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Presenting a live 110‐minute teleconference with interactive Q&A
Passive Activity Loss Rules: Strategies for Pass‐Throughs to Maximize DeductionsLeveraging Latest Federal Guidance and Rulings to Establish Material Participation
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
TUESDAY, FEBRUARY 28, 2012
Today’s faculty features:
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
Anne Bushman, Tax Services 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, [email protected]
Anne Bushman, McGladrey & [email protected]
Monica Tillett, WTAS [email protected]
Michael Grace, Milbank Tweed Hadley & McCloy [email protected]
Today’s Program
Overview Of Federal Passive Activity Loss Rules[Anne Bushman]
Slide 7 – Slide 13
Passive Activity Concepts For Real Estate Professionals[Anne Bushman, Peter Jorstad]
Slide 14 – Slide 20
Material Participation By LPs And LLC Members[Michael Grace]
S R l d P i A i i l d l d
Slide 21 – Slide 30
State Tax Issues Related To Passive Activity Losses[Monica Tillett]
Practical Issues From Compliance Work And Audits
Slide 31 – Slide 36
Slide 37 – Slide 54Practical Issues From Compliance Work And Audits[Anne Bushman, Michael Grace, Peter Jorstad]
Slide 37 Slide 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 yparticipated any three preceding tax years- PSA: Involves the performance of personal services or
other trade or business in which capital is not a material pincome-producing factor
Test seven: Based on facts and circumstances participationTest 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 activitiesAllocated 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 theincrease 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 & PullenPeter Jorstad, CJBS
PASSIVE ACTIVITY CONCEPTS FOR REAL ESTATE PROFESSIONALS
Real Estate Activities
“Per se” passive activitiesp
$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 professionalsS 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 spousep y p Real property trade or business: “Any real property
development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, q , , , p , g , g,or 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 iElecting
How to make election: Why or why not?
Late election under Rev. Proc. 2011-34: Why or why not?
RevocationRevocation
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 hoursActivity 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 on 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 limitedpartner—(i) In general. Except as provided in
section, for purposes of section 469(h)(2) and thisparagraph (e), a partnership interest shall be treated asa limited partnership interest if—
(A) Such interest is designated a limitedhi i i h li i d hi
paragraph (e)(3)(ii) of this section, for purposes ofsection 469(h)(2) and this paragraph (e), an interest inan entity shall be treated as an interest in a limitedpartnership as a limited partner if—
(A) Th i i hi h h i i h ldpartnership interest in the limited partnershipagreement or the certificate of limited partnership,without regard to whether the liability of the holder ofsuch interest for obligations of the partnership islimited under the applicable State law; or
(A) The entity in which such interest is heldis classified as a partnership for Federal income taxpurposes under § 301.7701-3; and
(B) The holder of such interest does noth i ht t th tit t ll ti d i thpp ;
(B) The liability of the holder of such interestfor obligations of the partnership is limited, under thelaw 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 theentity’s taxable year under the law of the jurisdictionin which the entity is organized and under thegoverning agreement.
( pof the holder’s capital contributions to the partnershipand contractual obligations to make additional capitalcontributions 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 tlimited 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 limitedpartner—(i) In general. Except as provided in
section, for purposes of section 469(h)(2) and thisparagraph (e), a partnership interest shall be treated asa limited partnership interest if—
(A) Such interest is designated a limitedhi i i h li i d hi
paragraph (e)(3)(ii) of this section, for purposes ofsection 469(h)(2) and this paragraph (e), an interest inan entity shall be treated as an interest in a limitedpartnership as a limited partner if—
(A) Th i i hi h h i i h ldpartnership interest in the limited partnershipagreement or the certificate of limited partnership,without regard to whether the liability of the holder ofsuch interest for obligations of the partnership islimited under the applicable State law; or
(A) The entity in which such interest is heldis classified as a partnership for Federal income taxpurposes under § 301.7701-3; and
(B) The holder of such interest does noth i ht t th tit t ll ti d i thpp ;
(B) The liability of the holder of such interestfor obligations of the partnership is limited, under thelaw 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 theentity’s taxable year under the law of the jurisdictionin which the entity is organized and under thegoverning agreement.
( pof the holder’s capital contributions to the partnershipand contractual obligations to make additional capitalcontributions to the partnership).
