Final Regs Define 'Activity' for Passive Loss Purposes

 [4830-01-u]

ACTION: Final regulations.

 SUMMARY: This document contains final regulations defining the term "activity" for purposes of applying the limitations on passive activity losses and passive activity credits. The final regulations affect taxpayers subject to the limitations on passive activity losses and passive activity credits and provide them with the guidance necessary to comply with the law.

DATES: These regulations are effective May 11, 1992.

 For dates of applicability of these regulations, see section 1.469-11 of these regulations.

 FOR FURTHER INFORMATION CONTACT: William M. Kostak at (202) 622-3080 (not a toll-free number).

 SUPPLEMENTARY INFORMATION:

BACKGROUND

This document amends 26 CFR part 1 to provide additional rules under section 469. Section 469 limits the use of passive activity losses and passive activity credits. Section 469(l)(1) provides that the Treasury Department will prescribe regulations that may be necessary or appropriate to carry out the provisions of section 469, including regulations that specify what constitutes an activity for purposes of that section.

 On May 15, 1992, the IRS published in the Federal Register a notice of proposed rulemaking (57 FR 20802) to replace certain temporary regulations defining the term "activity." A number of public comments were received concerning the proposed regulations, and a public hearing was held on September 3, 1992. After consideration of the comments received, the proposed regulations are adopted as revised by this Treasury decision.

EXPLANATION OF PROVISIONS

I. General Background

 Section 469 disallows losses from passive activities to the extent they exceed income from passive activities and similarly disallows credits from passive activities to the extent they exceed tax liability allocable to passive activities. Passive activities are defined, generally, as rental activities and activities in which the taxpayer does not materially participate, but the statute does not define the term "activity." Except for modifications in response to comments received on the proposed regulations, the final regulations generally adopt the same definition of activity as contained in the proposed regulations.

II. Public Comments

 One comment suggested that the regulations make explicit that the same facts and circumstances may result in more than one permissible grouping of activities. In response to this comment, the final regulations clarify that there may be more than one reasonable method for grouping a taxpayer's activities after taking into account all the relevant facts and circumstances.

 Another comment concerned an example in the proposed regulations that illustrates the grouping of two activities, both conducted through partnerships, where one activity involves the sale of non- food items to grocery stores and the other activity involves the warehousing of goods predominantly for the first activity. The comment suggested clarifying whether the warehousing activity is a rental activity or a trade or business activity. To clarify this point, the final regulations use the example of a trucking activity rather than a warehousing activity.

 Several comments requested clarification of the rule that trade or business activities may be grouped together with rental activities only if one is insubstantial in relation to the other. Some comments suggested specifying that the term "insubstantial" refers to factors other than gross income. Other comments suggested adopting a bright- line or safe-harbor gross revenue test. Because the regulations already adopt a facts-and- circumstances test that looks at all of the pertinent factors, it is not necessary to specify that the term insubstantial refers to factors other than gross income. In addition, to avoid complex and mechanical rules, the final regulations do not adopt a bright-line or safe-harbor gross revenue test.

 Another comment suggested that the insubstantial requirement should not apply when a taxpayer is renting property to the taxpayer's trade or business. In response to this comment, the final regulations provide that the portion of a rental activity that involves the rental of items of property to a trade or business activity may be grouped with the trade or business activity, regardless of whether one activity is insubstantial in relation to the other, provided each owner of the trade or business activity has the same proportionate ownership interest in the rental activity.

 As under the proposed regulations, the Commissioner is authorized to issue guidance identifying activities that may not be grouped with other activities. The final regulations clarify that this authority is not restricted to activities owned by limited partners or limited entrepreneurs.

 A commentator requested clarification on whether activities conducted through a C corporation may be grouped with activities not conducted through the C corporation. The final regulations clarify that in determining whether a taxpayer materially or significantly participates in an activity, a taxpayer may group that activity with activities conducted through C corporations that are subject to section 469 (that is, personal service and closely held C corporations).

