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Passive Activity Loss Rules: Strategies for Pass‐Throughs to Maximize Deductions

Leveraging Latest Federal Guidance and Rulings to Establish Material Participation

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific TUES DAY, FEBRUARY 28, 2012

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific Anne Bushman, Tax S ervices Manager, McGladrey & Pullen, Washington, D.C. , g , y , g , Peter Jorstad, Tax Manager, CJBS, Northbrook Michael Grace, Managing Director, Milbank Tweed Hadley & McCloy, Washington, D.C. Monica Tillett, Managing Director, WTAS LLC, Washington, D.C.

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Passive Activity Loss Rules: Strategies f P Th h t M i i for Pass‐Throughs to Maximize Deductions Seminar

• Feb. 28, 2012

Peter Jorstad, CJBS paj@ cjbs.com Anne Bushman, McGladrey & Pullen anne.bushman@ mcgladrey.com Monica Tillett, WTAS LLC monica.tillett@ wtas.com Michael Grace, Milbank Tweed Hadley & McCloy mgrace@ milbank.com

Today’s Program

Overview Of Federal Passive Activity Loss Rules [Anne Bushman] S lide 7 – S lide 13 Passive Activity Concepts For Real Estate Professionals [Anne Bushman, Pet er Jorst ad] S lide 14 – S lide 20 Material Participation By LPs And LLC Members [Michael Grace] S R l d P i A i i l d l d S lide 21 – S lide 30 S tate Tax Issues Related To Passive Activity Losses [Monica Tillet t ] Practical Issues From Compliance Work And Audits S lide 31 – S lide 36 S lide 37 – S lide 54 Practical Issues From Compliance Work And Audits [Anne Bushman, Michael Grace, Pet er Jorst ad] S lide 37 S lide 54

OVERVIEW OF FEDERAL

Anne Bushman, McGladrey & Pullen

OVERVIEW OF FEDERAL PASSIVE ACTIVITY LOSS RULES

Passive Activity Losses

• Applicable to:
• Individuals, trusts, estates, closely held C Corporations and

personal service corporations

• Limit deductibility of losses and credits
• How to determine passive status
• How to determine passive status
• Regular, continuous and substantial
• Material participation

8

Material Participation Tests

• Test one: Participation for more than 500 hours
• Test two: Participation represents substantially all of the

participation in the activity of all individuals

• Test three: Participation for more than 100 hours, and at least as

much as any other individual

• Test four: The activity is a significant participation activity, and

total participation in SPAs is more than 500 hours. SPA T d b i ti it i hi h ti i t d f

• SPA: Trade or business activity in which you participated for

more than 100 hours and in which you did not materially participate under any of the other material participation tests

9

Material Participation Tests (Cont.)

• Test five: Materially participation in any five of the 10

immediately preceding tax years

• Test six: Activity is a personal service activity, and you materially

y p y, y y participated any three preceding tax years

• PSA: Involves the performance of personal services or
• ther trade or business in which capital is not a material

p income-producing factor

• Test seven: Based on facts and circumstances participation

Test seven: Based on facts and circumstances, participation was regular, continuous and substantial (if activity was more than 100 hours).

10

Disallowed Losses And Credits

• No current-year effect
• Taxable income
• Self-employment income
• Allocated among taxpayer’s passive activities

Allocated among taxpayer s passive activities

• Carryforward indefinitely
• Order of hurdles

B i

• Basis
• At risk
• Passive
• Capital loss

11

Dispositions Of Passive Activities

• Disallowed losses are deductible when:
• Substantially all of activity is disposed
• Disposition is a taxable event.
• Disallowed credits
• Continue to carry forward, unless taxpayer elects to

increase property’s basis immediately before transfer by the increase property s basis immediately before transfer by the amount of credit that decreased property’s basis when placed in service

12

Return Compliance

• Form 8582

13

A B h M Gl d & P ll

PASSIVE ACTIVITY CONCEPTS

Anne Bushman, McGladrey & Pullen Peter Jorstad, CJBS

PASSIVE ACTIVITY CONCEPTS FOR REAL ESTATE PROFESSIONALS

Real Estate Activities

• “Per se” passive activities

p

• $25,000 passive loss from active participation in rental real estate

may offset against non-passive activities (subject to AGI limits) may offset against non passive activities (subject to AGI limits).

