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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, CJBSpaj@cjbs.com

Anne Bushman, McGladrey & Pullenanne.bushman@mcgladrey.com

Monica Tillett, WTAS LLCmonica.tillett@wtas.com

Michael Grace, Milbank Tweed Hadley & McCloy mgrace@milbank.com

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