 In response to a comment, the final regulations clarify that an owner of an interest in an entity may not treat as separate activities the activities grouped together by the entity. However, if the activities are not grouped together by the entity, an owner of that entity may group the activities together so long as the grouping is appropriate under the general rules for grouping activities.

 The final regulations also clarify the Commissioner's regrouping authority. Under the final regulations, the Commissioner may regroup a taxpayer's activities if any of the activities resulting from the taxpayer's grouping is not an appropriate economic unit and a principal purpose of the taxpayer's grouping is to circumvent the underlying purposes of section 469. If the Commissioner can show that the effect of a taxpayer's grouping is the circumvention of the underlying purposes of section 469, this will be evidence, sufficient in certain cases, of a principal purpose of the grouping. It is expected, however, that the Commissioner's regrouping authority will be exercised infrequently.

 Tax practitioners have also inquired concerning the circumstances in which suspended losses will be allowed on the disposition of part of an activity. The final regulations modify the rule in the proposed regulations to provide that the rule allowing suspended losses on partial dispositions applies only to dispositions of substantially all of an activity. However, the effective date of the final regulations provides transitional rules that allow taxpayers to use the rules provided in the proposed regulations for taxable years beginning before October 4, 1994.

 Several comments requested guidance on when activities grouped in accordance with the rules in the temporary regulations must be regrouped under the final regulations. In accordance with the effective date provisions, taxpayers that grouped their activities under the rules in the temporary regulations must regroup their activities if their activities are not appropriate economic units under these regulations. The effective date and transition rules reflect this clarification.

 These regulations do not address the grouping of rental real estate activities by taxpayers subject to section 469(c)(7), as enacted by the Revenue Reconciliation Act of 1993.

III. Effective Dates

 In general, these regulations are effective for taxable years ending after May 10, 1992. However, for taxable years in which these regulations apply and that begin before October 4, 1994, a taxpayer may determine its tax liability in accordance with proposed section 1.469-4 published at 1992-1 C.B. 1219. For taxable years ending on or before May 10, 1992, taxpayers must apply the rules of section 1.469-4T. For the taxable year that includes May 10, 1992, taxpayers may choose to apply the rules in section 1.469-4T, rather than the rules in these regulations.

SPECIAL ANALYSES

 It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding these regulations was submitted to the Small Business Administration for comment on its impact on small business.

DRAFTING INFORMATION

 The principal authors of these regulations are Ronald M. Gootzeit and William M. Kostak, Office of the Assistant Chief Counsel (Passthroughs and Special Industries), IRS. However, other personnel from the IRS and Treasury Department participated in their development.

LIST OF SUBJECTS IN 26 CFR PART 1

 Income taxes, Reporting and recordkeeping requirements.

Treasury Decision 8565

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR part 1 is amended as follows:

PART 1 -- INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by removing the entry "sections 1.469-1, 1.469-1T, 1.469-2, 1.469-2T, 1.469-3, 1.469-3T, 1.469-5, 1.469-5T and 1.469-11" and adding the following entries in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.469-1 also issued under 26 U.S.C. 469(l).

Section 1.469-1T also issued under 26 U.S.C. 469(l).

Section 1.469-2 also issued under 26 U.S.C. 469(l).

Section 1.469-2T also issued under 26 U.S.C. 469(l).

Section 1.469-3 also issued under 26 U.S.C. 469(l).

Section 1.469-3T also issued under 26 U.S.C. 469(l).

Section 1.469-4 also issued under 26 U.S.C. 469(l).

Section 1.469-5 also issued under 26 U.S.C. 469(l).

Section 1.469-5T also issued under 26 U.S.C. 469(l).

