IRC §469 – Passive Activities
Part 1
Background, purpose, basics, relevance
in the tax law, some considerations in
properly applying the rules
1
Background


Widespread tax shelter investments by middle to
high income taxpayers in 1980s
Bluebook to TRA’86 page 210 – Per Treasury, “in
1983, out of 260,000 tax returns reporting “total
positive income” in excess of $250,000, 11% paid
taxes equaling 5% or less of total positive income,
and 21% paid taxes equaling 10% or less of total
positive income. Similarly, in the case of tax returns
reporting total positive income in excess of $1
million, 11% paid tax equaling less than 5% of total
positive income, and 19% paid tax equaling less
than 10% of total positive income.”

In 1981, top individual rate was dropped from 70% to 50%.
2
Purpose of the §469 rules

Per TRA’86 Blue Book (pages 209-214)


Curb expansion of tax shelters.
Only allow taxpayers with substantial and bona fide
involvement in certain activities to deduct losses for the
activity.


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Other taxpayers (passive ones) can only use losses against
passive activity income or upon disposition when the “true”
economic benefit can be determined
Prevent taxpayers from offsetting wage and investment
income with passive losses.
Provide limited relief to moderate income taxpayers with
rental real estate activities.
Prevent investment capital from being diverted from
productive activities to tax shelter activities.
3
§469 Guidance
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IRC and legislative histories
Final and temporary regulations
A few rulings and court cases
Forms 8582 and 8801 and instructions are
also helpful, as is IRS Pub 925 (but not
primary authority)
4
What does §469 do?


Only allows current year use of a deduction or credit
from a “passive activity” to be used against passive
activity income or tax on such income.
Any disallowed loss or credit for the year is carried
forward to the next year and subject to the same
PAL and PAC limitations.


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It is suspended.
Generally, PAL “triggered” if activity disposed of in a
fully taxable transaction.
So – prevents use of passive activity loss against
non-passive income (such as wages and investment
income).
5
Key to application of the rules …


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Activity is “passive” if:
 T or B in which taxpayer does not materially participate.
 Any rental activity.
Exceptions and special rules
 Rental real estate with active participation and AGI < $150,000.
 Real estate professional (added in 1993)
Important –
 Meaning of:
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“activity”
“trade of business”
“rental”
“material participation”
Tracking of income, losses and suspended losses (and credits) of
passive activities.
Recordkeeping.
6
Early reaction to §469 and initial guidance


Is somewhat complicated due to length of rules, lots
of definitions and special rules, and the grouping
and recordkeeping needed to determine each
passive activities PAL and PAC
Letter reprinted in DTR 6/30/99 – letter signed by
“Disgusted” called the temporary regulations “boring
and incomprehensible” and suggested that IRS
should “throw them out altogether as unworkable
and unenforceable.”
7
And more …

Friends of Oregon, et al v. Sec. of Treasury and IRS
Comm’r (DC Or 1988) – brought action to require
IRS to prepare environmental impact study and to
obtain court approval before adopting the §469 regs.
Were concerned with the MP tests. Noted that regs
encourage timber owners to convert timber lands to
non-timber uses to get better tax result.

Court disallowed claim for lack of subject matter jurisdiction
8
More reactions

Concerns that the rules hurt the real estate
industry, such as

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Price declines (which also hurt local governments
due to drop in property tax collections)
Some say the rules helped fuel the subsequent
S&L crisis
9
Economic consequences

Testimony of Bill Archer, now with PWC, but formerly
member and chair (1995-2001) of the House Ways
& Means Committee



9/23/10 SFC hearing on lessons learned from TRA’86
“The 1986 Act made a significant change to real estate
investments on a retroactive basis, causing serious adverse
consequences. I am referring to the passive loss rules that
imposed restrictions on the deduction of losses from existing
real estate investments. A number of economists and the
Federal Reserve have cited this change as adversely
impacting real estate values, which in turn contributed to the
U.S. savings and loan crisis during the late 1980's and early
1990's.”
http://finance.senate.gov/hearings/hearing/?id=1d2a76365056-a032-5282-4bb7cf0d5078
10
§469 is in Subchapter E

Accounting method?

