Successful businesses change over time. We often see this when a business gets ready for the founder or owner to exit the business.
The business is often reorganized and maybe even divided up. Various tax strategies come into play to help facilitate the transfer, like the F Reorganization for S corporations. Other plans to minimize state and Federal taxes may be considered.
These restructuring activities are often carefully planned for, but there are numerous traps and foot faults. The application of the passive activity loss rules during the pre-sale holding period is an example. This period may be overlooked as it is a transition period that may not be expected to last for very many years. But this period is usually marked by high income by the business. The passive activity loss rules can result in significant taxes being due sooner than one had anticipated.
The recent Rogerson v. Commissioner, T.C. Memo. 2022-49 was covered in the tax press because it involved tax losses from a yacht. But the facts of the case show the broader application of the ruling. Those who are restructuring their business ventures pending a later sale should take note of this case.
Facts & Procedural History
The taxpayer is the founder and CEO of several aerospace companies. The companies were essentially reported as a single activity on one tax return.
As part of his estate planning and business succession planning, the taxpayer decided to separate his business into two separate business lines. This made sense as part of the business focused on older technology and part of the business focused on newer technology. The taxpayer segregated this business brands into two S corporations, one for each technology focus.
The taxpayer also formed a management company that provided management services to the two operating businesses.
The taxpayer reported income from the management company and one of the operating businesses on his tax returns. He reported a loss from the other operating business on his tax returns.
The income from the management company and the loss from one of the operating entities were reported as non-passive. The income from the other operating company was at issue in this case. The taxpayer reported the income from this entity as passive.
By reporting the income as passive, the income was able to offset the passive losses the taxpayer incurred from yachts that he owned.
On audit by the IRS, the auditor determined that the income from the operating company was non-passive.
The tax court had to decide whether the income from the operating company was passive or non-passive.
About the Passive Activity Loss Rules
The passive activity loss rules were enacted by Congress in the late 1980s to prevent high-income individuals from using losses from passive activities from offsetting income from non-passive activities.
Thus, the typical fact pattern involves a high-income individual who owns and operates a business and makes an investment, such as the yachts at issue in this case, that incurs losses. The losses may even involve real estate losses by real estate agents and other real estate professionals. The taxpayer’s federal income tax liability is reduced greatly if the losses offset the taxpayer’s income.
There are numerous rules and limitations that apply to the passive activity loss rules. These rules are frequently at the center of disputes between taxpayers and the IRS. We have addressed a number of these disputes on this website, such as this case that considers the 5 percent owner rules and the difficulty in explaining the concepts underlying the exceptions for the PAL rules to IRS employees.
Dividing and Grouping Activities
This case presents the question as to whether a taxpayer can divide up their business and then assert that one part of the business is passive. That is what the taxpayer did in this case. Presumably, he did so as part of his estate planning and business succession planning, not necessarily with the passive activity loss rules in mind.
The regulations generally say that a shareholder of an S corporation cannot treat activities grouped together by the S corporation as separate activities. The shareholder is stuck with the grouping by the S corporation.
The rules also say that an entity, such as an S corporation, can have both passive and non-passive activities. This is the same result as if the business was formally split into separate legal entities. So the premise of dividing up business activities into legal entities is possible. The division into legal entities, which isn’t actually required, just further clarifies the division of activities between passive and non-passive.
There are court cases that show how this works. One involved a doctor who owned a medical practice and, in a separate entity, a medical equipment rental business. The court respected the passive nature of the equipment rental business. This made it possible for this passive income to offset passive losses from other activities. The IRS has also issued guidance addressing a similar fact pattern and concluded that it fails if the taxpayer set up the equipment company to avoid paying taxes. You can read about the guidance here.
The Five of Ten Rule
That brings us back to this case. The IRS and court focused on the “five of ten” rule. There hasn’t been much guidance on the application of this rule, but it is usually relied on by taxpayers to show that they met the material participation standard.
This rule says that a taxpayer materially participates in an activity for the current year if he materially participated in the activity for any five out of the ten years immediately preceding the taxable year.
In this case, the court concluded that there was sufficient similarity between the current-year activity and the prior year’s activity. The court noted that the activities were not divided up previously. It also seems to suggest that the activities are similar, i.e., being CEO of one business vs. the other. However, the court did not have to go further in this analysis, as it concluded that the taxpayer materially participated even without the application of this rule.
The five of ten-year rule has to be considered when applying the passive activity loss rules. While most taxpayers cite and rely on the rule to show that they materially participated, the rule can be an obstacle in cases where the taxpayer is trying to show that the income entity (not the loss entity) was passive. This case provides an example of this type of fact pattern.
This presents a challenging planning situation as the IRS is likely to assert that a new business with no prior participation fails as it was set up for tax avoidance (technically it’s just tax deferral, not avoidance) and, pursuant to this case, that there was continued participation if the business existed previously. This type of heads-I-win, tails-you-lose situation should be considered when deciding how to group activities for purposes of the passive activity loss rules.