Section 1.469-11 also issued under 26 U.S.C. 469(l). * * *

Par. 2. Section 1.469-0 is amended by:

1. Revising the heading for section 1.469-4 and adding entries for section 1.469-4(a) through (h).

2. Revising the entry for section 1.469-11(b)(1).

3. Revising the entry for section 1.469-11(b)(2).

4. Adding entries for section 1.469-11(b)(2)(i) and (ii).

5. Adding an entry for section 1.469-11(b)(3).

6. The additions and revisions read as follows:

SECTION 1.469-0 TABLE OF CONTENTS.

* * * * *

SECTION 1.469-4 DEFINITION OF ACTIVITY.

(a) Scope and purpose.

(b) Definitions.

(1) Trade or business activities.

(2) Rental activities.

(c) General rules for grouping activities.

(1) Appropriate economic unit.

(2) Facts and circumstances test.

(3) Examples.

(d) Limitation on grouping certain activities.

(1) Grouping rental activities with other trade or business activities.

(i) Rule.

(ii) Examples.

(2) Grouping real property rentals and personal property rentals prohibited.

(3) Certain activities of limited partners and limited entrepreneurs.

(i) In general.

(ii) Example.

(4) Other activities identified by the Commissioner.

(5) Activities conducted through section 469 entities.

(i) In general.

(ii) Cross reference.

(e) Disclosure and consistency requirements.

(1) Original groupings.

(2) Regroupings.

(f) Grouping by Commissioner to prevent tax avoidance.

(1) Rule.

(2) Example.

(g) Treatment of partial dispositions.

(h) Rules for grouping rental real estate activities for taxpayers qualifying under section 469(c)(7) for taxable years beginning after December 31, 1993 [Reserved].

* * * * *

SECTION 1.469-11 EFFECTIVE DATE AND TRANSITION RULES.

* * * * *

(b) * * *

(1) Application of 1992 amendments for taxable years beginning before October 4, 1994.

(2) Additional transition rules for 1992 amendments.

(i) In general.

(ii) Additional rule for activity regulations.

(3) Certain investment credit property.

* * * * *

Par. 3. Section 1.469-4 is added to read as follows:

SECTION 1.469-4 DEFINITION OF ACTIVITY.

(a) SCOPE AND PURPOSE. This section sets forth the rules for grouping a taxpayer's trade or business activities and rental activities for purposes of applying the passive activity loss and credit limitation rules of section 469. A taxpayer's activities include those conducted through C corporations that are subject to section 469, S corporations, and partnerships.

(b) DEFINITIONS. The following definitions apply for purposes of this section --

(1) TRADE OR BUSINESS ACTIVITIES. Trade or business activities are activities, other than rental activities or activities that are treated under section 1.469-1T(e)(3)(vi)(B) as incidental to an activity of holding property for investment, that --

(i) Involve the conduct of a trade or business (within the meaning of section 162);

(ii) Are conducted in anticipation of the commencement of a trade or business; or

(iii) Involve research or experimental expenditures that are deductible under section 174 (or would be deductible if the taxpayer adopted the method described in section 174(a)).

(2) RENTAL ACTIVITIES. Rental activities are activities that constitute rental activities within the meaning of section 1.469-1T(e)(3).

(c) GENERAL RULES FOR GROUPING ACTIVITIES -- (1) APPROPRIATE ECONOMIC UNIT. One or more trade or business activities or rental activities may be treated as a single activity if the activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of section 469.

(2) FACTS AND CIRCUMSTANCES TEST. Except as otherwise provided in this section, whether activities constitute an appropriate economic unit and, therefore, may be treated as a single activity depends upon all the relevant facts and circumstances. A taxpayer may use any reasonable method of applying the relevant facts and circumstances in grouping activities. The factors listed below, not all of which are necessary for a taxpayer to treat more than one activity as a single activity, are given the greatest weight in determining whether activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of section 469 --

(i) Similarities and differences in types of trades or businesses;

(ii) The extent of common control;

(iii) The extent of common ownership;

(iv) Geographical location; and

(v) Interdependencies between or among the activities (for example, the extent to which the activities purchase or sell goods between or among themselves, involve products or services that are normally provided together, have the same customers, have the same employees, or are accounted for with a single set of books and records).