• Exception for real estate professionals

S b t ti ll i l d i l t t d b i

• Substantially involved in real property trades or businesses
• Must qualify as REP and still materially participate

15

Real Estate Professional

• Qualifications
• > ½ personal services are performed in trades or

businesses by the taxpayer are in real property trades or businesses in which the taxpayer materially participated.

• > 750 total hours of services are in real property trades or

businesses in which taxpayer materially participated.

• Cannot include time spent by spouse

p y p

• Real property trade or business: “Any real property

development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, q , , , p , g , g,

• r other brokerage trade or business”

16

Consequences Of Qualifying As REP

• No longer “per se” passive, and fall back to normal passive

activity rules

• $25,000 limit does not apply.
• Default rule treats each rental activity separately
• Default rule treats each rental activity separately.

17

El i Electing

How to make election: Why or why not? Late election under Rev. Proc. 2011-34: Why or why not? Revocation Revocation

18

Sh ld Th L El i B M d ? Should The Late Election Be Made?

Was an election ever made?

• Yes: Well documented
• Don’t know: No documentation
• No: Well documented

19

Bailey v. Commissioner (“Bailey II”) Bailey v. Commissioner ( Bailey II )

T.C. Summary Opinion 2011‐22

Bailey v. Commissioner (“Bailey I”) Bailey v. Commissioner ( Bailey I )

T.C. Memo 2001‐296

Activity 1 358 hours Activity 1 358 hours Activity 2 24 Activity 3 105 Activity 4 192 679 “Inn” 324 Short-term rental – not per se rental Total hours 1,003

20

MATERIAL PARTICIPATION BY

Michael Grace, Milbank Tweed Hadley & McCloy

LPs AND LLC MEMBERS

Limited Partner Material Participation

 Issue: When is an individual a “limited partner,” for determining whether the individual materially participates?  Relevance: How many of the seven regulatory tests for material participation may the TP apply ? p p y pp y  Generally: To test material participation in trade or business activities?  Real estate: To test material participation in real property trades or businesses and in rental real estate activities (469(c)(7))?

22

Limited Partner Material Participation (Cont.)

 Statutory rules: 469(h)  In general: A taxpayer shall be treated as materially participating in an activity only if that taxpayer is involved in the operations of the activity

• n a basis which is:
• Regular,
• Continuous and
• Substantial
• Substantial.

 Interests In limited partnerships: 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.

23

Limited Partner Material Participation (Cont.)

 Regulations interpreting 469(h)  Current: Reg. 1.469-5T(e) (1988)  Proposed: Reg. 1.469-5(e), REG-109369-10, 76 FR 72875 (11/28/11)

24

Limited Partner Material Participation (Cont.)

 There are two regulatory exceptions to statutory rule generally prohibiting a limited partner from materially participating.  Even a limited partner may materially participate under three of the seven regulatory tests.

• (a)(1): Limited partner participates in the activity for more than 500

hours during the year

• (a)(5): Limited partner materially participated in the activity for any

five taxable years (whether or not consecutive) during the 10 taxable years immediately preceding the taxable year.

• (a)(6): Personal service activity, and limited partner materially

participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year.  Limited partner is also a general partner in the same partnership.  R 1 469 5T( )

25

 Reg. 1.469-5T(e)

Limited Partner Material Participation (Cont.)

Current Proposed

(3) Limited partnership interest.—(i) In general.— Except as provided in paragraph (e)(3)(ii) of this (3) Interest in a limited partnership as a limited partner—(i) In general. Except as provided in section, for purposes of section 469(h)(2) and this paragraph (e), a partnership interest shall be treated as a limited partnership interest if— (A) Such interest is designated a limited hi i i h li i d hi paragraph (e)(3)(ii) of this section, for purposes of section 469(h)(2) and this paragraph (e), an interest in an entity shall be treated as an interest in a limited partnership as a limited partner if— (A) Th i i hi h h i i h ld partnership interest in the limited partnership agreement or the certificate of limited partnership, without regard to whether the liability of the holder of such interest for obligations of the partnership is limited under the applicable State law; or (A) The entity in which such interest is held is classified as a partnership for Federal income tax purposes under § 301.7701-3; and (B) The holder of such interest does not h i ht t th tit t ll ti d i th pp ; (B) The liability of the holder of such interest for obligations of the partnership is limited, under the law of the State in which the partnership is organized, to a determinable fixed amount (for example, the sum have rights to manage the entity at all times during the entity’s taxable year under the law of the jurisdiction in which the entity is organized and under the governing agreement. ( p

• f the holder’s capital contributions to the partnership

and contractual obligations to make additional capital contributions to the partnership).

