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New, improved definition of activity.

Under Internal Revenue Code section 469, a passive activity is a rental or business activity in which the taxpayer does not materially participate. Generally, passive activity losses (PALs) are allowed only to the extent of income from other such activities. Therefore, PALs cannot offset a taxpayers nonpassive income such as wages, interest, dividends or "active" business income.

This month, Larry Witner, CPA, LLM, associate professor of accounting, and Kathy Simmons, CPA, DBA, assistant professor of accounting, both of Bryant College, North Smithfield, Rhode Island, explain how a new definition of activity will affect PAL deductions.

Defining activity is essential to applying section 469. The meaning affects many concepts, including material participation, disposition of a passive activity, recharacterization of passive income from certain activities and allocation of disallowed losses among a taxpayer's activities.

To illustrate the definition's importance, consider material participation. A taxpayer participates materially in an activity if the participation is regular, continuous and substantial, as shown by meeting one of seven tests, most of which focus on the number of hours devoted to the activity.

Assume a taxpayer works 55 hours per year in each of her 10 restaurants. Under the test requiring more than 500 hours of participation, if each restaurant is treated as a separate activity, the taxpayer (at 55 hours) does not materially participate. But, if all 10 restaurants are treated as a single activity, the taxpayer has 550 hours and does participate materially.

OLD DEFINITION

The statute does not define activity, but in May 1989 the Internal Revenue Service issued over 100 pages of temporary regulations (regulations section 1.469-4T) in attempting to do so. ! Using a building-block approach, the regulations required a taxpayer to determine "operations" and "undertakings." The latter elements were combined into activities through complex aggregation and integration rules. Special rules applied to professional service organizations and oil and gas entities.

The 1989 regulations were severely criticized as lengthy, complex, inflexible and burdensome on all taxpayers. May 1992 saw simultaneously the expiration of regulations section 1.469-4T (the old definition) and the issuance of proposed regulations section 1.469-4 (the new definition).

NEW DEFINITION OF ACTIVITY

The new seven-page definition is clear, concise and simple. It embraces an "appropriate economic unit" as determined by all relevant facts and circumstances.

The new proposed regulations provide a nonexclusive list of the most significant facts and circumstances to be considered in identifying an appropriate economic unit:

* Similarities and differences in types of business.

* The extent of common control.

* The extent of common ownership.

* Geographical location.

* Interdependence of activities.

The proposed regulations also contain an example illustrating the new definition's strengths and weaknesses.

Example. A hypothetical taxpayer owns a bakery and a movie theater in a shopping mall in Baltimore and a bakery and a movie theater in a Philadelphia mall. Depending on the facts and circumstances, the taxpayer could have

* A single activity.

* Four different activities.

* A Baltimore activity and a Philadelphia activity.

* A bakery activity and a movie theater activity.

As this example illustrates, the new definition does not nail down everything, but its simplicity and flexibility outweigh the uncertainty. The new definition's facts-and-circumstances approach relies on common sense, the IRS and the courts to fill any gaps. The IRS is expected to lessen the uncertainty with future rulings.

GROUPING ACTIVITIES

A number of different rules apply to grouping activities.

Grouping rental activities with business activities. A rental activity may not be grouped with a business activity unless either is insubstantial in relation to the other. The new regulations do not define "insubstantial", but the term is believed to address de minimis situations.

For example, assume a taxpayer owns a hotel where he rents rooms to short-term lodgers and lobby space to a long-term newsstand vendor. The income generated by the rental activity (the newsstand) is insubstantial in relation to the income generated by the business activity (the lodging). Consequently, the rental activity and the business activity may be grouped together.

Prohibition against grouping "listed activities." Listed activities are those once viewed as tax shelters: motion pictures,video tapes, farming, leasing of personal property and exploring for or exploiting oil and gas resources and geothermal deposits. The new definition prevents limited partners from grouping a listed activity with any other activity.

Consider, for example, a taxpayer who materially participates in her bakery business and becomes a limited partner in a farming partnership. The new definition prevents her from grouping the bakery and the farming investment together into one activity.

Consistency requirement. As a general rule, once activities are grouped together, they must remain together. The proposed regulations allow taxpayers to regroup in a later year only if the original grouping was inappropriate or if a material change in the facts and circumstances makes the original grouping inappropriate. If regrouping occurs, the taxpayer must disclose this to the IRS in a manner yet to be determined.

Activities conducted through partnerships and S corporations. These entities must group their activities in accordance with the new definition. For instance, assume the taxpayer in the Baltimore-Philadelphia example is a partnership instead of an individual. The partnership determines the groupings (activities) and conveys the result to partners. The partners, in turn, use the new definition (if desired and appropriate) to further group the partnership's result with activities the partners conduct directly.

Partial dispositions. According to the new definition, a taxpayer may treat a disposition of a substantial part of an activity as a disposition of a separate activity. To do this, the taxpayer must establish with reasonable certainty the income and deductions for that part. Thus, if a taxpayer disposes of a part for which the "numbers" can be established, he or she can currently use (trigger) suspended PALs associated with that part.

1992 ELECTION

The old definition applies to tax years ending before May 11, 1992; the new definition applies to tax years ending after May 10, 1992. Thus, for calendar year taxpayers,the new definition is effective in 1992, but there is a special transition rule. Taxpayers may elect to apply the old definition for any tax year including May 10,1992. Thus, a calendar year taxpayer could use the old definition in 1992 but not in 1993.

In light of numerous problems with the old definition and the advantages of the new one, it is anticipated few taxpayers will use the transition rule. Some will, however, choose to continue using the same activity definitions developed under the old rules. The new rules permit taxpayers to decide what's best for them in 1992.

GOOD NEWS AND BAD NEWS

As usual, there is the proverbial good news-bad news. Because the new definition of activity relies on a factsand-circumstances approach, it promotes simplicity and flexibility at the same time it creates uncertainty. The new definition permits "any reason* able method" in applying the facts and circumstances to grouping activities. Even though this leaves some questions unanswered, the any-reasonable-method standard will provide some level of comfort for taxpayers.
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Article Details
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Author:Simmons, Kathy
Publication:Journal of Accountancy
Date:Nov 1, 1992
Words:1158
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