Taxpayers are often surprised to learn that some losses may not be netted against gains in the current tax year. This is often due to the passive activity loss and material participation rules. The IRS National Office addressed these rules in TAM 201634022, in the context of whether two businesses should be grouped together and trigger these loss limitation rules.
Facts & Procedural History
The taxpayer was an otolaryngologist (an ear, nose, and throat doctor).
The taxpayer and several other doctors invested in a partnership.
The partnership in turn owed an an interest in a second partnership.
The second partnership provided outpatient surgery facilities for qualified licensed physicians.
The facilities were used by a number of other doctors and their patients–including the taxpayer and his patients.
Patients would often choose to have surgeries at these facilities as it was cheaper than having the surgeries at a hospital.
The taxpayer also had losses from a rental condo.
The taxpayer netted the losses from the condo with the income from the hospital facility partnership on his individual income tax returns.
The IRS apparently audited the taxpayer’s returns and concluded that the losses were not allowable. It appears that the IRS auditor concluded that the taxpayer’s income from the partnership had to be grouped with his income from his medical practice.
On appeal, the IRS Office of Appeals asked the IRS National Office to weigh in on the issue.
The Passive Activity Loss Rules
This ruling addresses the passive activity loss and material participation rules. These rules suspend otherwise deductible losses until the taxpayer has income from passive activities or disposes of the passive activity that generated the loss.
This requires a determination as to whether an item of income or loss is passive or nonpassive. Income and losses from rental activities are considered to be passive. Income and losses from business activities in which the taxpayer materially participates are considered to be nonpassive. Thus, passive rental losses normally cannot be netted against nonpassive business income.
The Passive Activity Loss Grouping Rules
The regulations also provide grouping rules. These rules allow taxpayers to group activities for purposes of the passive activity loss rules. They generally ask whether the activity grouping represents an appropriate economic unit. The regulations focus on these factors in evaluating whether grouping is appropriate:
- Similarities and differences in types of trades or businesses;
- The extent of common control;
- The extent of common ownership;
- Geographical location;
- Interdependencies between or among the activities (for example, the extent to which the activities purchase or sell goods between or among themselves, involve products or services that are normally provided together, have the same customers, have the same employees, or are accounted for with a single set of books and records).
The Parties Positions
The taxpayer treated his medical practice, partnership, and rental activities as separate activities. He did not make an election to group them together. Since he did not materially participate in the partnership, not electing to group the partnership with his medical practice allowed the partnership income to be passive and be netted against the taxpayer’s passive real estate losses.
With the IRS auditor’s position, that the taxpayer’s income from the partnership had to be grouped with his income from his medical practice, the income from the partnership would be nonpassive as the taxpayer materially participated in the medical practice. This would mean that the partnership income could not be netted against the taxpayer’s passive rental losses.
The IRS National Office
The IRS national office considered the examples in the regulations whereby a taxpayer carves out a part of their business to create passive income, which would allow them to net the income against their passive rental losses.
The regulations provide an example of this in which doctors create a separate business that leases medical equipment back to the doctors. The doctors do not materially participate in the equipment rental business, so its income is nonpassive income for the doctors. The regulations say that this is not permissible given that the doctors formed the equipment rental business to avoid the passive activity loss rules. The rules allow the IRS to regroup the activities to prevent taxpayers from circumventing the passive activity loss rules.
The IRS national office concluded that it was not appropriate for the IRS to try to re-group the taxpayer’s medical practice with the partnership. It reached this conclusion by determining that the taxpayer did not enter into the partnership to circumvent the passive activity loss rules and that the taxpayer’s grouping was reasonable given the grouping rules.
As a result, the taxpayer will likely be allowed to net his passive rental losses with his nonpassive partnership income.