Notice 94-49 – “the passive activity rules may be
viewed as character rules because they limit absorption
of losses, or as timing rules because the losses
ultimately will be absorbed”

St. Charles Investment Co. v. Commissioner, 110
T.C. 46 (1998), rev’d on appeal


Noted that while Congress did place §469 in Subchapter E,
in the legislative history, it is explained under topic of “tax
shelters” rather than accounting methods (such as where
§448 is discussed).
TAM 201035016 ---
11
TAM 201035016



T says was MP in partnership in 1990 –
1994.
IRS auditing 1994 and says did not MP in
1994.
Asked National Office if “a recharacterization
of the taxpayers' activities from nonpassive to
passive for purposes of the passive activity
loss and credit limit rules of §469 was a
change in a “method of accounting” for
purposes of §§446(e) and 481(a)?
12
TAM 201035016 - more

“Each year the taxpayers review their facts and decide whether during that year they
materially participated in their nursing home activity. If the taxpayers did not materially
participate, their nursing home activity must be classified as passive under the §469 rules.
Based on the facts present in one year, the activity may be nonpassive in that year, while in
another year, under the facts present in that year, the activity may be passive. Under the
argument advocated by the examiner, each year that the activity changed from nonpassive
to passive, or vice versa, the taxpayers would be required to file a Form 3115, Application
for Change in Accounting Method. In each year of change, the taxpayers would be required
to compute an adjustment under §481(a). If, for example, a taxpayer materially participated
in an activity in 1997, but did not in 1998, the examiner would have the taxpayer file a Form
3115 for 1998. Any amounts that were properly deducted in 1997 because the activity was
nonpassive, that would have been deferred had the activity been passive would be
included in the computation under §481(a). Similarly, in the instant case, the examiner
believes that if the taxpayers did not materially participate in 1994, the examiner may bring
into income in 1994 any amounts that were deducted in prior years, that would not have
been deductible in those years if the taxpayers had not materially participated in those
years. The examiner believes that this may be done, by virtue of §481(a), without regard to
whether the taxpayers materially participated in the nursing home activity in the prior years.
The examiner notes that this is because, if a change from determining that a taxpayer
materially participated in an activity to determining that it did not materially participate in the
activity is a change in method of accounting, §481(a) authorizes necessary adjustments to
prevent amounts from being duplicated or omitted.”
13
TAM 201035016 – conclusion


“We do not believe that a determination of whether a taxpayer
materially participates in an activity is a method of accounting. In this
case, the taxpayers' determination of whether they materially
participate in their nursing home activity does not determine into
which period an item of income or deduction will be placed. The
taxpayers' determination does not involve the treatment of a
“material item.” Simply, determining whether the taxpayers materially
participated in their activity for purposes of classifying the activity as
passive or not is not an “item“—it is not a recurring incidence of
income or expense. Instead, the taxpayers' determination
establishes the character of their activity for that year—it is either
passive or it is not passive. Once the character of the activity is
determined, then if the activity is passive, the taxpayers must apply
the statutorily mandated rules of §469 to any existing loss.”
So, if improperly applied MP in 1994, that is an error.
14
TAM 201035016 - comments

Odd ruling

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Statute is clear that MP is an annual determination, so
whether an activity is passive or not can change from year
to year.
What is benefit of change from non-passive to passive
being a method?
Better question would be:


T thought it met a MP test for past 6 years, but turns out did
not. If method, §481(a) adjustment would bring past
improperly claimed losses back into income.
Notice 94-49 and St. Charles Investment Co. v.
Commissioner, 110 T.C. 46 (1998)
15
Who is subject to §469
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Individuals
Estates
Trusts
Closely-held C corporations
Personal Service Corporations
16
What is a passive activity?
Either:
1. A trade or business in which the taxpayer
does not materially participate, or
2. A rental activity (exception for real estate
professionals at §469(c)(7))
17
Activities specifically excluded from §469
loss limitation rules

