What is a "tax shelter" for purposes of the "recurring item" exception?

Sec. 461(i)(l) provides that the "recurring item" exception to the Sec. 461(h) economic performance rules does not apply to a tax shelter. Sec. 461(i)(3) defines a tax shelter as

(A) any enterprise (other than a C corporation) if at any time interests in such enterprise have been offered for sale in any offering required to be registered with any Federal or State agency having the authority to regulate the offering of securities for sale,

(B) any syndicate (within the meaning of section 1256(e)(3)(B)), and

(C) any tax shelter (as defined in section 6662(d)(2)(C)(ii)).

Many partnerships and S corporations fall outside the definition of a tax shelter under definition A. Additionally, many entities may be able to argue that their principal purpose is not the avoidance or evasion of federal income tax (the criterion set forth in Sec. 6662(d)(2)(C)(ii)) and, accordingly, do not meet the definition under C. Surprisingly, however, many partnerships and S corporations will be deemed to be tax shelters under definition B, referring to the Sec. 1256(e)(3)(B) rules.

Sec. 1256 contains the mark-to-market rules relating to certain regulated futures contracts, foreign currency contracts, nonequity options and dealer equity options. The initial reaction might be that definition B also does not apply; additionally, most partnerships and S corporations would not consider themselves to be syndicates. However, Sec. 461(i)(3)(B) merely looks to Sec. 1256(e)(3)(B) for definitional purposes, not to the overall applicability of Sec. 1256.

Sec. 1256(e)(3)(B) defines a "syndicate as

any partnership or other entity (other than a corporation which is not an S corporation) if more than 35 percent of the losses of such entity during the taxable year are allocable to limited partners or limited entrepreneurs (within the meaning of section 464(e)(2)).

Accordingly, it is clear that a limited partnership will be deemed to be a syndicate, and hence a tax shelter, for purposes of the economic performance rules, if more than 35% of losses are allocable to the limited partners.

S corporations may be tax shelters if 35% of losses are allocable to "limited entrepreneurs." Sec. 464 applies limitations on deductions for certain farming expenses. Again, reference is made to Sec. 464(e)(2) for definitional purposes, not to the applicability of Sec. 464.

Sec. 464(e)(2) defines a "limited entrepreneur" as a person who

(A) has an interest in an enterprise other than as a limited partner, and

(B) does not actively participate in the management of such enterprise.

Prop. Regs. Sec. 1.464-2(a)(3) may create more confustion than solutions since it defines active participation within the context of farming:

Factors which tend to indicate active participation include participating in the decisions involving the operation or management of the farm, actually working on the farm, living on the farm, or hiring and discharging employees (as compared to only the farm managers). Factors which tend to indicate a lack of active participation include lack of control of the management and operation of the farm, having authority only to discharge the farm manager, having a farm manager who is an independent contractor rather than an employee, having limited liability for farm losses.

While the proposed regulations do not offer a great deal of assistance in defining active participation in nonfarm entities, many S corporations have children, inactive spouses and other nonactive individuals who own more than 35% of stock. If so, these S corporations are tax shelters.

Determination that the limited partnership or S corporation is a tax shelter subjects the entity to the Sec. 461(h) economic performance rules without the benefit of the "recurring item" exception. Accordingly, tax planning before year-end is of greater importance since economic performance must occur within the entity's tax year, not up to 8 1/2 months after year-end.