26

Limited Partner Material Participation (Cont.)

 Why Treasury Department/IRS have proposed updated rules  Relevant state non-tax law has evolved since 1985.  IRS has lost a series of court cases attempting to treat LLC members as li it d t limited partners.  Newell, TCM 2010-23; Hegarty, TC Summary Opinion 2009-153; Thompson v. US, 87 Fed. Cl. 728, 104 AFTR 2d 2009-5381 (Fed. Cl. 2009); Garnett, 132 TC 368 (2009); Gregg v. US, 180 F. Supp. 1123, 87 AFTR 2d 2001-337, 2001-1 USTC Par. 50,169 (D. Ore. 2000)

27

Limited Partner Material Participation (Cont.)

Current Proposed

(3) Limited partnership interest.—(i) In general.— Except as provided in paragraph (e)(3)(ii) of this (3) Interest in a limited partnership as a limited partner—(i) In general. Except as provided in section, for purposes of section 469(h)(2) and this paragraph (e), a partnership interest shall be treated as a limited partnership interest if— (A) Such interest is designated a limited hi i i h li i d hi paragraph (e)(3)(ii) of this section, for purposes of section 469(h)(2) and this paragraph (e), an interest in an entity shall be treated as an interest in a limited partnership as a limited partner if— (A) Th i i hi h h i i h ld partnership interest in the limited partnership agreement or the certificate of limited partnership, without regard to whether the liability of the holder of such interest for obligations of the partnership is limited under the applicable State law; or (A) The entity in which such interest is held is classified as a partnership for Federal income tax purposes under § 301.7701-3; and (B) The holder of such interest does not h i ht t th tit t ll ti d i th pp ; (B) The liability of the holder of such interest for obligations of the partnership is limited, under the law of the State in which the partnership is organized, to a determinable fixed amount (for example, the sum have rights to manage the entity at all times during the entity’s taxable year under the law of the jurisdiction in which the entity is organized and under the governing agreement. ( p

• f the holder’s capital contributions to the partnership

and contractual obligations to make additional capital contributions to the partnership).

28

Limited Partner Material Participation (Cont.)

Current Proposed

(ii) Limited partner holding general partner interest.—A partnership interest of an individual shall (ii) Individual holding an interest other than an interest in a limited partnership as a limited partner. not be treated as a limited partnership interest for the individual’s taxable year if the individual is a general partner in the partnership at all times during the partnership’s taxable year ending with or within the individual’s taxable year (or portion

• f

the An individual shall not be treated as holding an interest in a limited partnership as a limited partner for the individual’s taxable year if such individual also holds an interest in the partnership that is not an interest in a limited partnership as a limited individual s taxable year (or portion

• f

the partnership’s taxable year during which the individual (directly or indirectly) owns such limited partnership interest). interest in a limited partnership as a limited partner (as defined in paragraph (e)(3)(i) of this section), such as a state-law general partnership interest, at all times during the entity’s taxable year ending with or within the individual’s taxable year (or th ti f th tit ’ t bl d i hi h the portion of the entity’s taxable year during which the individual (directly or indirectly) owns such interest in a limited partnership as a limited partner).

29

Limited Partner Material Participation (Cont.)

Scope of proposed regulations The proposed regulations provide rules concerning an interest in a limited hi b d h f hi h i 469 d d partnership based on the purposes for which section 469 was enacted, and the manner in which the provision is structured and operates within the

• Code. Accordingly, the rules concerning an interest in a limited partnership

in the proposed regulations are provided solely for purposes of section 469 in the proposed regulations are provided solely for purposes of section 469 and no inference is intended that the same rules would apply for any other provisions of the Code requiring a distinction between a general partner and a limited partner a limited partner. 76 FR at 72876

