A notable milestone in the cat-and-mouse game of individuals seeking to minimize their tax burden, and Congress making new laws to end potential shelter activity, is the Passive Activity Rule. Originally enacted as part of the Tax Reform Act of 1986, recent developments have brought it prominently to the minds of tax advisors. In particular, an important one-time opportunity to avoid being trapped under this rule arises from new IRS regulations issued in November 2013 due to the new net-investment income tax passed as part of the 2010 Patient Protection and Affordable Care Act (a/k/a “Obamacare”). Without proper planning, the Passive Activity Rule threatens to deny taxpayers the ability to utilize deductions to which they are fully entitled.
The Passive Activity Rule
Lawmakers deem the Passive Activity Rule necessary because of the way the tax law allows businesses to write off the cost of equipment: each item is assigned a schedule (stated in terms of a percentage of the purchase price each year) for writing off the cost of the property. This provides the business with a tax deduction, even though the business has not actually, in the year of the deduction, incurred any cash expense.
The theory in allowing the depreciation deduction is that it corresponds to the amount of value the property lost during the given year and, thus, the depreciation rules simply allow the business to accurately report its income by taking into account the loss in value that has occurred, but that has not yet been reduced to a dollar amount and realized under the accounting rules. However, as a further measure, Congress has chosen to encourage businesses to invest in equipment by allowing these write-offs to be taken over an accelerated period.
For example, a non-commercial business aircraft can generally be fully written off over a five-year period, even though its true economic useful life may be much longer.
However, Congress, in creating the Passive Activity Rule, determined that the benefit of accelerated depreciation should not be freely available to business equipment in all cases, but only under appropriate circumstances. The Senate Finance Committee, in conjunction with enacting the Passive Activity Rule, wrote that, “in order for tax preferences to function as intended, their benefit must be directed primarily to taxpayers with a substantial and bona fide involvement in the activities to which the preferences relate.” (The provision for accelerated depreciation, discussed above, is the most prominent example of the “tax preferences” to which the Committee refers.)
To accomplish the goal of restricting “tax preferences” to taxpayers who have “substantial and bona fide involvement” in the underlying activity, rules were established to divide items of income and expense into two categories: passive, and non-passive (generally referred to as “active”).
The first essential concept in separating passive from non-passive is the concept of an “activity,” which is an abstract notion that can be thought of as the way a person might answer the question, “What business are you in?” Some people will have multiple answers to that question (if they engaged in more than one business), some will have a single answer (for example, a W-2 employee who has no side businesses), and some will answer with none (a retiree). Each answer a person would give to this question is a candidate for being considered an “activity” under the Passive Activity Rule.
Once the activity has been ascertained, it will be deemed passive if either (1) the individual does not “materially participate” in the activity (based on a complicated definition, but generally meaning more than 500 hours of work in the given year), or (2) the activity is a “rental” activity (another complicated definition, but generally referring to activities that make money by selling use of tangible property to others, such as a leasing company; various exceptions apply).
When a passive activity incurs losses, those losses cannot be used as a tax deduction against income from non-passive activities. Rather, the losses accumulate until either used to offset other passive income, or until the passive activity is disposed of, at which time the formerly passive activity becomes non-passive, and the accumulated losses can be used to offset non-passive income, thus reducing net income and therefore tax. When passive activities generate income, that income, starting in 2013, is subject to an additional 3.8% Net Investment Income Tax, on top of regular income tax, if received by a high-income taxpayer (starting at $250,000 per year for joint filers).
Defining an “Activity” When Business Entities Are Involved
The activities of an individual can include not only what is carried out by him personally, but also activities conducted through related business entities, whether they are partnership, LLCs, S corporations, or even certain C corporations. Once entities are involved, defining an individual’s activities can be quite vague. Take, for example, a real-estate developer who is engaged in developing 10 different properties, with each property being, as is common in the industry, owned by a different, though related, LLC. Is such a developer involved in a single activity of real estate development, or is he involved in 10 different activities, one for each project?
