¶2980. Passive Loss Rules - William Bryant

1 2980. Passive loss RulesbyKevin R. Conzelmann, S. Ocko, , Day & Lord, Barrett SmithNew York, New York OVERVIEW The Passive loss Rules apply to individuals, including partners and S corporation shareholders,estates, closely held C corporations, and personal service corporations. Special Rules apply topublicly traded partnerships. Taxpayers subject to the Rules must determine which of theirundertakings constitute separate activities and whether any of these activities are Passive . Apassive activity is an activity which involves a trade or business in which the taxpayer does notmaterially participate. Beginning in 1994, rental activities are treated as Passive activities, exceptto the extent that the taxpayer is engaged in rental real estate activities as a real participation requires a taxpayer to be involved in the operations of the activity on aregular, continuous and substantial basis.

2 Under the regulations, a taxpayer will be treated asmaterially participating in an activity if he satisfies one of several quantitative "safe-harbor" partners are not generally treated as materially participating in an taxpayer subject to the Passive loss Rules who owns an interest in a Passive activity duringthe taxable year must calculate whether he has a Passive activity loss or credit for the taxable Passive activity loss is the amount by which Passive activity deductions for the year exceedpassive activity gross income for the year. Passive activity gross income does not include portfolioincome ( , dividends and interest), personal service income and certain other income for theyear. In addition, the regulations contain several Rules which recharacterize Passive income aseither active or portfolio income.

3 A taxpayer who has excess Passive deductions and credits isallowed to carry them forward a taxpayer completely disposes of his interest in a Passive activity in a taxabletransaction, all of the suspended losses (but not credits) from the activity are allowed to offsetnonpassive , special Rules apply to closely held C corporations, personal service corporations andpublicly traded partnerships. The Passive loss Rules are generally effective for years beginning afterDecember 31, 1986, but complex effective date and transitional Rules apply. EXPLANATION Tax Practice Series Analysis 1995-2000 Tax Management 08/2000 Pg. 1 Passive loss Rules were enacted as part of the Tax Reform Act of The Rules wereintended to prevent taxpayers from using losses and credits from tax shelters to offset incomefrom such sources as wages, interest and Congress was concerned that the growth oftax shelters created unfairness and caused taxpayers to lose confidence in the federal income taxsystem.

4 The elimination of tax shelters was also viewed as necessary to generate revenue to helpoffset the effect of the 1986 TRA's tax rate 99-514 (1986).2 S. Rep. No. 313, 99th Cong., 2d Sess. 713-14 (1986) (hereafter "S. Rep. 99-313").Congress felt that taxpayers who were simply investors in a business activity should use taxbenefits only against income from such activities, at least until a complete disposition of anactivity demonstrated the taxpayer's true economic loss . On the other hand, taxpayers withsubstantial involvement in a business activity should be entitled to fully use tax benefits from Thus, the Passive loss Rules allow taxpayers who materially participate in an activity(other than rental activities) to use losses from the activities to shelter nonpassive S.

5 Rep. 99-313 at , a Passive activity is any trade or business in which the taxpayer does not materiallyparticipate and any rental activity without regard to the taxpayer's participation. Deductions andcredits from Passive activities are limited to the income from such activities. Disalloweddeductions or credits from a Passive activity may be carried forward indefinitely. Any unusedpassive activity losses (but not credits) may be used to offset nonpassive income upon a taxpayer'scomplete disposition of his interest in the Passive statute grants the Treasury broad regulatory authority to interpret and carry out thepassive loss 469(l). Subject to the Passive loss Rules IndividualsThe Passive loss Rules apply to all individuals.

6 Thus an individual's share of the loss from apassive activity is subject to the Passive loss 469(a)(2)(A). EstatesEstates are also subject to the Passive loss Practice Series Analysis 1995-2000 Tax Management 08/2000 Pg. 26 Id. Example (1) Estate Subject to RulesA owns a limited partnership interest in Partnership X. A dies in 1989 and his limitedpartnership interest passes to his estate. The estate's losses from X are subject to the passiveloss Rules . TrustsThe Passive loss Rules apply to trusts, including inter vivos trusts and testamentary , the Rules do not apply to grantor trusts because these trusts are treated as Id. Example (2) Trust Subject to RulesB contributes her limited partnership interest to a trust which is not a grantor trust.

7 Any lossattributable to the trust from the partnership is subject to the Passive loss Rules . Pass-Through Entities1. PartnershipsA partnership is not a separate taxpayer. Partners are subject to the Passive loss Rules becausethe partnership's items of income, gain, loss , deduction and credit are passed through and taxed atthe partner level. Example (3) Partners Subject to the RulesA and B each own 50% partnership interests in Partnership X. Although X is not subject tothe Passive loss Rules , A and B are each separately subject to the Passive loss Rules on itemspassed through to them from S CorporationsAn S corporation is also not a separate taxpayer except in certain limited Instead, an Scorporation's items of income, gain, loss , deduction and credit are passed through and taxed tothe corporation's shareholders.

8 The Passive loss Rules apply separately to each shareholder of theS S corporations are discussed in 4210 et seq. Example (4) S Corporation Shareholders Subject to the RulesA and B are shareholders in an S corporation. Although the S corporation is not subject to thepassive loss Rules , A and B are subject to the Passive loss Rules on items passed through tothem from the S Grantor TrustsTax Practice Series Analysis 1995-2000 Tax Management 08/2000 Pg. 3A grantor trust's income or loss is taxed at the grantor level rather than the trust See 671 et seq. and the discussion of grantor trusts in 6120. Example (5) Grantor Trust Beneficiary Subject to RulesA transfers an apartment building to a trust and retains various rights, including the right toterminate the trust and take back the building.

9 A is subject to the Passive loss Rules rather thanthe trust because the trust is a grantor trust and A is taxed on its income. Closely Held C Corporations1. DefinitionThe Passive loss Rules apply to closely held C corporations (CHCs).10 CHCs are subject tothe Passive loss Rules because of concern that individuals would incorporate their portfolioinvestments to avoid the A C corporation is closely held if, at any time during thelast half of its taxable year, more than 50% (in value) of its stock is owned, directly or indirectly,by five or fewer As discussed in below, the Passive loss Rules prevent a CHC from using its passivelosses against portfolio income but permit the losses to be used against active business S.

10 Rep. 99-313 at 469(j)(1), referring to 465(a)(1)(B); Regs. (g)(2)(ii), referring to 542(a)(2). AC corporation that meets the definitions of a CHC and of a personal service corporation is treated as apersonal service corporation. Example (6) CHC Subject to RulesA and B own 40% of the stock of Corporation X and the remainder is widely-held. X is acalendar year corporation. On June 15, 1989, C acquires 11% of X's stock. Corporation X is aCHC because A, B and C together own 51% of Corporation X's stock throughout theremainder of ownership test for CHCs is the same as that used in the at-risk Rules and is based on thestock ownership test for personal holding companies. See 2970 for a discussion of the at-riskrules and 5110 for a discussion of the personal holding company stock ownership Attribution of OwnershipIn determining whether a C corporation is closely held under the Passive loss Rules , the stockownership can be attributed from one related person to another.