Grouping and Separate Activities Under Section 469 of the Internal Revenue Code

In episode 36 of How Tax Works, Matt Foreman discusses grouping elections for the passive activity loss limitations, which are also generally applicable for sections 465 (at-risk limitations), 199A (qualified business income), and other parts of the Internal Revenue Code.

How Tax Works, hosted by Falcon Rappaport & Berkman LLP Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions.

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Transcript

Matthew Foreman [00:00:03]:
Welcome to the 36th episode of How Tax Works. I'm Matt Foreman. In this episode, I'll discuss grouping and separate activities under Section 469 of the Internal Revenue Code. That's passive activity loss rules. But these general rules also encompass 465, 199 Cap A grouping is pretty universal. Anyway, How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising and it is not legal advice. Please hire your own attorney.

Matthew Foreman [00:00:38]:
How Tax Works is intended to help listeners navigate through intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business decisions that we all make. Right before we start, get some administrative stuff out of the way. New episodes in 2 weeks. Uh, the next episode is going to talk about— I don't, I don't really know how to, how to title it yet, um, but it's based off the prompt that my cousin asked me. He said, why do people say this? If you win the lottery, the first thing you should do is call a tax attorney. Why? And, uh, I'm going to try to answer that question, but, you know, we'll see how that goes. Uh, if you have any questions, comments, or constructive criticism, you can email me at my FRB email address. Which you can find via your favorite search engine.

Matthew Foreman [00:01:22]:
Upcoming webinars. I have 4 webinars, they are free. They are on Thursdays in November and December. They're at 1:00 Eastern time. And the topics are November 6th, 704(c) allocations. November 20th is succession planning at the margins using profits, interests, not as at the margins as some, as it, the title may suggest. December 4th, stock sales, taxes, asset sales. Also going to talk about, you know, in that, your 338(h) channel actions.

Matthew Foreman [00:01:47]:
Sale of subsidiaries. December 18th, changes to qualified small business stock, Section 1202, under OB Thrice is what I'm calling it. All right, so now we're talking about grouping and separate activities under Section 469. One or more trade or business activities treated as a single activity if the activities constitute an appropriate economic unit. You have to look at the relevant facts or circumstances, and the taxpayer may use any reasonable method when grouping. According to a 1986 Senate report. All right. So not that recent.

Matthew Foreman [00:02:26]:
What undertakings consist of an integrated and interrelated economic unit conducted in coordination with or reliance upon each other are to be considered a single economic unit. All right, so what does that mean? All right, undertakings integrated and interrelated economic unit conducted in coordination with or conducted in reliance upon each other, that is a single economic unit. There are factors for this, they're in the regulations. All right, Treasury Reg 1.469-4(c)(2). Similar, and you look at, here's what you look at, all right, the similarities and differences in types of a trade or business. The extent of common control, the extent of common ownership, geographical location, specifically proximity, and the interdependencies between or among the activities, such as the extent to which: 1, the activities purchase and sell goods between and among themselves; 2, they involve products or services normally provided together; 3, they have the same or very similar customers— same is a tough one, but very similar, right? And 4, accounted for with a single set of books and records. What the IRS and the Treasury Department are trying to get out of this analysis is the extent to which you view it as a single business, you the business owner, and the extent to which you treat it as a single business, and the extent to which a reasonable person who is very disinterested would view this as a single trader business, right, to be grouped. Excuse me, a single economic unit.

Matthew Foreman [00:04:01]:
We're talking about economic, we're talking about a lot of units, right? The big unit, right? Randy Johnson. All right, before we get into examples, all right, lots of examples, let's get some music in here, come back in a sec. All right, we're back with the examples. There are many examples. Many, many examples. Many, many, many, many, many, many, many examples. There's a lot of case law on this. There's a lot of stuff.

Matthew Foreman [00:04:32]:
I'm not going to go through it all because I'm only doing this in 20 minutes and I don't think it's that interesting. But I think a lot of them go into it, right? So two partnerships under common control. One sells non-food grocery stores. One owns and operates a trucking business, right? This is a single business. The key is whether, you know, one, it could be a single business. Would it be reasonable to sell non-food items to grocery store and have your own trucks. Yeah, right? Treasury Regulations 1.469-43/4C3 example 2. The second one, an airplane charter and a real estate developer.