The tax law largely permits the individual to decide the answer to that question, so long as the answer represents one of the various ways these entities can be carved up into appropriate economic units. Traditionally, the individual was not forced to declare to the IRS his chosen method of divvying up the entities into activities. Starting in 2011, however, taxpayers must disclose the chosen grouping to the IRS, or else be subject to a default rule that each LLC will be regarded as a separate activity.
The Consequences of Treating Entities Separately or Together
Under the default rule of treating each entity as a separate activity, it is likely that at least some of the hypothetical development projects would be considered passive, because it is unlikely that the developer “materially participates” in all 10 of them (which would require as much as 5,000 hours of work per year). If the passive ones were generating losses, this would mean that those losses could not be used to offset income the developer has from other, active, sources.
On the other hand, treating the LLCs as separate activities may make it easier to later convert accumulated passive losses to active ones because it will be easier to dispose of a single LLC (and therefore of an entire activity, which would convert its accumulated passive losses to non-passive) than it would be to dispose of the entire collective endeavor of ten LLCs.
Heightened Impact to Aircraft
For numerous reasons, a common aircraft-industry practice is to purchase a business aircraft in a dedicated, special-purpose entity, and then have that entity lease the aircraft to a related company for that company’s use in its trade or business. Typically, the aircraft-ownership entity will generate tax losses, due to depreciation, while the lessee/operator entity which conducts the main business may be very profitable. It is extremely valuable for the principal in both related companies to be able to offset the income earned in the operating company with the losses generated in the aircraft-ownership company.
However, if the principal neglects to make an IRS grouping disclosure declaring that the two entities should be treated as part of the same activity, the two entities risk being treated as separate. The likely result of such treatment is that the aircraft entity will be deemed passive, either as a rental activity, or because the principal does not materially participate in it, in isolation. The tax depreciation losses generated by the aircraft will not be usable to reduce the principal’s individual income taxes, unless he or she receives significant passive income, which usually is not the case.
This means that it is essential for aircraft owners to properly submit the Passive-Activity grouping election to the IRS, which will generally require coordination between the individual’s 1040 tax preparer, and those who prepare the tax returns for each entity. This is true because the grouping election must be filed with the 1040 return, but depends on the nature of the activities carried out in business entities owned, in whole or in part, by the individual.
One-Time Opportunity to Correct Activity Grouping
Generally, once a taxpayer has declared his/her chosen grouping of activities, that decision is irrevocable unless changed conditions render it clearly inappropriate, in which case the taxpayer must file an explanatory statement with the IRS. However, in recent regulations, the IRS provides a one-time opportunity to make changes without providing justification. Starting in 2013, the new Net Investment Income Tax raises the tax rate on passive income. Prior to this new tax, it was often desirable to treat income-generating activities as passive, rather than active, because this would mean that the income from them might be offset by other passive activities. The fact that passive activities may now be subject to a higher tax rate radically changes this analysis.
Recognizing this unfairness, the IRS will allow a one-time regrouping of activities, without the need to show that the prior grouping was clearly inappropriate. Complex eligibility criteria govern when a taxpayer is able to take advantage of this fresh-start, but it is generally available in the first year the taxpayer would (without the re-grouping) be required to pay Net Investment Income Tax.
Conclusion
The Passive Activity Rule, if not appropriately handled, has the potential to present an unpleasant surprise to many aircraft owners. There are numerous cases where simply filing a piece of paper (the grouping election) can make all the difference. Tax return 1040 preparers who are not versed in the subject matter should seek guidance before filing tax returns without such elections that may come back to haunt. This article provides a basic introduction to a complex area, but only covers a small portion of the field. Always consult a qualified advisor.
Jonathan Levy, Esq. is Legal Advisor for Advocate Consulting Legal Group, PLLC, a law firm whose practice is limited to serving the needs of aircraft owners and operators relating to issues of income tax, sales tax, federal aviation regulations, and other related organizational and operational issues.
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