28
Limited Partner Material Participation (Cont.)Current Proposed
(ii) Limited partner holding general partnerinterest.—A partnership interest of an individual shall
(ii) Individual holding an interest other than aninterest in a limited partnership as a limited partner.
not be treated as a limited partnership interest for theindividual’s taxable year if the individual is a generalpartner in the partnership at all times during thepartnership’s taxable year ending with or within theindividual’s taxable year (or portion of the
An individual shall not be treated as holding aninterest in a limited partnership as a limited partner forthe individual’s taxable year if such individual alsoholds an interest in the partnership that is not aninterest in a limited partnership as a limitedindividual s taxable year (or portion of the
partnership’s taxable year during which the individual(directly or indirectly) owns such limited partnershipinterest).
interest in a limited partnership as a limitedpartner (as defined in paragraph (e)(3)(i) of thissection), such as a state-law general partnershipinterest, at all times during the entity’s taxable yearending with or within the individual’s taxable year (orth ti f th tit ’ t bl d i hi hthe portion of the entity’s taxable year during whichthe individual (directly or indirectly) owns suchinterest 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 limitedhi b d h f hi h i 469 d dpartnership based on the purposes for which section 469 was enacted, and
the manner in which the provision is structured and operates within theCode. Accordingly, the rules concerning an interest in a limited partnershipin the proposed regulations are provided solely for purposes of section 469in the proposed regulations are provided solely for purposes of section 469and no inference is intended that the same rules would apply for any otherprovisions of the Code requiring a distinction between a general partner anda limited partnera 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 §469Code; oweve , o spec c e t o o C § 69
B. Specific 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 dportion disallowed
III.Non-conformity with IRC §469
32
S C f i Wi h IRC § 6State Conformity With IRC §469No personal income taxGeneral conformitySpecific conformityConformity with exceptionsDoes not conform
33
State Conformity With IRC §469 (Cont.)
I.New York
1. Current conformity with IRC
2 Form IT 1822. Form IT-182
II.Maryland
A. Current conformity with IRCy
B. No form used to calculate passive activity limitations
a. Instead, passive activity losses are limited, based on the loss ratio calculated on the federal Form 8582.
34
S C f i Wi h E iState Conformity, With Exceptions
I.California – Cal. Rev. & Tax. Cd. §17561 modifies IRC §469
A. Definition of passive activities
1 Real property trade or business professionals1. Real property trade or business professionals
B. Calculation of loss on disposition of passive activity
C Limitation amountsC. Limitation amounts
1. Rental real estate limitation related to low-income housing
D. CA Form 3801
35
State Non‐Conformity With IRC §469
I PennsylvaniaI.Pennsylvania
A. Income items are grouped into categories and reported on p. 1 of Form PA-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 PA taxable income.
a. No carryover for disallowed losses
2. Spouses 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 & PullenMichael Grace Milbank Tweed Hadley & McCloy
PRACTICAL ISSUES FROM
Michael Grace, Milbank Tweed Hadley & McCloyPeter 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 EFocus 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 oractivities, 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 timay 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 themeans 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 dexamination or when preparing for court) are viewed unfavorably and
suspiciously.
Lists without precise hours are unpersuasive; approximated or estimated hours d ’t t itdon’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 MedicalGroup, Inc.(S Corp.)
Salary, Rents
Lease: Building
Patients
Lease: Building
Lease: MRI Scanner MedicalServices
Patients
46
Self-Rented Property (Cont.)Item Amount 469 Character
Salary $300 000 ActiveSalary $300,000 Active
Rental: Building 75,000 Active
Rental: MRI scanner (24,000) Passive
47
Self-Rented Property (Cont.)
Doctor Ozzie Other DoctorsDoctor Ozzie Other Doctors
30%
70%
Harrietta MedicalGroup, Inc.(C Corp.)
Salary, Rents
Lease: Building
Patients
Lease: Building
Lease: MRI Scanner MedicalServices
Patients
48
Self-Rented Property (Cont.)Item Amount 469 Character
Salary $300 000 ActiveSalary $300,000 Active
Rental: Building 75,000 Active
Rental: MRI Scanner (24,000) Passive
49
Self-Rented Property (Cont.)
Doctor Ozzie Other DoctorsDoctor Ozzie Other Doctors
0%
100%
Harrietta MedicalGroup, Inc.(S Corp.)
Salary, Rents
Lease: Building
Patients
Lease: Building
Lease: MRI Scanner MedicalServices
Patients
50
Self-Rented Property (Cont.)Item Amount 469 Character
Salary $300 000 ActiveSalary $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 ISelf‐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