Avoiding the pitfalls associated with attempts to recharacterize activities.

Facts: Wilson Engineering, Inc., is a personal service corporation (PSC) that has decided to acquire, for investment purposes, an undeveloped tract of land available for $115,000. Property values are escalating rapidly in the area end Wilson's three shareholders plan to hold the property while it appreciates and then sell it at the peak of the market. The carrying costs (interest and taxes) for the land are anticipated to be $20,000 per year. * On July 15, 1996, the corporation bought the tract of land for $115,000. * In May 1997, the shareholders tell their tax adviser that the corporation can obtain an agricultural exemption for property tax purposes by leasing the land to a farmer for grazing livestock. The corporation plans to charge a nomInal rent of $200 a month. They also tell their tax adviser that the property has appreciated in value to $145,000.

Issue: Will the company create a passive activity by leasing the land at a nominal rental?

Analysis

Generally, rental activities are considered passive activities. Under Temp. Regs. Sec. 1.469-1T(e), there are six exceptions to the general rule that rental activities are always passive. Under one of these exceptions, a rental . activity will not be considered passive if the rental of the property is incidental to a nonrental activity. The three classifications of incidental use are:

1. Rental of property held for investment, if the gross rental income is less than 2% of the lesser of the property's unadjusted basis or its fair market value (FMV). Property is held for investment if the principal purpose for holding the property is to realize gain from its appreciation.

2. Rental of property used in a trade or business in which the taxpayer owns an interest, if the gross rental income is less than 2% of the lesser of the property's unadjusted basis or its FMV. The taxpayer must own an interest in the trade or business during the tax year and the property must have been predominantly used in such trade or business during the tax year or during at least two of the five immediately preceding tax years.

3. Rental of lodging to employees for the employer's convenience.

Wilson Engineering does not meet any of these exceptions:

1. Although the land is being held for investment, the gross rental income will be more than 2% of the lesser of the property's unadjusted basis or its FMV (2% of $115,000 is $2,300; the property will be rented in 1997 for $200 per month, for a total of $2,400).

2. As mentioned in item #1, the gross rental income is more than 2% of the property's unadjusted basis or its FMV. Further, the property will not be used in the corporanon's trade or business in 1997, nor was it used in the corporation's trade or business during at least two of the five immediately preceding tax years.

3. The property is not used to provide lodging to employees for the convenience of Wilson Engineering.

In addition, the corporation cannot qualify for use of the real property trade or business exception, because it is a PSC. Therefore, the rental will be a passive activity, and the excess of the interest and taxes on the land over the gross rental income will be a passive loss. Because Wilson Engineering is a PSC with no sources of passive income, the passive loss will be suspended and carried forward until the corporation either generates offsetting passive income or sells the land in a qualifying disposition.

Conclusion

The tax adviser should recommend that the corporation not lease the land. If the corporation rents the land to the farmer, the loss will be passive and the corporation will be able to deduct only $2,400 (the amount of the rental income) of the carrying charges on the land. The excess of the carrying charges over the rental income, $17,600 ($20,000 -- $2,400), will be a suspended passive loss.

Editor's note: This case study has been adapted from "PPC Tax Planning Guide--Closely Held Corporations," 9th Edition, by Albert L. Grasso, R. Barry Johnson, Linda Ketter, Lenvis A. Siegel, Joan Wilson Gray, Elizabeth DiTommaso, Robert L. Popovitch, Richard L. Grasso, Donald R. Levy and Frances H. Davis, published by Practitioners Publishing Company, Fort Worth, Tex., 1996.