Recharacterization of income from nonpassive to passive is not a change in accounting method.

• Author: Beavers, James A.

The IRS National Office ruled that the recharacterization of income from nonpassive to passive for purposes of the passive activity loss and credit limit rules of Sec. 469 is not a change of accounting method for purposes of Sees. 446(e) and 481(a).

Background

X owned a 1% general partner interest and X and Y (collectively, the taxpayers) owned a 99% limited partner interest, through their living trust, in a state limited partnership that developed a nursing home. The partnership hired a management company to operate the nursing home in exchange for a fee plus a portion of the profits. The nursing home became fully operational in 1990.

The taxpayers determined that they materially participated in the nursing home from 1990 through 1994, and therefore they treated the majority of the losses flowing from the partnership as nor being subject to the passive loss limitation rules under Sec. 469. The taxpayers' treatment of the losses for the tax years 1990-1994 as nonpassive resulted in their either carrying back the losses to prior years or offsetting them against other income in those years. This treatment allowed the taxpayers to offset their ordinary income with the losses from the nursing home on their tax returns from 1990 through 1994.

The IRS examined the taxpayers' 1994 tax year, and the IRS examiner questioned whether the taxpayers were correct in deciding that their ownership of the nursing home was not a passive activity in 1994. Specifically, the examiner questioned whether the taxpayers were correct in claiming that they "materially participated," as defined in Sec. 469(h), in the nursing home activity in 1994.

The examiner believed that the taxpayers did not materially participate in the activity in 1994 and that the nursing home ownership was a passive activity, which resulted in the taxpayers being subject to the passive activity loss and credit limit rules of Sec. 469 in 1994. The examiner requested guidance on whether a recharacterization of the taxpayers' activities from nonpassive to passive for purposes of Sec. 469 is a change in a method of accounting for purposes of Sec. 446(e), requiring the computation of an adjustment under Sec. 481(a).

The taxpayers did not agree with the examiner's Sec. 469 position. However, the taxpayers and the examiner agreed that only the change in method of accounting issue would be submitted to the National Office for consideration. Both the taxpayers and the examiner agreed that the National...