30

STATE TAX ISSUES RELATED

Monica Tillett, WTAS LLC

TO PASSIVE ACTIVITY LOSSES

Passive Activity Loss: State Conformity

I.Conformity with IRC §469

• A. General conformity – Conform with the Internal Revenue

Code; however, no specific mention of IRC §469 Code; oweve , o spec c e t o o C § 69 B. S pecific conformity II.Conformity with exceptions to IRC §469

• A. Exceptions to definition of passive activities

B. Modification to calculation of passive activity losses or ti di ll d portion disallowed III.Non-conformity with IRC §469

32

S C f i Wi h IRC § 6 State Conformity With IRC §469

No personal income tax General conformity Specific conformity Conformity with exceptions Does not conform

33

State Conformity With IRC §469 (Cont.)

I.New Y

• rk

1. Current conformity with IRC 2 Form IT 182 2. Form IT-182 II.Maryland

• A. Current conformity with IRC

y B. No form used to calculate passive activity limitations a. Instead, passive activity losses are limited, based

• n the loss ratio calculated on the federal Form

8582.

34

S C f i Wi h E i State Conformity, With Exceptions

I.California – Cal. Rev. & Tax. Cd. §17561 modifies IRC §469

• A. Definition of passive activities

1 Real property trade or business professionals 1. Real property trade or business professionals B. Calculation of loss on disposition of passive activity C Limitation amounts

• C. Limitation amounts

1. Rental real estate limitation related to low-income housing

• D. CA Form 3801

35

State Non‐Conformity With IRC §469

I Pennsylvania I.Pennsylvania A. Income items are grouped into categories and reported on p. 1 of Form P A-40. 1. While some income categories may be reported on the tax returns as negative amounts, any net loss per category may not offset income from negative amounts, any net loss per category may not offset income from a different category and will not be included in the calculation of P A taxable income. a. No carryover for disallowed losses 2. S pouses may not offset each other’s income and losses. II.New Jersey A. Income items are grouped into categories and reported on p. 3 of Form NJ- 1040. 1. Losses may offset income within an income category; however, net loss per income category is disallowed and not reported on the tax return. a. No carryover for disallowed losses

36

Anne Bushman, McGladrey & Pullen Michael Grace Milbank Tweed Hadley & McCloy

PRACTICAL ISSUES FROM

Michael Grace, Milbank Tweed Hadley & McCloy Peter Jorstad, CJBS

PRACTICAL ISSUES FROM COMPLIANCE WORK AND AUDITS

IRS Letter Program

• IRS contacting return preparers nationally
• Focus on large number of Schedules A C or E

Focus on large number of Schedules A, C or E

• Common error on Schedule E – limitations surrounding passive

activities basis and at risk rules not properly considered or activities, basis and at-risk rules not properly considered or calculated

38

Material Participation

 Relevant for three purposes  Does a taxpayer have non-passive income and/or losses from trade or business activities?  I TP lifi d l t t f i l (469 ( )(7))?  Is TP a qualified real estate professional (469 (c)(7))?  Does a qualified real estate professional have non-passive income and/or losses from rental real estate activities?

39

Material Participation (Cont.)

 Sect. 469 (c) (7) requires a two-step analysis:  Is TP a qualified real estate professional?  If so, does TP materially participate in relevant rental real estate ti iti ? activities?

40

Material Participation (Cont.)

 Proving participation: Theory  Methods of proof: The extent of an individual’s participation in an activity b t bli h d b bl C t d il ti 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 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. period, based on appointment books, calendars, or narrative summaries.

• Reg. 1.469-5T(f)(4)

41

Material Participation (Cont.)

 Proving participation: Reality

 Contemporaneous daily time reports, logs, etc. are highly preferred. “b ll k i ” i d i i l d d  Post-event “ballpark guesstimates” are viewed suspiciously and tend not to persuade.  Logs and similar summaries reconstructed “after the fact” (e.g., during an IRS i ti h i f t) i d f bl d examination or when preparing for court) are viewed unfavorably and suspiciously.  Lists without precise hours are unpersuasive; approximated or estimated hours d ’t t it don’t cut it.  Having worked fulltime other than in activities in question is generally fatal.  Hours claimed had better conform reasonably to the nature of tasks performed. y p  Don’t try to claim TP worked for more than 24 hours during any day!  Testimony that is vague, unsupported, exaggerated or contradicted by other evidence can dig taxpayer further into a hole

42

evidence can dig taxpayer further into a hole.  Time “on call” doesn’t count.

