Practice Areas

Proposed Regulations Provide Opportunity to Regroup Activities under the Passive Activity Rules

January 23, 2013
Joshua L. Cannon

The IRS recently released proposed regulations detailing the new 3.8% tax on net investment income (“NII”) contained in Code section 1411, which was created as part of PPACA.  This new NII tax applies only to individuals filing a joint return with modified adjusted gross income of more than $250,000 ($200,000 for single filers) and trusts and estates with adjusted gross income in an amount placing such trust or estate in the highest income tax bracket for trusts and estates ($11,950 for 2013).  The proposed NII regulations contain considerable detail on exactly which individuals, estates, and trusts are subject to the tax, what income is includable in NII, and what deductions may be taken against such income.

The IRS included a new proposed regulation under Code section 469, the passive activity rules, with the proposed NII regulations.  This new proposed passive activity regulation may provide taxpayers subject to the NII tax with an opportunity to reduce the amount of their NII.  

As background, one category of income subject to the NII tax is gross income from a trade or business that is a passive activity with respect to the taxpayer as determined under the passive activity rules.  In general, passive activities are those activities in which a taxpayer does not materially participate, which is generally determined based on whether the taxpayer meets certain minimum hourly participation thresholds for such activities.  The passive activity rules limit the deduction of losses generated by such passive activities.

The regulations under the passive activity rules provide taxpayers with the ability to group various activities together for purposes of determining whether such activities are passive.  Under these regulations, taxpayers may group activities only if such activities constitute an appropriate economic unit under the taxpayer's particular facts and circumstances.  Factors to consider in this determination include the similarities between the activities, their geographic location, their ownership, and the extent to which they are interdependent.  By grouping together various activities in which the taxpayer participates into a single activity for purposes of the passive activity rules, the taxpayer may exceed the applicable hourly participation threshold under which an activity would be deemed passive and thereby avoid the deduction limitations on losses from passive activities.  However, once a grouping election is made, the taxpayer generally must continue to use such grouping in all future years, unless a change in the taxpayer's facts and circumstances renders the grouping clearly inappropriate.

The newly proposed passive activity regulation provides taxpayers that have made such groupings with a one-time, “no questions asked” chance to regroup their activities, as long as the regrouping continues to comply with the passive activity regulations for making such groupings (i.e., the grouping constitutes an appropriate economic unit under the taxpayer's facts and circumstances).  Notably, this opportunity is available only in the first year in which the taxpayer is subject to the NII tax. 

By taking advantage of the chance to regroup their activities for purposes of the passive activity rules, taxpayers subject to the NII tax may be able to reduce their potential exposure to the tax by creating groupings that remove additional activities from the passive activity rules and thereby reduce the amount of income includable in NII.  This may be the only way for taxpayers to avoid the NII tax on income generated by passive activities.  As with groupings made previously, the taxpayer must continue to use any regrouping made in connection with the NII tax in subsequent tax years, unless the taxpayer's facts and circumstances change in a way that a regrouping is permissible under the passive activity regulations.

TAX ADVICE LIMITATION:  To ensure compliance with the requirements of Circular 230, we inform you that any tax advice contained above is not intended or written to be used and cannot be used (i) by any taxpayer for the purpose of avoiding penalties that may otherwise be imposed under the Internal Revenue Code or (ii) by anyone for the purpose of promoting, marketing or recommending to another party any entity, investment plan or arrangement addressed herein.