Matthew Foreman [00:05:05]:
He used the chart, he chartered the airplanes to visit sites. Not a single business. That's Brumbaugh TC Memo 2018-40. Really, really, really, really, really, really, really important. Just, I have seen people group charter airplane businesses in with other businesses. Just because you use one business for another does not group them, right? 3, this is not really an example, but it's an important point, right? The IRS cannot change a reasonable grouping. Harding, uh, Hardie 2016-34022. The key isn't whether it's the best grouping.

Matthew Foreman [00:05:40]:
The key is whether the grouping is reasonable. I often talk to clients about this because the IRS in audit, and I've dealt with this enough, 469 audits over the years that I've dealt with this, the IRS will be like, well, we have to see if it's the right grouping. And I respond, friend, thank you for your message. It doesn't matter whether it's the right grouping. It matters whether it's the— or the best grouping. It matters whether it is a reasonable grouping. And I cite that, and I have never had the IRS push back on that. I expect that even if you did not push back on it and you had a reasonable grouping, they would let it go.

Matthew Foreman [00:06:17]:
And they would let it go for one specific reason: they don't want to lose as to what is a reasonable grouping, because every time they lose, it gets chipped away and it's harder for them to audit. So they'll phrase it poorly, but I suspect they'll come to the right conclusion. There are also many limitations on grouping, right? The first one, the big one, the big honker: rentals and the trade or business activity. You generally cannot group rentals with a trade or business. Treasury Regulations 1.469-4(d)(1)(i). Romanette 1, Romanette 1, for those who haven't listened before, is that little i, right? Number 2, in the 1986 Senate report, also in the 1986 Blue Book. Yes, for those wondering, yes, I really do read Senate reports and Blue Books as part of this. You know, you find examples, you read in history, and you sit down and you read it.

Matthew Foreman [00:07:04]:
I do prepare for these. It may not sound like it sometimes, but I do. There is no— so, you know, going through it. So an example in the '86 Senate report, '86 Blue Book, is an automobile leasing and an automobile manufacturing. That is no group. Thought that was really interesting, but nope, no dice there. Number 2, a travel agency owns a building that's 10 floors, uses 3 of them, and leases the other 7. Nope, not a group.

Matthew Foreman [00:07:27]:
Not a group at all. The next one is the, uh, a rental apartment building and a hotel. Not a group, not a group. Thought that was a really interesting one. Um, I get clients all the time who have residential buildings and commercial buildings, or if you live and, you know, you rent in a city, right? I, I always think about New York, it's where I live, but if you've ever spent any time in New York, you'll see that there are a lot of buildings, not so much in Midtown, although it does exist in Midtown a little bit, but less so, you know, the more residential areas SoHo, whatever, the first floor is almost always commercial. Okay. And then the second floor and above, you know, sometimes first two are commercial, right? Madison Avenue has a lot that are like two commercial, then residential or whatever, where they'll have it in one building, residential, commercial. But there's a number who have some straight commercial buildings and some residential buildings.

Matthew Foreman [00:08:17]:
And the question is whether they can be grouped. And it's a question again, and I always go back to this, is the grouping reasonable? I've had successful audits with it. So clearly the IRS is going to look at it, right? And it's not just, you know, between how the buildings are done, it's also how you look at it. And I always talk about that. How do you look at it? People say, well, you know, each building has a P&L ledger. That's fine. How's it reported? Is it consolidated up? How's it reported for tax return purposes? How's it returned for audited financials? A lot of these have a lot of debt on them. So banks want to see it.

Matthew Foreman [00:08:46]:
How's that viewed, right? Exceptions to the general prohibition. So rentals and a trade or business activity, These are exceptions to prohibitions. So these are things where grouping is permitted if the rental activity is insubstantial in relation to the trade or business. Okay, so you know, you are renting space, but the trade or business is really it. You know, that one's really interesting. I go back to that travel agency. If they owned 4 floors, they use 3, and one of them they rented out, I bet you, you could group it. So they kind of sunk their boat there, right? Sunk my battleship.

Matthew Foreman [00:09:20]:
Two, if the trade or business is insubstantial in relation to the rental activity. Again, I go back to the travel agency owning the building. So if that were— they used one floor and rented nine, I bet that's okay. Um, if each owner of the trade or business has some proportionate ownership in the rental— has the same proportionate ownership in rental activity. So that, that is an exception. You still need other stuff to kind of work out there, but you know, it's not that bad. Rentals of real estate, this the second limitation is a rental of real estate and a rental of personal property at the same time. Generally not allowed.

