PORTFOLIO

Passive Loss Rules (Portfolio 549)

Tax Management Portfolio, Passive Loss Rules, No. 549-2nd, describes in detail the application of the passive loss rules to losses and credits from investments in passive activities. In general, the passive loss rules limit the deduction of net losses from passive activities and the use of credits from such activities to offset tax liability on income that is not from such activities. These rules, which apply generally to all non-corporate taxpayers (and personal service corporations and closely held C corporations), treat portfolio income (e.g., dividends and interest not derived in the ordinary course of business) as income not derived from a passive activity.

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DESCRIPTION

Tax Management Portfolio, Passive Loss Rules, No. 549-2nd, describes in detail the application of the passive loss rules to losses and credits from investments in passive activities. In general, the passive loss rules limit the deduction of net losses from passive activities and the use of credits from such activities to offset tax liability on income that is not from such activities. These rules, which apply generally to all non-corporate taxpayers (and personal service corporations and closely held C corporations), treat portfolio income (e.g., dividends and interest not derived in the ordinary course of business) as income not derived from a passive activity.


In general, passive activities under the rules are those activities involving the conduct of a trade or business in which the taxpayer does not materially participate. Material participation requires regular, continuous, and substantial involvement by the taxpayer in the operations of the activity — a relatively high standard that requires considerably more than general management responsibility. All rental activities are treated as per se passive, except for interests in rental real estate owned by certain real estate operators. Except as provided in regulations, no interest as a limited partner is treated as an interest with respect to which the taxpayer materially participates.


Deductions and credits from passive activities that are disallowed for any year, because in excess of income and tax liability attributable to all such activities, are suspended and carried forward indefinitely to be used against passive income arising in a subsequent taxable year. Suspended passive losses are allowed against nonpassive income upon the disposition of the taxpayer's entire interest in the activity, or in limited cases upon a partial disposition. Certain losses and credits from rental real estate activities may also be allowed against nonpassive income and tax liability, up to a maximum of $25,000 per year.


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AUTHORS

DANIEL N. SHAVIRO
Daniel N. Shaviro, A.B., Princeton University (1978); J.D., Yale Law School (1981); member, District of Columbia Bar; author of various books including When Rules Change: A Political and Economic Analysis of Retroactivity and Transition Relief and Making Sense of Social Security Reform; contributor of articles to various journals including Tax Law Review, Virginia Tax Review, TAXES, Harvard Law Review, University of Chicago Law Review, and Michigan Law Review; Caplin & Drysdale, Washington D.C. (1981–84); Legislation Attorney, Joint Committee on Taxation (1984–87); Assistant Professor and then Professor of Law at University of Chicago Law School (1987-1995); Professor of Law at NYU Law School since 1995.

TABLE OF CONTENTS

Detailed Analysis

I. Overview

II. Taxpayers Subject to the Passive Loss Rules

A. In General

B. Personal Service Corporations

1. Definition

2. Definition of an Employee–Owner

3. 10% Ownership Requirement

4. Meaning of “Personal Services”

5. Meaning of “Substantially Performed by Employee–Owners”

C. Closely Held C Corporations

1. Definition of “Closely Held”

2. Application of the Passive Loss Rules to Closely Held C Corporations

D. Consequences of Ceasing to Be a Corporation Subject to the Passive Loss Rules

E. Treatment of Consolidated Groups

1. In General

2. Intercompany Transactions Between Members of a Consolidated Group

F. Treatment of Publicly Traded Partnerships

1. Background–Related Statutory Provision

2. Tax Treatment of Partners in a PTP That Is a Partnership for Tax Purposes

a. Modified Application of the Passive Loss Rules

b. Tax Treatment of Corporate Partners in a PTP That Is a Partnership for Tax Purposes

III. Identifying Passive Activities

Introductory Material

A. Definition of a Separate Activity

1. Significance of Identifying Separate Activities

2. A Brief History of the Activity Regulations

3. The Permanent Activity Regulations

a. Overview

b. Allowance of Any Reasonable Method in Grouping Activities

(1) Scaled-Down Implicit Retention of the “Building Block” Approach

(2) Taxpayer Discretion in Applying Relevant Facts and Circumstances

c. Decisions to Be Made at the Entity Level by Partnerships and S Corporations

d. Limitations on Grouping Certain Types of Activities with Other Types of Activities

(1) Overview

(2) General Limitation on Grouping a Rental Activity with a Trade or Business Activity

(3) Exception for Trade or Business Activity and Rental Activity with Same Proportionate Ownership

(4) Limitation on Grouping Rentals of Real Property with Rentals of Personal Property

