The Passive Activity Loss (PAL) rules of Internal Revenue Code (IRC) Section 469 were born out of the tax shelter days of the late 1980's and early 1990's. As taxpayers have discovered, the acronym "PAL" can be anything but friendly. In simplest terms, the PAL rules place limitations on taxpayer's ability to deduct losses or utilize tax credits from activities in which the taxpayer does not "actively" or "materially" participate. In March 2010, the IRS released Revenue Procedure (Rev. Proc.) 2010-13 which will require taxpayers to make certain disclosures on their tax return in connection with how they "group" their trade or business activities for purposes of applying the PAL rules and related limitations.

The new rules and disclosure requirements are effective for all tax years beginning on or after January 25, 2010. Therefore, there will be no impact on a taxpayer's 2010 return. In Part 1 of this two-part series, we will cover the basics of the PAL rules as they relate to a taxpayer's grouping of activities. In Part 2 which will appear in the March issue of The Focus, we will cover the pros and cons of grouping activities, the new disclosure requirements as well as the impact of failing to make the required disclosures.

Generally, losses from "passive activities" can only be used to offset income or gain from passive activities. A passive activity is defined by IRC Section 469(c) as any rental activity or any trade or business in which the taxpayer does not materially participate. A taxpayer's "activities" include those conducted through S corporations and partnerships. In some circumstances, the activities could also include those conducted through a C corporation. On an annual basis, if the aggregate losses from all passive activities exceed the aggregate income from such activities, the excess passive loss cannot be deducted and is carried forward to future taxable years.

The Income Tax Regulations with respect to the grouping of a taxpayer's trade or business activities and rental activities for purposes of applying the PAL and credit limitations have remained largely unchanged since 1995. Under the regulations, a taxpayer can group several business or rental activities into a single combined activity if the activities constitute an appropriate "economic unit" for measuring income, gain or loss for PAL purposes.

The determination of whether a group of activities constitute an appropriate economic unit is based on facts and circumstances. A taxpayer may use any reasonable method of applying the relevant facts and circumstances when grouping activities. The regulations list several factors, not all of which are necessary, that are given the greatest weight in determining whether activities constitute an appropriate economic unit for the purposes of applying the PAL rules. The factors include, but are not limited to, the following:

• Similarities and differences in types of trades or businesses;
• The extent of common control;
• The extent of common ownership;
• Geographical location; and
• Interdependence between or among the activities (for example, the extent to which the activities purchase and/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).

To illustrate, the regulations provide an example of a taxpayer who has significant ownership in a bakery and a movie theater in Baltimore and in a bakery and movie theater in Philadelphia. Depending on the relevant facts and circumstances, the taxpayer may be able to group the activities as: (1) a single activity, (2) a bakery activity and a movie theater activity, (3) a Baltimore activity and a Philadelphia activity, or (4) four separate activities.

The grouping of activities is also subject to several limitations. Among them is the limitation that a rental activity may not be grouped with a trade or business activity unless the combined activities constitute an appropriate economic unit and –

• The rental activity is insubstantial in relation to the trade or business activity;
• The trade or business activity is insubstantial in relation to the rental activity; or
• 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 or property for use in the trade or business activity may be grouped.

Furthermore, an activity involving the rental of real property may not be grouped with an activity involving the rental of personal property unless the personal property is provided in connection with the rental of the real property (or vice versa).

For activities conducted through S corporations, partnerships or C corporations that are subject to the PAL rules, the entity must group its activities into appropriate economic units. After the entity groups its activities, the partner or shareholder is allowed to group those activities with each other, with other activities conducted directly by the partner or shareholder, or with other activities conducted through other partnerships or corporations if doing so results in an appropriate economic unit at the partner or shareholder level. However, a partner or shareholder cannot treat activities that are grouped by the partnership or corporation as separate activities at the partner or shareholder level.

Prior to the release of Rev. Proc. 2010-13 in March 2010, there were generally no disclosure requirements with respect to how a taxpayer grouped its activities subject to the PAL rules. In our March issue of The Focus we will cover those new disclosure requirements as well as address the advantages and disadvantages of grouping activities versus treating them as separate activities.

Stay tuned, and as always, please contact your Dermody, Burke & Brown tax advisor to discuss how the passive activity loss rules may affect your personal tax situation.

The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.