Expiration of the Sec. 469 temporary regulations for C corporations.

The Tax Reform Act of 1986's (TRA) main purpose was tax simplification and revenue raising. The TRA closed tax loopholes by means of restricting losses from activities classified as "passive," those activities creating losses and deductions arising from limited partner interests and rental properties. Part of the reason for these changes was the sense "that taxpayers [were] losing faith in the Federal income tax system." The Senate Report to the TRA attributed this loss of confidence in part to the tax system, which allowed taxpayers the opportunity to offset income from one source with tax deductions and credits from another. The Senate Committee believed that action needed to be taken to curb the expansion of the tax sheltering and to restore to the tax system the degree of equality that was a necessary precondition to a beneficial and widely desired reduction in rates.

However, a loophole for the deduction of losses was kept intact for property rented to a taxpayer's closely held C corporation or personal service corporation (PSC). The TRA gave the Treasury permission to reclassify passive income to prevent taxpayers from structuring income-producting activities in ways that were designed to produce passive income. The Conference Committee gave the Treasury the authority to classify as nonpassive (1) income from ground rents that produce income without significant expenses; (2) relatedparty leases on property used in a business activity and creating passive income; and (3) activities previously generating active business losses that the taxpayer intentionally sought to treat as passive at the time when they generated net income.

The temporary regulations dealing with the recharacterization of passive income applied to the net rental income derived from renting property to a passthrough entity in which the taxpayer materially participated. Regs. Sec. 1.469-2(f)(6) provides that an amount of the taxpayer's gross rental activity income, for the tax year from an item of property, is treated as not from a passive activity if the property is rented for use in a trade or business activity (within the meaning of Temp. Regs. Sec. 1.469-1T(e)(2)) in which the taxpayer materially participates (within the meaning of Temp. Regs. Sec. 1.469-5T, which defines a trade or business activity). The amount so treated is equal to the net rental income activity for the year from that item of property. It defines this activity as a trade or business activity for a tax year, if and only if such activity is not a rental activity for such tax year and involves conduct during such tax year of business or rental operations not treated under Temp. Regs. Sec. 1.469-1T(e)(3)(vi)(B) as incidental to an activity of holding property for investment.

These rules for recharacterization of passive income did not apply to rentals to a C corporation. The temporary regulations provided that a shareholder was not deemed to be materially participating in a C corporation's activities. Therefore, the rental income received by a taxpayer, from property rented to a C corporation he owned, was treated as income from a passive activity. Temp. Regs. Sec. 1.469-4T(b)(2)(ii)(B) provided that a taxpayer's activities did not include operations that a taxpayer conducted through one or more entities, other than passthrough entities. Thus, a small loophole was created from generating passive income received from a C corporation. The guidelines practitioners used in advising their clients concerning the rent they could charge to C corporations was to set the rent using a fair market value for the property rented. Thus, taxpayers were given some ability to generate additional passive income from these activities to shelter other passive losses.

This loophole expired with the automatic expiration of the Sec. 469 temporary regulations three years after their issuance (1992). Prop. Regs. Sec. 1.469-4 does not discuss this issue. The provision that supported this treatment in the temporary regulations has not been included in the proposed regulations. A review of the proposed regulations by themselves would not result in a clear picture that the rules have definitely changed. The IRS in its internal reference guide for auditing passive activities (issued in April 1994) addresses the net rental income from a closely held C corporation or a PSC. It instructs its auditors to be aware that this income is subject to recharacterization as nonpassive income. The IRS examiners are instructed to review those rental arrangements for purposes of recharacterization.

Taxpayers that entered into rental agreements before Feb. 19, 1988, using a written binding contract will not be subject to this recharacterization and may continue to treat this income as passive income.

Therefore, for tax years 1993 and after, the treatment of net rental income from a closely held C corporation should not be treated as passive income. Practitioners should consider this and review the 1993 tax returns prepared based on last year's methodology rather than on this recent change. Additionally, clients should be alerted to this change and its impact on their future planning.

From Michael Gratz, CPA, Aidman, Piser & Company, P.A., Tampa, Fla.