(3) EXAMPLES. The following examples illustrate the application of this paragraph (c).

EXAMPLE 1. Taxpayer C has a significant ownership interest in a bakery and a movie theater at a shopping mall in Baltimore and in a bakery and a movie theater in Philadelphia. In this case, after taking into account all the relevant facts and circumstances, there may be more than one reasonable method for grouping C's activities. For instance, depending on the relevant facts and circumstances, the following groupings may or may not be permissible: a single activity; a movie theater activity and a bakery activity; a Baltimore activity and a Philadelphia activity; or four separate activities. Moreover, once C groups these activities into appropriate economic units, paragraph (e) of this section requires C to continue using that grouping in subsequent taxable years unless a material change in the facts and circumstances makes it clearly inappropriate.

EXAMPLE 2. Taxpayer B, an individual, is a partner in a business that sells non-food items to grocery stores (partnership L). B also is a partner in a partnership that owns and operates a trucking business (partnership Q). The two partnerships are under common control. The predominant portion of Q's business is transporting goods for L, and Q is the only trucking business in which B is involved. Under this section, B appropriately treats L's wholesale activity and Q's trucking activity as a single activity.

(d) LIMITATION ON GROUPING CERTAIN ACTIVITIES. The grouping of activities under this section is subject to the following limitations:

(1) GROUPING RENTAL ACTIVITIES WITH OTHER TRADE OR BUSINESS ACTIVITIES -- (i) RULE. A rental activity may not be grouped with a trade or business activity unless the activities being grouped together constitute an appropriate economic unit under paragraph (c) of this section and--

(A) The rental activity is insubstantial in relation to the trade or business activity;

(B) The trade or business activity is insubstantial in relation to the rental activity; or

(C) Each owner of the trade or business activity has the same proportionate ownership interest in the rental activity, in which case the portion of the rental activity that involves the rental of items of property for use in the trade or business activity may be grouped with the trade or business activity.

(ii) EXAMPLES. The following examples illustrate the application of paragraph (d)(1)(i) of this section:

EXAMPLE 1. (i) H and W are married and file a joint return. H is the sole shareholder of an S corporation that conducts a grocery store trade or business activity. W is the sole shareholder of an S corporation that owns and rents out a building. Part of the building is rented to H's grocery store trade or business activity (the grocery store rental). The grocery store rental and the grocery store trade or business are not insubstantial in relation to each other.

(ii) Because they file a joint return, H and W are treated as one taxpayer for purposes of section 469. See section 1.469-1T(j). Therefore, the sole owner of the trade or business activity (taxpayer H-W) is also the sole owner of the rental activity. Consequently, each owner of the trade or business activity has the same proportionate ownership interest in the rental activity. Accordingly, the grocery store rental and the grocery store trade or business activity may be grouped together (under paragraph (d)(1)(i) of this section) into a single trade or business activity, if the grouping is appropriate under paragraph (c) of this section.

EXAMPLE 2. Attorney D is a sole practitioner in town X. D also wholly owns residential real estate in town X that D rents to third parties. D's law practice is a trade or business activity within the meaning of paragraph (b)(1) of this section. The residential real estate is a rental activity within the meaning of section 1.469-1T(e)(3) and is insubstantial in relation to D's law practice. Under the facts and circumstances, the law practice and the residential real estate do not constitute an appropriate economic unit under paragraph (c) of this section. Therefore, D may not treat the law practice and the residential real estate as a single activity.

(2) GROUPING REAL PROPERTY RENTALS AND PERSONAL PROPERTY RENTALS PROHIBITED. An activity involving the rental of real property and an activity involving the rental of personal property (other than personal property provided in connection with the real property or real property provided in connection with the personal property) may not be treated as a single activity.