Matthew Foreman [00:09:55]:
The exceptions are where the personal property is provided in connection with the real property and vice versa. The example they give is furniture rented with an apartment. Thought that was a really interesting one. You know, look, the furniture could be a pretty big chunk of the thing. You know, I've never, I've never rented a furnished apartment before. I guess my dorms were in college. Think back to that. So maybe that was, but not-for-profit entities.

Matthew Foreman [00:10:18]:
So it didn't really matter. So that's something you want to do, you know, is it substantial? And that's the key, right? You're really renting the real estate. So the personal property's ancillary. Next one, you can't group if the limited partners or persons are not sufficiently involved in management, right? So if you're a limited partner, you can't group activities. You know, I think this makes sense, right? Because only people actively involved in the business. Can group. So that's it. So the, the way this is defined is if you are a limited entrepreneur— that's the term they use— say you can't group.

Matthew Foreman [00:10:50]:
Limited entrepreneur is defined as any person other than limited partner who does not actively participate in the management of the enterprise, IRC 461(k)(4). There are additional limitations on this. This is, this is some really mechanical stuff, so I know it's really exciting. Um, each publicly traded partnership has its own activity from K-1, which Oil and gas is not passive, but it is separate from any other activity, and from any other activity that is not related to the oil and gas working interests. All right. That's in the 1986 Senate report. So kind of a loose one there. No code, no regs, but '86 Senate report is kind of tough to do.

Matthew Foreman [00:11:27]:
Very taxpayer-friendly. IRS, to my knowledge, has not— I actually looked this up— has not challenged it in a meaningful sense. And if it has, no one has litigated it. So I don't know. And finally, additional limitations. You can't group trading activities to prevent 163 limitation issues. Treasury Regulation 469-4(d)(6). So you can't group trading activities.

Matthew Foreman [00:11:46]:
You must split the interest for 163(j) between partners who materially participate and those who don't, right? So you're not going to group trading activities to deal with 163(j). So if you have one activity has a whole lot of debt and a lot of interest payments, you can't really group it with the other one simply to get 163(j). So that may be an exception to the rule that any reasonable one is done, because it may not be reasonable, and that may push it out. All right, let's get some music in, and then we'll bring this bad boy home. All right, hope you enjoyed the, uh, the final little musical bit bringing it— bringing this bad boy home right now. So consistency and disclosure requirements are really, really important. Uh, Revenue Procedures 2010-13 has reporting requirements for the grouping procedures. If you are preparing a return and you are doing it for the first time, or the second time, or the third time, I would not be averse to the idea that you read Rev Proc 2010-13 because it's important.

Matthew Foreman [00:12:54]:
It is very detailed and it is the IRS telling you explicitly what it wants. And if there's one thing that anyone who interacts with the IRS will tell you, it is that if you do what the IRS tells you to do, they will be happy. And if you don't do what the IRS tells you to do, and in fact you do something else, they will be grumpy and they will not like you from the start, right? So let's talk about the requirements in Rev. Proc. 2010-32. Once grouped, you cannot regroup unless there is either a material change in facts and circumstances or The grouping was clearly inappropriate, which is under Treasury Regulation 1.4. So basically, material change in facts and circumstances, or you made a whoopsie-doo, right? And you're correcting it and you're required to correct it, right? You have a whoopsie-doo. I know I'm using very technical terms there, but if you have a mistake, you have to do it, right? And the phrase they use is clearly inappropriate.

Matthew Foreman [00:13:46]:
That doesn't mean not perfect. Again, reasonable is okay. Perfect, not required. Number 2. If grouped within the partnership and S corp, you don't use revenue procedure 2010-13. You disclose per instructions in Form 1065 or 1120-S as appropriate. If you have a partnership that owns 5 businesses and you're grouping 5 of the businesses or 3 of the businesses, you actually disclose in the instructions in the 1065. Same rule for S corps.