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Working interests in oil and gas well
 §469(c)(3) & (4) and §1.469-1
 t/p must have unlimited liability
Rental of dwelling unit subject to §280A(c)(5) limitations
 §469(j)(10) and §1.469(e)(5) and §1.469-2(d)(2)(xii)
Activity of trading personal property §1.469-1(e)(6)
 “(i) In general. An activity of trading personal property for the
account of owners of interests in the activity is not a passive
activity (without regard to whether such activity is a trade or
business activity (within the meaning of paragraph (e)(2) of this
section)).

(ii) Personal property. For purposes of this paragraph (e)(6), the
term “personal property” means personal property (within the
meaning of section 1092(d), without regard to paragraph (3)
thereof).”
18
T or B versus Rental Activity
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
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1.469-4(b)
“(1) Trade or business activities. Trade or business activities are
activities, other than rental activities or activities that are treated
under §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 §1.469-1T(e)(3).”
19
Rental Activity
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Generally, per §469(j)(6) and §1.469-1T(e):
Involves tangible property used by customers or
held for use by customers; and
The gross income generated is from “amounts paid
or to be paid principally for the use of such tangible
property (without regard to whether the use of the
property by customers is pursuant to a lease or
pursuant to a service contract or other arrangement
that is not denominated a lease).”
6 exceptions exist
20
6 Rental Exceptions
§1.469-1T(e) and -1(e)

Average period of customer use < 7 days
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Average period of customer use < 30 days AND
significant personal services provided
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Average period of customer use > 30 days and
extraordinary personal services provided

Rental incidental to a non-rental activity

Property available during defined business hours
for nonexclusive use by various customers

Property provided by its owner for use in an
activity of a p/s, S corp or joint venture in which the
owner has an interest
Exceptions must be applied each year.
21
“Average period of customer use”


Original definition was changed by a later reg to
avoid abuse.
OLD definition:
Aggregate # days in all period of customer use during TY
# such periods of customer use

NEW: weighs difference in rental value of the
activity’s property causing higher rental value
property to have greater effect than lower rental
value property

Prevents t/p from lowering a longer rental period by shortterm rentals of low value property
22
Example of formula
Old formula: 3000 ÷ 2,035 = 1.47 average days
New formula: 8.41 average days
So new formula prevents t/p from converting something that meets
the definition of a rental to a non-rental by also renting out a small
value item for a very short time period.
Taxpayer in example still needs to see if Rental Exception #2 is met.
23
Example – Residential Care Center

TAM 9247003 – retirement center owned by
ltd p/s.
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Q – rental or T or B?
Centers provided all meals, maid service, laundry,
recreational activities and transportation.
Rental charge exceeded 2X cost of a luxury apt
due to the services provided
IRS Auditor – rental activity
IRS National Office – what do you think?
24
EX – Construction of rental property

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T was constructing and developing what
would become rental property.
Q – how to characterize the construction
activity?
TAM 9251003
25
Material Participation

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§469(h) – exists when t/p “is involved in the
operations of the activity on a basis which is— (A)
regular, (B) continuous, and (C) substantial.”
Ltd p/s – “Except as provided in regulations, no
interest in a limited partnership as a limited partner
shall be treated as an interest with respect to which
a taxpayer materially participates.”
Married taxpayers


