Passive activity loss allocations; careful planning can reduce the adverse impact of Sec. 469.

• Author: Allen, Stephen D.

The Tax Reform Act of 1986 (TRA) introduced taxpayers to the Sec. 469 passive activity loss (PAL) rules. These rules were designed to deal with the problem of tax shelters, a problem that Congress believed was undermining the integrity of the tax system. Sec. 469 quickly established itself as one of the most complicated and far-reaching sections of the Code. Other tax provisions may rival the passive activity rules in complexity, but few of the more intricate provisions can match the breadth of a section that touches virtually every trade or business in which an owner does not materially participate.

The complexity that characterizes the passive activity provisions arises from two sources. First, there are the problems of delineating the scope of each of a taxpayer's activities and classifying each activity as passive or nonpassive. This task is complicated to a considerable extent by the Treasury's attempts to structure the Sec. 469 regulations in a manner that will thwart all taxpayer efforts to increase passive income of decrease passive losses. Second, there are the computational problems. Special allowances must be computed, losses must be allowed and suspended, and the suspended amounts must be allocated among and within activities.

This articl will focus on the second of these problems, the passive loss allowance, suspension and allocation procedures; explore the workings of these procedures and, in the process, reveal a number of planning opportunities; and expose inconsistencies between the intra-activity allocation procedure described in the regulations and the allocation procedure embodied in the form on which lossesl from passive activities are reported.

The Basic Loss Suspension Process

The passive loss rules are built around a simple idea: deductions from passive activities are allowed only to the extent of the income from passive activities. Unallowed deductions are "suspended" and are treated as passive activity deductions in the following year. Before exploring this idea more fully, however, some terms must be precisely defined in order to understand the passive activity rules.

Five terms must be distinguished: current, suspended, dispositional, overall and collective. An activity produces "current income" if the gross income produced by the activity in the current year exceeds the deductions associated with the activity in the current year (disregarding any suspended losses carried from prior years and any gains and losses from disposition of the taxpayer's entire interest in the activity). An activity produces "current loss" if the deductions associated with the activity exceed the gross income from the activity in the current year (again disregarding prior year suspended losses, and gains and losses from disposition). Current income or loss usually arises from the operation of an activity and from the disposition of property used in an activity, although it can also arise from such sources as a partial dispositional of an interest in an activity. The "suspended loss" associated with an activity is the amount of dissalowed loss resulting from application of the passive loss rules. As Sec. 469(b) states, this loss "shall be treated as a deduction ... allocable to such activity in the next taxable year." The term "dispositinal gain or loss" refers to the gain or loss realized when a taxpayers completely disposes of an interest in a passive activity in a fully taxable sale or exchange. The term "overall income or loss" refers to the sum of the current income or loss, the suspended loss from the prior year (if any) and the dispositional gain or loss (if any). An activity will be said to be "loss-producing" if it produces an overall loss and "income-producing" if it produces overall income. Finally, the term "collective income or loss" refers to the sum of the overall income and loss from all passive activities or to the sum of the overall income and loss from a designated group of activities.

Sec. 469 (d) (1) defines a "passive activity loss" as the amount (if any) by which --the aggregate losses from all passive activities for the tax year (including suspended losses) exceed --the aggregate income from all passive activities for such year. Equivalently, the PAL can be defined as the collective loss, if any, from all passive activities. This definition of the passive activity loss leads to a very precise statement of the basic passive loss disallowance rule in Sec. 469(a): the passive activity loss for the tax year will not be allowed. Unfortunately, this definition can also lead to some confusion because the phrase "passive activity loss" is often used to refer to the loss from a single loss-producing passive activity. (In fact, Sec. 469(g) used this phrase in exactly this fashion before it was amended by the Technical and Miscellaneous Revenue Act of 1988.) To reduce ambiguity, this article will avoid such usage. Example 1. Taxpayer T with taxable income of $100,000 from nonpassive sources has an interest in exactly three passive activities, A, B and C. There are no dispositions during the year. Current income (loss), prior year suspended losses and overall income (loss) associated with these activities in year 1 are as follows.

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The sum of the overall losses from loss-producing passive activities equals $20,000, the combination of an overall loss of $4,000 from B and $16,000 from C. The sum of the overall income from income-producing passive activities equals $15,000, the overall income from A. The passive activity loss, $5,000, equals the collective loss from all passive activities, which equals the sum of the overall income and loss from all passive activities. Applying the basic passive loss disallowance rule, all of the overall income from A will be recognized, while $15,000 of the $20,000 of overall losses from B and C will be allowed. The remaining $5,000 of losses from B and C will be suspended and carried forward to be combined with current income and loss in the next year. Taxable income will be $100,000.

Interactivity Suspended Loss Allocations

Once the total amount of loss to be suspended during the current year has been computed, this loss must be translated into a suspended loss for each activity. Sec. 469(j)(4) states that "[t]he passive activity loss . . . shall be allocated to activities, and within activities, on a pro rata basis. . . ." Temp. Regs. Sec. 1.469-1T(f)(2)(i)(A) further specifies that the passive activity loss is to be apportioned only among loss-producing activities. Perhaps the easiest way to allocate the PAL is to compute the loss suspension percentage (designated as "S" in the following formula), which represents the portion of the losses from loss-producing activities that will be suspended.

S = The passive activity loss / Sum of the overall losses from loss-producing passive activities

Since the passive activity loss is allocated on a pro rata basis, S also represents the percentage of the overall loss associated with each loss-producing activity that will be suspended.

Alternatively, the allowed loss for each loss-producing activity can be computed using the loss allowance percentage, A, which measures the portion of the losses from loss-producing passive activities that will be allowed.

A = Sum of the overall income from income-producing passive activities / Sum of the overall losses from loss-producing passive activities

Note: A = 1 - S.

Example 2: For taxpayer T from Example 1, the loss suspension and allowance percentages are calculated in the following manner.

S = $(5,000) (the PAL) / $(4,000) (overall loss from B) + $(16,000) (overall loss from C) / = $(5,000) / $(20,000) / = 0.25

A = $15,000 (overall income from A) / $(4,000) (overall loss from B) + $(16,000) (overall loss from C / = $15,000 / $(20,000) / = 0.75

Thus, 25% of the overall loss from each loss-producing passive activity will be suspended and the remaining 75% will be allowed.

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Dispositions

The key passive activity disposition rule of Sec. 469(1)(A) states that current and suspended losses from an activity will be recognized when a taxpayer disposes of his entire interest in the activity in a fully taxable sale or exchange. Losses are allowed on disposition because Sec. 469 was designed to...