8016 / How is an activity defined for purposes of the passive loss rules?

Regulations allow taxpayers to use a facts-and-circumstances approach to define one or more trade or business activities as a single activity if the activities constitute an appropriate economic unit for purposes of IRC Section 469. (In the case of a limited partnership interest in an electing large partnership, all passive loss limitation activities of the partnership are treated as a single passive activity. See Q 7733.) Relevant factors to consider include: (1) similarities and differences in types of businesses; (2) the extent of common control; (3) the extent of common ownership; (4) geographical location; and (5) interdependencies between the activities. There may be more than one reasonable method for grouping activities.¹

Rental activities may not be grouped with trade or business activities unless either the rental activity is insubstantial in relation to the trade or business activity or vice versa, or ownership interests in the trade and business activity are held in the same proportion as ownership interests in the rental activity.² An activity involving the rental of real property and an activity involving the rental of personal property may not be treated as a single activity (unless the personal property is provided in connection with the real property or vice versa).³

For activities conducted through partnerships, S corporations, or C corporations subject to the passive loss rules, the entity must first group its activities under the above rules. Individual partners and shareholders may then group those activities with others conducted directly by the individual taxpayer or with activities conducted through other partnerships, S corporations, or C corporations subject to the passive loss rules, under the same rules. However, a shareholder or partner may not treat activities grouped by an entity as separate activities.⁴

Example: 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.

A taxpayer involved as a limited partner or limited entrepreneur in certain activities (generally, holding, producing, or distributing motion picture films or videotapes; farming; equipment leasing; or exploring for, or exploiting oil and gas resources or geothermal resources) may group that activity with another activity only if the two activities are in the same type of business and the grouping is appropriate under the facts-and-circumstances test above.⁵

Once a taxpayer has grouped individual activities under the rules above, he or she may not regroup them in subsequent taxable years unless the original grouping was clearly inappropriate or there is a material change in facts and circumstances making the original grouping clearly inappropriate.⁶ The IRS 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) is to circumvent the underlying purpose of IRC Section 469.⁷

Example: 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.

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 IRS 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. Additionally, the IRS may assert penalties under IRC section 6662 against the taxpayers in appropriate circumstances.⁸

A taxpayer who disposes of substantially all of an activity may treat the disposed interest as a separate activity, but only if the taxpayer can establish with reasonable certainty both (1) the amount of deductions and credits allocable to that part of the activity for that taxable year under IRC Section 469 and (2) the amount of gross income and any other deductions and credits allocable to that part of the activity for the taxable year.⁹

In general, for the first taxable year ending after May 10, 1992, taxpayers that are not in compliance with the activity grouping rules of Treasury Regulation Section 1.469-4 must regroup their activities under those rules without regard to how the activities were previously grouped. Further, regrouping is permissible for the first taxable year ending after May 10, 1992, even if the taxpayer is already in compliance with the activity grouping rules of Treasury Regulation Section 1.469-4.¹⁰

For special rules relating to rental real estate in which a taxpayer materially participates, see Q 8021.