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Include participation of each spouse to determine if either
participates.
Can be beneficial when want to be a MP, but detrimental
when trying to not be a MP
Regs. §1.469-5 and -5T
26
Material Participation Tests
Quantitative Tests
1.
> 500 hours
2.
Participation constitutes substantially all of the participation in such
activity of all individuals (including individuals who are not owners of
interests in the activity) for such year
3.
Participation > 100 hours and is not less than participation of any
other individual (including individuals who are not owners of interests
in the activity) for such year;
4.
Significant participation activity (SPA) and aggregate participation in
all SPAs during year > 500 hours
Prior Year MP Tests
5.
MP in any 5 prior tax years (whether or not consecutive) during prior
10 years
6.
Personal service activity and individual materially participated in the
activity for any 3 prior tax years (whether or not consecutive)
Facts and Circumstances Test
7.
Based on all of facts and circumstances, individual participates in the
activity on a regular, continuous, and substantial basis during the year
27
MP definitions - SPA


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Trade or business activity (§1.469-1T(e)(2))
in which individual significantly participates
for the year
Would be an activity in which individual does
not materially participate for the year if
material participation for the year were
determined without regard to the SPA rule.
MP must exceed 100 hours for the year.
28
Example
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Jessica owns following activities and participates as
follows for 2010
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Analysis:
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A – Engineering business 1,600 hours
B – Rental property 120 hours
C – Fast food S corp
300 hours
D – Video rental S corp 350 hours
A – not SPA because another MP test met
B – not SPA because not a T or B (is a rental)
C and D – SPA because > 100 hours and no other MP test
met (assuming prior years’ MP test met for neither) AND
total hours in SPAs > 500
Conclusion – Jessica is MP in A, C and D
29
MP Definitions – Personal Service Activity
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Involves performance of personal services
in—
(1) fields of health, law, engineering,
architecture, accounting, actuarial science,
performing arts, or consulting; or
(2) any other trade or business in which
capital is not a material income-producing
factor.
30
MP – facts & circumstances test
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“Facts and circumstances” – reserved
Hours must exceed 100
Certain management activities - individual's services performed
in management of an activity are ignored in determining if he is
material participant for F & C test UNLESS, for the year—
“(A) No person (other than such individual) who performs
services in connection with the management of the activity
receives compensation described in section 911(d)(2)(A) in
consideration for such services; and
(B) No individual performs services in connection with the
management of the activity that exceed (by hours) the amount of
such services performed by such individual.”
1.469-5T(b)
31
MP – limited partners

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§1.469-5T(e)
Can be MP if meet Test 1, 5 or 6
If also holds general partner interest:

Don’t treat as ltd partner for MP measurement
purposes, so can meet any MP test
32
MP and LLCs

Garnett v. Commissioner, 132 T.C. No. 19 (2009)

Generally, interest held as limited partner is passive unless provided
otherwise in regs.





§469 enacted 1986; LLPs not around until 1991
IRS – owners of LLPs and LLCs have limited liability so should be treated
similar as limited partners under §469
Court noted that §469(h)(2) is not that broad – says, ““interest in a limited
partnership as a limited partner” – so, specific to ltd partnerships
Conclusions:




Regs allow ltd partner to meet material participation test if also GP or can use
3 of the 7 MP tests of 1.469-5 (> 500 hours, prior MP in 5/10 years, or
personal service activity and MP in any prior 3 years)
Partners did not hold their interests in certain LLPs and LLCs as “limited
partners.” Therefore, not subject to rule of presumed passive activity at
§469(h)(2).
Also, because partners' “interests in the tenancies in common are not
interests in limited partnerships, these interests also are not subject to the rule
of sec. 469(h)(2)”
Basically, legislative purpose of §469 better served by treating the LLP and
LLC members as general partners. Thus, they can apply any of the 7 MP
tests.
Similarly – Thompson v. U.S., 104 AFTR 2d 2009-5381, (Ct Fed Cl), acq
33
AOD on Thompson case