(3) CERTAIN ACTIVITIES OF LIMITED PARTNERS AND LIMITED ENTREPRENEURS -- (i) IN GENERAL. Except as provided in this paragraph, a taxpayer that owns an interest, as a limited partner or a limited entrepreneur (as defined in section 464(e)(2)), in an activity described in section 465(c)(1), may not group that activity with any other activity. A taxpayer that owns an interest as a limited partner or a limited entrepreneur in an activity described in the preceding sentence may group that activity with another activity in the same type of business if the grouping is appropriate under the provisions of paragraph (c) of this section.

(ii) EXAMPLE. The following example illustrates the application of this paragraph (d)(3):

EXAMPLE. (i) Taxpayer A, an individual, owns and operates a farm. A is also a member of M, a limited liability company that conducts a cattle-feeding business. A does not actively participate in the management of M (within the meaning of section 464(e)(2)(B)). In addition, A is a limited partner in N, a limited partnership engaged in oil and gas production.

(ii) Because A does not actively participate in the management of M, A is a limited entrepreneur in M's activity. M's cattle-feeding business is described in section 465(c)(1)(B) (relating to farming) and may not be grouped with any other activity that does not involve farming. Moreover, A's farm may not be grouped with the cattle-feeding activity unless the grouping constitutes an appropriate economic unit for the measurement of gain or loss for purposes of section 469.

(iii) Because A is a limited partner in N and N's activity is described in section 465(c)(1)(D) (relating to exploring for, or exploiting, oil and gas resources), A may not group N's oil and gas activity with any other activity that does not involve exploring for, or exploiting, oil and gas resources. Thus, N's activity may not be grouped with A's farm or with M's cattle- feeding business.

(4) OTHER ACTIVITIES IDENTIFIED BY THE COMMISSIONER. A taxpayer that owns an interest in an activity identified in guidance issued by the Commissioner as an activity covered by this paragraph (d)(4) may not group that activity with any other activity, except as provided in the guidance issued by the Commissioner.

(5) ACTIVITIES CONDUCTED THROUGH SECTION 469 ENTITIES -- (i) IN GENERAL. A C corporation subject to section 469, an S corporation, or a partnership (a section 469 entity) must group its activities under the rules of this section. Once the section 469 entity groups its activities, a shareholder or partner may group those activities with each other, with activities conducted directly by the shareholder or partner, and with activities conducted through other section 469 entities, in accordance with the rules of this section. A shareholder or partner may not treat activities grouped together by a section 469 entity as separate activities.

(ii) CROSS REFERENCE. An activity that a taxpayer conducts through a C corporation subject to section 469 may be grouped with another activity of the taxpayer, but only for purposes of determining whether the taxpayer materially or significantly participates in the other activity. See section 1.469-2T(c)(3)(i)(A) and (c)(4)(i) for the rules regarding dividends on C corporation stock and compensation paid for personal services.

(e) DISCLOSURE AND CONSISTENCY REQUIREMENTS -- (1) ORIGINAL GROUPINGS. Except as provided in paragraph (e)(2) of this section, once a taxpayer has grouped activities under this section, the taxpayer may not regroup those activities in subsequent taxable years. Taxpayers must comply with disclosure requirements that the Commissioner may prescribe with respect to both their original groupings and the addition and disposition of specific activities within those chosen groupings in subsequent taxable years.

(2) REGROUPINGS. If it is determined that a taxpayer's original grouping was clearly inappropriate or a material change has occurred that makes the original grouping clearly inappropriate, the taxpayer must regroup the activities and must comply with disclosure requirements that the Commissioner may prescribe.

(f) GROUPING BY COMMISSIONER TO PREVENT TAX AVOIDANCE -- (1) RULE. The Commissioner may regroup a taxpayer's activities if any of the activities resulting from the taxpayer's grouping is not an appropriate economic unit and a principal purpose of the taxpayer's grouping (or failure to regroup under paragraph (e) of this section) is to circumvent the underlying purposes of section 469.

