April 24, 2017
Do you materially participate in a business or rental activity — or are you just a passive investor who isn’t directly involved in a project’s day-to-day operations? The IRS has prescribed seven tests to help individuals classify income, gains and losses from activities as passive or nonpassive. (See “PAL Basics” below.)
The passive activity loss (PAL) rules have been around since 1986. In general, passive investors can currently deduct PALs only to the extent that they have income from other passive activities. Here are a couple of recent examples of how the IRS and courts are currently interpreting the PAL rules in real-life situations.
IRS Auditor Could Not Regroup S Corporation Shareholder’s Activities
For purposes of applying the PAL rules, the IRS has the power to regroup a taxpayer’s activities. They might exercise this power if the taxpayer’s grouping or groupings don’t result in appropriate economic units, and a principal purpose of the taxpayer’s grouping or groupings is to circumvent the PAL rules.
In the facts underlying a recently released IRS technical advice memo, the taxpayer was a medical doctor who owned interests in and was employed by two S corporations. The doctor also held an indirect interest in an outpatient surgery facility, and his income from the surgery facility wasn’t tied to the number of surgeries he performed there.
On his personal federal income tax returns, the doctor didn’t group the S corporations and surgery facility activities together for PAL purposes. Instead, he kept them separate and offset passive income from the surgery facility with passive losses from the unrelated rental activities. The IRS Office of Chief Counsel concluded that the taxpayer’s grouping of activities wasn’t done with a principal purpose of circumventing the PAL rules. Therefore, the auditor wasn’t allowed to regroup the activities to achieve a more disadvantageous result for the taxpayer.
Supreme Court Refuses to Rule on Extraordinary Personal Services Exception
Under the PAL rules, rental activities are generally classified as passive by default. However, a favorable exception stipulates that the rental of tangible property isn’t a passive activity if the property owner provides extraordinary personal services.
Extraordinary personal services are considered to be provided only if the customers’ use of the taxpayer’s property is incidental to their receipt of such services. For example, a hospital is considered to provide extraordinary personal services to its patients, because the patients’ use of hospital facilities is incidental to the receipt of medical services. Similarly, a boarding school’s dormitory is considered to provide extraordinary personal services to the school’s students, because the students’ use of the dormitory is incidental to the receipt of educational services.
The Supreme Court recently declined to review a decision by the Fourth Circuit Court of Appeals that denied a deduction for the taxpayers’ losses from rental properties. The Fourth Circuit found that the rental losses were disallowed by the PAL rules, and that the aforementioned extraordinary personal services exception didn’t apply. (Brad Johnson and Elci Wijayaningsih v. Abby Pope, 117 AFTR 2d 2016-947, 4th Cir. 2016, October 3, 2016)
The taxpayers were a married couple who deducted losses incurred in 2006 and 2007 from three rental real estate properties. After an audit, the IRS disallowed the deductions under the PAL rules. The taxpayers went to District Court claiming that their losses were deductible because they provided extraordinary personal services in connection with their rental properties.
Specifically, the taxpayers claimed that they provided their renters with such amenities as fire and horseshoe pits, satellite television service, kitchen dishes and appliances, furniture, cleaning supplies, periodic household services, landscaping, bathroom toiletries, laundry facilities and continental breakfasts. The taxpayers also claimed that the husband provided counseling services to renters, including legal, tax, financial and psychological counseling. One of the renters testified that these extra amenities and services were the reason he had rented from the taxpayers. The renter also stated that he had observed other renters receiving similar services.
However, the District Court concluded that, even construing all facts and inferences in favor of the taxpayers, they still failed to establish that their renters received services that were akin to those offered by a hospital or boarding school, where the prime concern of the occupants is the receipt of such services. According to the District Court, the only services that would differentiate the taxpayers’ rental properties from typical rental properties were the counseling services that were allegedly provided by the husband.
Upon appeal, the Fourth Circuit affirmed the District Court’s decision. And the Supreme Court has declined to review the case, effectively finalizing the Fourth Circuit’s decision.
Plan Ahead
The PAL rules have been around for decades. But they still aren’t necessarily well understood — even by the IRS and courts. If you have business or rental activities that generate tax losses, you could be subject to the PAL rules. However, with strategic planning, you may be able to minimize or even eliminate the adverse effects of the PAL rules. Contact your tax advisor if you have questions or want more information.
© 2017