Passive Activity Grouping Rules (Part 2): New 2011 Disclosure Requirements

By: Kurt K. Ohliger, Jr., CPA (Mar, 2011)

In our February issue ofThe Focus, we discussed the basics of the Passive Activity Loss (PAL) rules as they related to a taxpayer's grouping of activities. In March 2010, the IRS released Revenue Procedure (Rev. Proc.) 2010-13 which will require taxpayers to make certain disclosures on their tax returns in connection with how they "group" their trade or business activities for purposes of applying the PAL rules and related limitations. Part 2 of our two-part series will outline the disclosure requirements as well as some basic advantages and disadvantages of grouping activities versus treating them as separate activities.

  • Why are activity groupings important? Remember the statutory definition of a "passive activity": any rental activity or trade or business in which the taxpayer does not materially participate. An individual is treated as materially participating in an activity if and only if:
  • the individual participates in the activity for more than 500 hours during the year,
  • the individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity by all individuals (including non-owners) during the year,
  • the individual participates in the activity for more than 100 hours during the year and the individual's participation is not less than the participation of any other individual,
  • the activity is a "significant participation activity" (one in which individual participates at least 100 hours) and the aggregate participation in all such activities exceeds 500 hours,
  • the individual materially participated in the activity for any 5 of the last 10 tax years,
  • the activity is a personal service activity in which the individual materially participated in any prior three taxable years, or
  • based on all facts and circumstances, the individual participates in an activity on a regular, continuous and substantial basis during the year.

If a taxpayer does not satisfy the material participation requirements any losses generated by the activity will be "passive losses" and only available to offset passive income. If there is no passive income to offset in the current taxable year, the losses become suspended and carried over to subsequent years. Grouping several activities into one combined activity often makes it easier to satisfy the material participation requirements. In doing so, the combined activity becomes exempt from the PAL rules. Those losses that would otherwise be suspended can now be deducted against all types of income (ordinary, investment, capital gain, etc.).

Similarly, when several activities are grouped together into one combined activity, losses from one or more activities within the grouping can offset any income generated from one or more of the other activities within the grouping. This is permissible even if the material participation requirements are not met for the combined activity. Again, this essentially results in losses being currently deductible that would otherwise be suspended losses with the grouping.

One drawback to grouping several activities occurs when the combined activity results in passive losses that are not deductible in the current year and must be carried forward. Without passive income in future years, the losses remain suspended until the taxpayer disposes of substantially all of the activity. The disposition of a single activity that is part of a combined grouping of activities may not be sufficient to allow for the utilization of any suspended losses attributable to the combined activity. If each activity was treated as a separate activity, all suspended losses attributable to that single activity would become deductible in the year the activity is disposed. Therefore, in certain situations it is advisable to treat each activity as a separate activity. This is especially true for taxpayers with multiple residential rental properties that are often held for short periods.

Effective for taxable years beginning on or after January 25, 2010, the new disclosure rules require tax return statements in the following circumstances:

  • New Groupings: Taxpayers must include a disclosure statement in the federal income tax return for the first tax year in which two or more trade or business activities or rental activities are originally grouped as a single activity. The statement must identify the names, addresses, and employer identification numbers (if applicable) for each of the activities being combined. In addition, the statement must contain a declaration that the grouped activities constitute an appropriate "economic unit" for the measurement of gain or loss for purposes of the PAL rules.
  • Addition of New Activities to Existing Groups: For any tax year in which the taxpayer adds a new activity to an existing grouping, the taxpayer must file a disclosure statement with the original return for that year. The statement must contain the same information as indicated above for "new groupings".
  • Regrouping of Activities: If, after an initial grouping of activities is disclosed, it is determined that the existing grouping is clearly inappropriate or that a material change in the facts and circumstances has occurred that makes the existing grouping clearly inappropriate, the taxpayer must regroup the activities into one or more appropriate economic units. A disclosure statement must be attached to the tax return, provide all of the information listed above plus provide an explanation of why the original grouping was deemed inappropriate.

No tax return disclosures will be required for groupings that existed before January 25, 2010 unless changes are made to the grouping after that date. Pass-through entities such as S Corporations and partnerships will not be required to comply with the disclosure requirements of Rev. Proc. 2010-13. These entities must already disclose activity groupings to shareholders or partners by separately stating income or loss amounts for each grouping on attachments to the annual Schedule K-1. The shareholders or partners are not required to disclose on their individual tax returns activity groupings that are simply "passed through" to them. However, tax return disclosures are required if shareholders and partners combine activities passed through to them with other activities conducted directly by the shareholder or partner or with other activities conducted through other S Corporations or partnerships.

As with most regulations requiring tax return disclosures, there are consequences for failing to do so. Pursuant to the Revenue Procedure, when the taxpayer fails to make a required disclosure that certain activities have been grouped together, each activity will be treated as a separate activity for PAL purposes. However, the IRS will reward a taxpayer for consistency. A timely disclosure shall be deemed made by a taxpayer who has filed all affected income tax returns consistent with the claimed grouping of activities provided the disclosure is included in the tax return for the year in which the failure is first discovered. If the failure to disclose is first discovered by the IRS, however, the taxpayer will be required to demonstrate "reasonable cause" for failing to make the disclosures required by the Revenue Procedure.

To group or not to group….that is the question! With proper planning, being a "groupie" (or not!) can help taxpayers potentially lessen or eliminate the impacts of the PAL rules. Now is the time to begin planning for the disclosures that may be required with your 2011 tax returns. Please contact your Dermody, Burke & Brown tax advisor to discuss planning alternatives suitable for your personal tax situation.

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