One technique for converting otherwise passive activities to nonpassive is grouping them and treating them collectively as a single activity, thereby combining the participation hours and improving a taxpayer’s ability to achieve the necessary hours for material participation. Regs. Sec. 1.469-4 provides general rules and limitations for grouping activities and applies a facts-and-circumstances test to determine the appropriateness of a particular grouping. In general, activities can be grouped for purposes of Sec. 469 if they constitute an appropriate economic unit for measuring gain or loss.
Benefits and Drawbacks
Grouping activities allows taxpayers to treat them as one when applying the tests to determine material participation. For example, a chef who owns two restaurants can treat them as a single activity, and if he spends 500 hours working in one of them during the year and none at the other, he will still pass the first test of the seven material participation tests under Temp. Regs. Sec. 1.469-5T(a) to be considered nonpassive. Since such a move likely forms an appropriate economic unit due to common ownership and similarity in business, he can add his catering company to this group as well. If the catering company produced a loss for the year and the chef did not materially participate in it, the passive loss may be suspended to a future tax year absent any passive income to offset it against in the current year. Grouping the catering company with the restaurants as a single activity and thereby treating it as nonpassive will allow the chef to realize the tax benefit of the loss currently.
However, once a taxpayer chooses a grouping, it must remain in effect for all future tax years. This may affect the taxpayer’s ability to use suspended losses in future tax years. When a passive activity is disposed of, its suspended losses are freed up to first offset any gain on the disposition, with the excess losses then treated as nonpassive and available to offset any other taxable income, including portfolio and earned income. But once the chef includes the catering company in the grouping with the restaurants, to entirely dispose of the activity requires disposing of the two restaurants and the catering company. Merely selling or abandoning the catering company will not constitute disposing of all or significantly all of the activity anymore.
Clearly, the existence of suspended losses should be considered when deciding whether to group certain activities into one. Another important consideration is the type of income and loss the taxpayer expects from other activities. If the chef owns another business that is a passive activity that typically generates losses, and the catering company is expected to produce income, the chef would do better tax-wise to leave the catering company as a separate activity without material participation.
For a detailed discussion of the issues in this area, see “Activity Grouping: The Impact of Recent Developments,” by Daniel Rowe, CPA, in the February 2013 issue of The Tax Adviser.
Alistair M. Nevius, editor-in-chief
The Tax Adviser
Also look for articles on the following topics in the February 2013 issue of The Tax Adviser:
- A look at recent developments affecting partnerships.
- An analysis of formula clauses in wills and gifts.
- A discussion of establishing an ethical culture in a tax practice.
The Tax Adviser is the AICPA’s monthly journal of tax planning, trends, and techniques. AICPA members can subscribe to The Tax Adviser for a discounted price of $85 per year. Tax Section members can subscribe for a discounted price of $30 per year. Call 800-513-3037 or email email@example.com for a subscription to the magazine or to become a member of the Tax Section.