PAL rules: definition of activity.
Under the basic rules, PALs and credits may only reduce income from other passive activities; excess passive losses are suspended. However, if an individual sells an entire passive activity interest, any suspended losses are freed up and may offset income generated by the sale or be used to offset nonpassive income. Passive activities generally are defined as rental activities and other trade, business or investment activities in which an individual does not materially participate.
Defining some of these basic terms is more difficult. Material participation is determined using several alternative tests that quantify the amount of an owner's participation in an activity. Generally, one or more trade or business or rental activities may be treated as a single activity if together they are an appropriate economic unit. Determining an individual's separate and grouped activities is the first step in figuring how passive losses may be used.
One key point is the ability to use suspended losses on the partial disposition of an activity. The final regulations are more stringent than those proposed earlier, which permitted use of suspended losses on dispositions of a substantial part of an activity. In contrast, final Regs. Sec. 1.469-4(g) requires disposition of substantially all of an activity. This test by definition is harder to satisfy. Another problem is that the IRS has not explained how to determine what constitutes "substantially all." The disposed part may be treated as a separate activity, but only if the amount of deductions and credits and the gross income allocable to that part for the tax year can be established with reasonable certainty.
Regs. Sec. 1.469-4(c)(2) also provides that an assessment of whether a grouping of activities is appropriate depends on the relevant facts and circumstances and may be based on any reasonable method.
The Service will regroup activities it finds inappropriate and will give the greatest weight to factors such as similarities and differences in types of business, extent of common control and common ownership, geographic location and any interdependence between the activities. Once made, the groupings must remain consistent for passive loss purposes.
Rules for grouping activities conducted through S corporations, partnerships, closely held C corporations and personal service corporations are included in the final regulations. An entity owner may group activities conducted within the entity or with activities conducted directly by the owner, or through other entities of this type. However, an owner may not separate the original entity's groupings.
A rental activity may not be grouped with a nonrental activity unless it is an appropriate unit. Under Regs. Sec. 1.469-4(d)(1), the rental activity must be insubstantial in relation to the business activity (or vice versa), and each business owner must have the same proportionate ownership interest in the rental activity. In that case, the portion of the rental activity that involves rentals for use in the business may be grouped with the business activity.
A rental activity involving real property generally may not be grouped with a rental activity involving personal property (Regs. Sec. 1.469-4(d)(2)). Also, with some exceptions, a limited partner or similar nonparticipant may not group the entity's activity with another activity (Regs. Sec. 1.469-4(d)(3)).
The final regulations are effective for tax years that end after May 10, 1992. However, the old proposed regulations may be used for years that begin before Oct. 4, 1994.
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|Title Annotation:||passive activity losses|
|Author:||Schmalz, John G.|
|Publication:||The Tax Adviser|
|Date:||Apr 1, 1995|
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