Material Participation (Cont.)

 Oft-cited cases rejecting non-contemporaneous proof of material participation in trade or business activities  Goshorn, TCM 1993-578  C l t dt TCM 1997 331  Carlstedt, TCM 1997-331  Speer, TCM 1996-323  Fowler TCM 2002 223  Fowler, TCM 2002-223

43

Material Participation (Cont.)

 Recent cases rejecting non-contemporaneous proof of material participation under 469(c)(7)  Lee, TCM 2006-193  Hill, TCM 2010-200, aff’d, 2011-2 USTC Par. 50,579 (5th Cir. 2011)  B il TCM 2001 296  Bailey, TCM 2001-296  D’Avanzo v. US, 67 Fed. Cl. 39, 96 AFTR 2d 2005-5464 (Fed. Cl. 2005), aff’d, 99 AFTR 2d 2007-877, 2007-1 USTC Par. 50,371 (Fed.

• Cir. 2007)

 Mowafi, TCM 2001-111 G l b TCM 2010 64  Goolsby, TCM 2010-64  Harnett, TCM 2011-191  Moss 135 TC 365 (2010)

44

 Moss, 135 TC 365 (2010)

Self-Rented Property

 Net income: Generally reclassified from passive to non-passive; see

• Reg. 1.469-2(f)(6)

 N t l G ll i R 1 469 1( )(3) 1 469 1T( )(3)  Net loss: Generally passive; see Regs. 1.469-1(e)(3), 1.469-1T(e)(3)

45

Self-Rented Property (Cont.)

Doctor Ozzie Other Doctors

30% 70%

Harrietta Medical Group, Inc. (S Corp.)

Salary, Rents Lease: Building Patients Lease: Building Lease: MRI Scanner Medical Services Patients

46

Self-Rented Property (Cont.)

Item Amount 469 Character Salary $300 000 Active Salary $300,000 Active Rental: Building 75,000 Active Rental: MRI scanner (24,000) Passive

47

Self-Rented Property (Cont.)

Doctor Ozzie Other Doctors Doctor Ozzie Other Doctors

30% 70%

Harrietta Medical Group, Inc. (C Corp.)

Salary, Rents Lease: Building Patients Lease: Building Lease: MRI Scanner Medical Services Patients

48

Self-Rented Property (Cont.)

Item Amount 469 Character Salary $300 000 Active Salary $300,000 Active Rental: Building 75,000 Active Rental: MRI Scanner (24,000) Passive

49

Self-Rented Property (Cont.)

Doctor Ozzie Other Doctors Doctor Ozzie Other Doctors

0% 100%

Harrietta Medical Group, Inc. (S Corp.)

Salary, Rents Lease: Building Patients Lease: Building Lease: MRI Scanner Medical Services Patients

50

Self-Rented Property (Cont.)

Item Amount 469 Character Salary $300 000 Active Salary $300,000 Active Rental: Building 75,000 Active Rental: MRI Scanner (24,000) Active *

* Assuming that trade or business activity (medical practice) and rental activity constitute an appropriate economic unit

51

g y ( p ) y pp p

Self-Rented Property (Cont.)

 Recent cases reclassifying net income from passive to non-passive under

• Reg. 1.469-2(f)(6)

 Shaw, TCM 2002-35  Willock, TCM 2010-75, aff’d, 2011-1 USTC Par. 50,369 (4th Cir. 2011) ( )  Langille, TCM 2010-49  Beecher, 2007-1 USTC Par. 50,379 (9th Cir. 2007), aff’g. California Interiors, Inc., TCM 2004-99  Carlos, 123 TC 275 (2004)

52

S lf Ch d I Self‐Charged Interest

Concept May elect out

53

Case Law For Combining Activities

• Senra v. Commissioner, TCM 2009-79: Wages from a C

corporation could not offset activities from pass-throughs.

• Rental activity not subject to per se passive treatment
• Misko, Jr. v. Commissioner, TCM 2005-166

Tarakci v Commissioner TCM 2000 358

• Tarakci v. Commissioner, TCM 2000-358
• Candelaria v. U.S., 100 AFTR 2d 2007-6381

54