The Tax Reform Act of 1986 created Internal Revenue Code (I.R.C.) Section 469.' The purpose of this Section is to prevent certain taxpayers from sheltering income with non-cash losses from businesses in which the taxpayers do not participate. The new Regulations are intended to provide taxpayers with guidance on compliance with the rules of Section 469. Taxpayer compliance is difficult for two reasons: First, the Regulations do not address some of the key Section 469 concepts and rules. The Section 469 concepts and rules omitted by the first set of Section 469 Regulations will be discussed in future regulations. The Treasury Department has not made known either the content or the date of future Section 469 regulations. The only currently available guidance for complying with the Section 469 rules that the Treasury Department has deferred to future regulations is Section 469 itself and its legislative history. Second, both the Section 469 rules and the new Regulations are characterized by labrynthian complexity. This article reduces the complexity by explaining the logic and concepts underlying Section 469 and the new Regulations. The overall logic of Section 469 and the new Regulations is based on differentiating three types of income and loss and placing limitations on the ability to offset either (a) one type of income with another type of loss, or (b) the amount of income with the same type of loss. Generally, loss is the excess of deductions allowed under the I.R.C. over taxable gross income. This article explains how the three types of gross income and the three types of allowable deductions are used to determine the three types of losses and the limitations placed on the type and amount of income these losses can offset.
This article begins by explaining how the Regulations define taxpayers to which the Section 469 rules apply. Next, it is shown that the key, to understanding the limitations the Section 469 rules and the new Regulations place on the ability to offset income with losses is th6 concept of an income-generating activity. Unfortunately, a discussion of what constitutes an activity has been deferred to future regulations. This deferral is unfortunate because Section 469 uses the concept of an income-generating activity to differentiate three types of gross income - active, passive, and portfolio. This article goes on to show how the Regulations explain what constitutes active activity, passive activity, and portfolio activity gross income. What distinguishes the three types of income is the degree of taxpayer participation in the income-generating activity. Gross income is active if the taxpayer materially participates in generating it. Separate regulations are provided for what constitutes "material" and "participation." Gross passive activity income is either income generated without the taxpayer's participation or rental income. Gross portfolio income is income generated by the taxpayer's investment activities. This article continues by explaining how the recharacterization rules in the Regulations are designed to prevent taxpayers from converting certain passive activity gross income into active activity income or portfolio activity income. Understanding the three types of income and the recharacterization rules is important because they determine the characterization of deductions and, hence, losses. The characterization of losses as active, passive, or portfolio is important because their character determines the amount and type of income they can offset.
The next section of this article explains that deductions are active if (1) incurred in the generation of active income, (2) passive, if incurred in the generation of passive income, and (3) portfolio, if incurred in the generation of portfolio income. Since loss is the excess of deductions allowed under the I.R.C. over taxable gross income. The three types of gross income and the three types of allowable deductions determine the character of losses. Active activity losses occur when active activity deductions exceed taxable active gross income. Passive activity losses (PALs) occur when passive activity deductions exceed taxable passive activity gross income. Losses are portfolio losses if generated by portfolio activities. Further, this article points out that (a) the character of losses received from flowthrough entities depends on the taxpayer's degree of participation in the activities that generated them and (b) that special rules apply to the characterization of a closely-held corporation's losses.
The next section of this article explains that a passive activity credit (PAC) is a tax credit arising in connection with a passive income-generating activity.
The explanation of what constitutes a PAL and a PAC is followed by a discussion of the limitations imposed on their ability to offset the three types of income. Generally, a taxpayer may use active activity losses to offset any other type of income. The limitations placed on PALs and PACs are similar. A taxpayer may use PALs only to offset passive activity income and PACs only against taxes from passive activity income. If no passive activity income is available, the PALs are suspended and may be used as deductions in the same activity that generated them in the immediately succeeding taxable year. The ability to offset portfolio losses is governed by other sections of the I.R.C. Realized losses resulting from a complete taxable disposition of either an active or a passive income-generating activity may be used to offset any other type of income except portfolio income.
This article goes on to explain the three exceptions to the PAL rules. These exceptions are for a working interest in an oil- and gas-producing activity, rental real estate, and trading personal property.
Obviously, no specific tax planning suggestions can be made based on an overview of the first set of Section 469 regulations. However, some general tax planning principles that can be inferred from the Regulations are provided.
Lastly, this article concludes that considerably more guidance is needed in the form of Treasury Department regulations in order for taxpayers to comply with Section 469.
"Passive Activity Losses in Light of the New Section 469 Temporary Regulations,"
Akron Tax Journal: Vol. 5
, Article 6.
Available at: https://ideaexchange.uakron.edu/akrontaxjournal/vol5/iss1/6