(5) Limitations in Grouping Certain Activities of Limited Partners and Persons Not Sufficiently Involved in Management

e. IRS Authority to Issue Additional Limitations on Permissible Groupings

f. Consistency and Disclosure Requirements

g. Grouping by the IRS to Prevent Tax Avoidance

h. Treatment of Partial Dispositions

i. Tax Planning Implications of the Activity Regulations

B. Determining Whether an Activity Is Passive

1. Existence of a Trade or Business

a. General Meaning of “Trade or Business”

b. Expansion of the Trade or Business Definition for Passive Loss Purposes

c. The Activity of Trading Personal Property Such as Securities or Commodities

2. Material Participation Standard

a. Test One: More Than 500 Hours of Participation

b. Test Two: Substantially All Participation Is by the Taxpayer

c. Test Three: Participation for More Than 100 Hours, If No Other Individual Participates More

d. Test Four: Significant Participation Activities

e. Test Five: Material Participation in Five of the Last 10 Taxable Years

f. Test Six: Material Participation in a Personal Service Activity for Any Three Prior Years

g. Test Seven: Regular, Continuous, and Substantial Involvement Under the Facts and Circumstances

(1) Effect of the Regulations on the General Standard

(2) High Threshold of Involvement Under the Facts and Circumstances Test

(3) Regularity of Involvement

(4) Continuity of Involvement

(5) Substantiality of Involvement

(6) Further Illustrations of Material Participation Under the Facts and Circumstances Test

h. General Distinction Between Investors and Entrepreneurs

i. Limited Partners

(1) General Rule

(2) Exceptions to Treatment of Limited Partners as Passive

j. Material Participation by Legal Entities

(1) Personal Service Corporations

(2) Closely Held Corporations

(3) Estates and Trusts

k. Special Rule for Interests Held by Retirees and Surviving Spouses in Farming Activities

3. Rental Activities

a. In General

b. Exceptions to Treatment as a Rental Activity

(1) Exception One: Average Customer Use Period of Seven Days or Less

(2) Exception Two: Average Customer Use Period of 30 Days or Less

(3) Exception Three: Providing Extraordinary Personal Services

(4) Exception Four: Rentals Incidental to Nonrental Activities of the Taxpayer

(a) Rentals Incidental to Holding Property for Investment

(b) Rentals Incidental to a Trade or Business of the Taxpayer

(c) Rentals of Lodging to Employees for the Convenience of the Employer

(5) Exception Five: Property Customarily Made Available for Nonexclusive Use by Various Customers

(6) Exception Six: Property Rented to a Passthrough Entity or Joint Venture in Which the Taxpayer Owns an Interest

(7) Exception Seven: Rental of Taxpayer's Residence

c. Statutory Exception to Treating Rental Activities as Per Se Passive for Interests in Rental Real Estate Owned by Certain Real Estate Operators

(1) Background

(2) Qualifying as a Real Estate Operator

(3) Grouping a Real Estate Operator's Interests in Rental Real Estate into Activities

(4) Determining a Real Estate Operator's Material Participation in One's Rental Real Estate Activities

(5) Issues Relating to Limited Partners

4. Working Interests in Oil and Gas Property

a. Definition of a Working Interest

b. Holding a Working Interest Through an Entity That Limits the Liability of the Taxpayer

c. Change in Form of Ownership of Working Interest

(1) Anti-Flip-Flop Rule

(2) Anti-Risk-Elimination Rule

d. Treatment of Spouses When Both Own Working Interests in the Same Well or Property

IV. Treatment of Particular Items

A. Items That Are Per Se Nonpassive

1. Portfolio Income

a. Items Generally Treated as Portfolio Income

b. Items Not Treated as Portfolio Because Derived in the Ordinary Course of a Trade or Business

c. Expenses Treated as Related to Portfolio Income

(1) Properly Allocable Interest Expense

(2) Clearly and Directly Allocable Expenses Other Than Interest

(3) Self-Charged Interest and Other Items

(a) Legislative History Background to the Self-Charged Interest Regulations

(b) The Self-Charged Interest Regulations

2. Compensation for Services

3. Other Items of Income That Are Per Se Nonpassive

4. Deductions That Are Treated as Per Se Not from Passive Activities

5. Payments to a Retiring Partner or a Deceased Partner's Successor in Interest

B. Net Income (But Not Net Loss) from Nonshelterable Passive Activities (NOPAs) Treated as Nonpassive

1. In General

2. Significant Participation Passive Activities (SIPPAs)

3. Rental of Nondepreciable Property

4. Equity-Financed Lending Activity

5. Property Rented Incidental to Development Activity

6. Property Rented to a Nonpassive Activity of the Taxpayer

7. Passthrough Entity, Engaged in Licensing Intangible Property, in Which the Taxpayer Acquires an Interest After the Entity Incurs Certain Expenses