Matthew Foreman [00:14:11]:
I have seen people in situations say, hey, my accountant, you know, my old accountant's a moron. You know, he's dumb. He used Rev Proc 2010-13, not the instructions. In the 1065, do I have to disclose? The technical answer is probably yes. I would make the argument, as long as it was properly disclosed in the partnership return, albeit not perfectly, I would say you're probably okay. Really what the IRS is looking for here is a certain set of information. They don't terribly care how, they just want to make sure they get that information. I know I said do what the IRS said, but you know, we're all human, we're going to make mistakes.

Matthew Foreman [00:14:48]:
As I tell our associates, so it's best to just look, did I do it right? If you have to come clean to fix it, fix it, be honest. Might not trigger an audit, you know, these days, who knows. There are rules around grouping information. There are rules around how you put the grouping information into your partnership partners' K-1s, right? If the partnership groups, the partner may not ungroup or change the grouping. That's in RevProc 2010-13. So we all sign. And anyone in a partnership signs this thing, you know, you won't do anything different than the partnership says. If the partnership does a bad grouping, you're actually not allowed to do it.

Matthew Foreman [00:15:22]:
You're not allowed to change it. How do I say this politely? However, if it is wrong, you are actually required to not follow it and you are required to group it or ungroup it yourself, right? So what happens if you're not compliant? So it's important to note you have to of course disclose that to the IRS. You're effectively causing an audit. So don't take that lightly. Talk to a tax professional about it. What to do if you didn't comply with RevProc 2010-13? They are all separate activities and you may be able to fix it. Section 4.07 in RevProc 2013-10 allows for a way to you to basically retroactively correct what you did, regroup, or just sort of fix how it was done. Highly recommend finding that one.

Matthew Foreman [00:16:03]:
The IRS may regroup and it requires both, okay? The rules for this, this is in Treasury Regulation 469-1 (4)(1), and this is, you know, any of these, right? Any of the activities from the taxpayer's grouping is not an appropriate economic unit. Appropriate, right? It only has to be reasonable. And, and the A principal purpose, not V, but A principal purpose of the taxpayer's grouping or failure to regroup under Treasury Regulation 4(e) is to circumvent the underlying purposes of 469. So if you grouped to get around 469 then, then that, then that's allowed. You know, as I always say, a mistake maybe, right? You need a principal purpose. The IRS regrouping authority is used infrequently. It's in the preamble to Treasury Decision 8565, uh, which are the regs under 469-4F. Um, I actually think that's true.

Matthew Foreman [00:16:54]:
I really do. I've dealt with situations where the IRS has— where you have some less than stellar grouping, and the IRS is pretty reasonable about it. You You know, again, it's a high bar, right? They could, they're going to regroup if any of the activities are not part of an appropriate economic unit and the principal purpose of the taxpayer's grouping or failure to regroup is to circumvent, you know, the underlying purposes of 469. That's a pretty high bar. The group only has to be reasonable, not perfect, et cetera, et cetera. So I think this is one where the audits are more focused on, they're not as focused on the grouping, whether it's appropriate. They're actually more focused on substantiating hours, which I find generally is is actually the bigger problem. I know I've talked about it in a couple of the prior podcast episodes, 13 and 31.

Matthew Foreman [00:17:38]:
I think that's important. Finally, you know, one thing that happens a lot under 469, if you sell the business, you sell the investment, you get to use the losses, losses get freed up. Great. Oh, you know, because of that, because the disposition of the activity allows for the passive losses to be used, they're no longer in suspension. There's always a question about what about partial dispositions? What if you sell half? Right? And the answer is if you dispose of substantially all of the activity, the disposed part, right, frees up the portion of the passive losses attributable to the disposed part. The other losses remain suspended. I have never dealt with this. There's not really a whole lot that deals with what is substantially all.

Matthew Foreman [00:18:18]:
So I'm going to explain this to you very carefully. Um, cause I think this is important. Define substantially all narrowly. 50% is not substantially all. 80%. Yeah, 60%, maybe, but 80% more so, right? You know, and that's what's important. It's a pro rata. It's like sort of tax on the basis in the same way.

Matthew Foreman [00:18:38]:
And I think that's what they were trying to get, trying to do in that situation. All right. Well, you know, thank you so much for listening. That was the 36th episode of How Tax Works. Hope you come back for 2 weeks, in 2 weeks, 37th episode. We're going to talk about what to do if you win the lottery. I think that's an interesting one. And now for the very, very best song of all time.