regulations with Rev. Proc. 2010-13 (2) and the 2010 Health Care and Education Reconciliation Act (Health Care Act). (3)

Medicare Tax and Passive Activity Income

Congress enacted the Health Care Act and added Sec. 1411 to the Code partly in response to the perceived threat of unfunded future Medicare obligations. As a result, this section imposes a 3.8% Medicare tax on the lesser of net investment income or the excess of modified adjusted gross income over a specific threshold amount for individuals. (4) Estates and trusts are assessed this additional tax on the lesser of undistributed net investment income or the excess of Sec. 67(e) adjusted gross income over the dollar amount at which the highest Sec. l(e) tax bracket begins. (5)

The significant component of Sec. 1411 for this article's purposes is its treatment of income from a trade or business that is a passive activity under Sec. 469 as "investment income." This is a departure from the traditional definition of investment income, which usually includes interest, dividends, annuities, rents, royalties, and portfolio gains, and excludes trade or business income. It also presents a potentially costly side effect for passive activity owners. Awareness of this side effect should prompt a careful analysis of taxpayers' activities and a thoughtful examination of whether these activities have been properly and optimally grouped. If a taxpayer has $300,000 of passive income but can group this with another activity and classify it as nonpassive, he or she has a potential tax savings of $11,400. Before addressing grouping considerations in addition to Sec. 1411 and in conjunction with Rev. Proc. 2010-13, it is useful to recap the passive activity loss rules in general, and Temp. Regs. Sec. 1.469-5T and Regs. Sec. 1.469-4 in particular.

Overview of Passive Activity Loss Rules

Sec. 469 was enacted under the '86 Act to drastically reduce the prevalence of tax shelters. Many tax shelters at the time were partnerships that generated losses for investors who did not participate in the business. The investors would receive a share of the entity's loss and use this to offset other income, including earned income. Sec. 469 limited the amount of losses from passive activities that could be recognized in a given year to the amount of income from passive activities, with any excess passive activity loss being suspended and carried forward to future tax years. This inhibited the ability of taxpayers to shelter their earned income by using losses from an entity in which they were simply passive investors rather than active owners.

In Sec. 469, Congress defines a passive activity as "any activity which involves the conduct of any trade or business, and in which the taxpayer does not materially participate" (6) and states that any rental activity is passive, unless the taxpayer qualifies as a real estate professional. The definition of material participation in the Code is quite vague, requiring "regular, continuous, and substantial" involvement for the...