8. Possible Areas for Expansion of the NOPA Rules

C. Determination of Items Allocable to a Passive Activity

1. General Rules for Allocating Items

2. Allocation of Interest Expense

3. Overhead and Other Problems in Allocating Items Between Activities

4. Disposition of Property Used in a Passive Activity

a. General Rule

b. Exceptions

(1) Property Used in More Than One Activity During 12 Months Before Disposition

(2) Disposition of Substantially Appreciated Property

(3) Property Held for Sale to Customers After Use in a Nondealing Activity

(4) Scope of the Property Disposition Rules

5. Disposition of an Ownership Interest in an Entity

a. Allocation of Ratable Portions of Gain or Loss

b. Applicable Valuation Date

c. Certain Gain Upon Disposition of an Ownership Interest, Otherwise Allocable to a Passive Activity, Treated as Not From a Passive Activity

6. Taxable Year of an Item

7. Determination of Which Items Have Been Disallowed

8. Effect of Changes in the Composition of the Taxpayer's Activities

9. Treatment of Credits

V. Allowance of Passive Losses and Credits Against Nonpassive Income and Tax Liability

Introductory Material

A. Disposition of a Passive Activity

1. General Rule

2. Requirement That a Taxpayer Dispose of his Entire Interest in a Passive Activity

a. Meaning of “Passive Activity” for Purposes of this Requirement

b. Disposing of a Taxpayer's Entire Interest in the Relevant “Activity”

3. Requirement of a Fully Taxable Transaction

4. Treatment of Related Party Transactions

5. Disposition by Death

6. Disposition by Installment Sale

7. Gifts

8. Distribution to Beneficiaries by Estate or Trust

9. Change in Nature of Activity

10. Treatment of Credits Upon Disposition

a. In General

b. Elective Basis Adjustment

11. Net Income from Years Before Disposition

B. Treatment of Former Passive Activities

C. Special Rules for Rental Real Estate (Other Than the Application of 469(c)(7) to Interests Owned by Certain Real Estate Operators)

1. Allowance of Up to $25,000 of Losses

2. Active Participation Requirement

3. Situations Where a Taxpayer, Otherwise Eligible Under the $25,000 Rule, Cannot Qualify as Actively Participating

4. Allowance of Up to the Deduction Equivalent of $25,000 for Credits

a. Calculation of the Deduction Equivalent

b. Credits and Deduction Not Subject to the Active Participation Requirement

5. Phase-Out Rules

a. Adjusted Gross Income Phase-Out

b. Special Rules for Rehabilitation and Low-Income Housing Credits and Revitalization Deduction

c. Ordering Rules

VI. Interaction of Passive Loss Rules with Other Code Provisions

A. Qualified Residence Interest ( 163(h)(3))

B. Business or Rental Use of a Personal Residence ( 280A)

C. Investment Interest Limitation ( 163(d))

D. Deduction for State and Local Property Taxes ( 164)

E. At-Risk Rules ( 465)

F. Adjustments Required Due to Change in Accounting Methods ( 481)

G. Basis Limitations on Losses of a Partner ( 704(d)) or S Corporation Shareholder ( 1366(d))

H. Computation of Adjusted Basis ( 1016)

I. Capital Loss Limitation ( 1211)

J. Limitation on Percentage Depletion for Oil and Gas ( 613A(d))

K. Foreign Tax Credit ( 27(a) and 901)

L. Operating Loss Deduction ( 172)

M. Alternative Minimum Tax ( 55)

N. Carryover of Losses and Credits to Bankruptcy Estates of Individuals ( 1398)

O. Limitation on Deductions for Property Used by Tax-exempt Entities ( 470)


WORKING PAPERS

Working Papers

Table of Worksheets

Worksheet 1 Senate Report to Accompany H.R. 3838 (The Tax Reform Act of 1986), S. Rep. No. 313, 99th Cong., 2d Sess. 713–746 (1986)

Worksheet 2 Conference Report to Accompany H.R. 3838 (The Tax Reform Act of 1986), H.R. Rep. No. 841, 99th Cong., 2d Sess. II–137–150 (1986)

Worksheet 3 General Explanation of the Tax Reform Act of 1986 (H.R. 3838, P.L. 99–514, 99th Cong., 2d Sess.), Prepared by the Staff of the Joint Committee on Taxation (May 4, 1987)

Worksheet 4 Conference Report to Accompany H.R. 3545 (The Revenue Act of 1987), H.R. Rep. No. 495, 100th Cong., 1st Sess. (1987)

Worksheet 5 House Report to Accompany H.R. 2264 (The Revenue Reconciliation Act of 1993), H.R. Rep. No. 111, 103d Cong., 1st Sess. 612 (1993)

Worksheet 6 IRS Publication 925, Passive Activity and At–Risk Rules

Worksheet 7 Announcement 98–12, 1998–8 I.R.B. 43

Worksheet 8 Material Participation Flow Chart

Worksheet 9 Sample Election Out of the Self-Charged Interest Rules Under Regs. 1.469-7(g)

Worksheet 10 Sample Election Under 469(c)(7) to Aggregate Rental Real Estate Interests

Worksheet 11 Election Under 469(j)(9) to Increase Basis of Property by Amount of Disallowed Credit

Bibliography

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Treasury Regulations:

Treasury Rulings:

Cases:

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