(2) EXAMPLE. The following example illustrates the application of this paragraph (f):

EXAMPLE. (i) Taxpayers D, E, F, G, and H are doctors who operate separate medical practices. D invested in a tax shelter several years ago that generates passive losses and the other doctors intend to invest in real estate that will generate passive losses. The taxpayers form a partnership to engage in the trade or business of acquiring and operating X-ray equipment. In exchange for equipment contributed to the partnership, the taxpayers receive limited partnership interests. The partnership is managed by a general partner selected by the taxpayers; the taxpayers do not materially participate in its operations. Substantially all of the partnership's services are provided to the taxpayers or their patients, roughly in proportion to the doctors' interests in the partnership. Fees for the partnership's services are set at a level equal to the amounts that would be charged if the partnership were dealing with the taxpayers at arm's length and are expected to assure the partnership a profit. The taxpayers treat the partnership's services as a separate activity from their medical practices and offset the income generated by the partnership against their passive losses.

(ii) For each of the taxpayers, the taxpayer's own medical practice and the services provided by the partnership constitute an appropriate economic unit, but the services provided by the partnership do not separately constitute an appropriate economic unit. Moreover, a principal purpose of treating the medical practices and the partnership's services as separate activities is to circumvent the underlying purposes of section 469. Accordingly, the Commissioner may require the taxpayers to treat their medical practices and their interests in the partnership as a single activity, regardless of whether the separate medical practices are conducted through C corporations subject to section 469, S corporations, partnerships, or sole proprietorships. The Commissioner may assert penalties under section 6662 against the taxpayers in appropriate circumstances.

(g) TREATMENT OF PARTIAL DISPOSITIONS. A taxpayer may, for the taxable year in which there is a disposition of substantially all of an activity, treat the part disposed of as a separate activity, but only if the taxpayer can establish with reasonable certainty --

(1) The amount of deductions and credits allocable to that part of the activity for the taxable year under section 1.469-1(f)(4) (relating to carryover of disallowed deductions and credits); and

(2) The amount of gross income and of any other deductions and credits allocable to that part of the activity for the taxable year.

(h) RULES FOR GROUPING RENTAL REAL ESTATE ACTIVITIES FOR TAXPAYERS QUALIFYING UNDER SECTION 469(c)(7) FOR TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1993. [Reserved]

Par. 4. Section 1.469-11 is amended as follows:

1. Paragraph (a)(1) is revised.

2. Paragraph (b)(1) is revised.

3. Paragraph (b)(2) is redesignated as paragraph (b)(3).

4. A new paragraph (b)(2) is added.

5. The added and revised provisions read as follows:

SECTION 1.469-11 EFFECTIVE DATE AND TRANSITION RULES.

(a) * * *

(1) The rules contained in sections 1.469-1, 1.469-1T, 1.469-2, 1.469-2T, 1.469-3, 1.469-3T, 1.469-4, 1.469-5, and 1.469-5T apply for taxable years ending after May 10, 1992.

* * * * *

(b) * * * (1) APPLICATION OF 1992 AMENDMENTS FOR TAXABLE YEARS BEGINNING BEFORE OCTOBER 4, 1994. Except as provided in paragraph (b)(2)(i) of this section, for taxable years that end after May 10, 1992, and begin before October 4, 1994, a taxpayer may determine its tax liability in accordance with Project PS-1-89 published at 1992-1 C.B. 1219 (see section 601.601(d)(2)(ii)(b) of this chapter).

(2) ADDITIONAL TRANSITION RULES FOR 1992 AMENDMENTS -- (i) IN GENERAL. If a taxpayer's first taxable year ending after May 10, 1992, begins on or before that date, the taxpayer may treat the taxable year, for purposes of paragraph (a) of this section, as a taxable year ending on or before May 10, 1992.

(ii) ADDITIONAL RULE FOR ACTIVITY REGULATIONS. For the first taxable year in which the rules in section 1.469-4 apply, taxpayers that are not in compliance with those rules must regroup their activities under those rules, without regard to the manner in which the activities were grouped in prior taxable years.

* * * * *