“On July 20, 2009, the Court of Federal Claims issued a summary judgment opinion in
Thompson v. U.S., 87 Fed. Cl. 728 (Fed. Cl. 2009), concluding that LLC interests are not
“limited partnership interests” for purposes of §1.469-5T(e)(3)(i). Thompson joined Garnett
v. Commissioner , 132 T.C. 19 (2009) and Gregg v. U.S., 186 F. Supp. 2d 1123 (D. Or. 2000)
as the third case to rule against the position that an interest in an LLC is a limited
partnership interest under §1.469-5T(e)(3)(i).
The taxpayer in Thompson directly owned 99% of an LLC that was in the airplane charter
business. The taxpayer indirectly owned the remaining 1% interest through a wholly-owned
S corporation. The Service disallowed losses that the taxpayer claimed arguing that the
taxpayer failed to meet the restricted material participation requirements that applied to
limited partners under §1.469-5T(e)(3)(i). Both parties stipulated that if the taxpayer's LLC
interest was not characterized for purposes of §469 as a limited partnership interest then
the taxpayer could establish material participation using any of the seven tests in §1.4695T(a). The Court in Thompson held that the taxpayer's interest was not a limited partnership
interest for purposes of §469, and that even if the interest was treated as an interest in a
limited partnership, the taxpayer's interest would best be categorized as a general
partnership interest under §1.469-5T(e)(3)(ii). Consequently, the Court held that the
taxpayer could establish material participation using any of the seven tests in §1.469-5T(a).
See also, Garnett and Gregg , supra.
Recommendation Acquiesce in result only.”
34
Different Tax Years & MP




§1.469-2T(e)(1)
Partnership has 9/30 year end
Partner Tom wants to know if he meets a MP
test.
Q – does he look at calendar year or year
ended 9/30/10?
35
MP Reminders




Must check each year
No prorating in quantitative tests for short years
Participation of spouse counts – always ask what spouse does in
the activity
-5(f) and -5T(f):
 Must be work customarily done by an owner of such an activity;
and
 One of the principal purposes for the performance of such work
must not be to avoid the 469 rules
 Generally, work done in individual's capacity as an investor
(studying financial statements, preparing financial analyses,
monitoring finances or operations in a non-managerial capacity)
in an activity is not counted unless the individual is directly
involved in the day-to-day management or operations of the
activity.
36
MP Question


Jane provides legal services to partnership X
as employee of law firm. Jane is also a 5%
owner of X which manufacturer widgets.
Q – Should Jane include her law firm hours
serving X as part of her hours in determining
if she is a material participant in X?
37
Proving MP


1.469-5T(f)(4) – “Methods of proof. The extent of an individual's
participation in an activity may be established by any reasonable
means. Contemporaneous daily time reports, logs, or similar
documents are not required if the extent of such participation
may be established by other reasonable means. Reasonable
means for purposes of this paragraph may include but are not
limited to the identification of services performed over a period of
time and the approximate number of hours spent performing
such services during such period, based on appointment books,
calendars, or narrative summaries.”
Practical application?
 Have client keep records, particularly if close to an hour cut off
point or has other full-time employment
38
Q – can < 100 hours of participation ever
be MP?

Yes


“substantially all” test
Prior years’ MP tests
39
Q – are MP regs valid?

Mordkin, et ux., TC Memo 1996-187
 Challenged the regs as invalid because applied quantitative
measures when statute implied a qualitative measure.
 Court upheld the reg noting it was appropriate interpretation
whether viewed as an interpretive reg or a legislative reg
 “a review of other portions of the legislative history of section 469
confirms that the material participation test implicates the amount
and extent of the time spent by a taxpayer in connection with the
operations of an activity. For instance, that legislative history
indicates that a taxpayer is most likely to participate materially in
an activity if involvement in that activity is the taxpayer's principal
business and the taxpayer devotes most of his or her time to that
business and does not devote a comparable amount of time to
another business (principal business factor).”
40
Next


Quiz on Desire 2 Learn
Then …


Podcast going over the examples in regs on rental
exceptions and material participation
Powerpoint presentation on more rules in 469
including definition of “activity,” measurements of
PAL and PAI, recharacterization rules, and more!
41