The principles behind the passive-activity loss limitations rules under Code Sec. 469 and the net investment income Medicare tax under Code Sec. 1411 are similar -- limit business losses from passive activities or raise the tax on passive-type income a bit more, when not the direct result (at least not a significant part) of a taxpayer's labor. Congress, however, did not leave it at that -- or, as some would argue, leave well enough alone.

One particular congressional "embellishment" that has attracted attention lately revolves around the carve-out of special rules -- exceptions and exceptions to the exceptions - for real estate. Intertwined is the interrelationship of real estate and rent from real estate to a "trade or business." The spotlight on this area has been intensified recently because of the debate over how proposed regulations under Section 1411 ought to be modified before they are made final later this year. So, too, have questions regarding the application of both Code Secs. 469 and 1411 to trusts, and what activities by the trustee can help save a trust from both Code Secs. 469 and 1411.



The term "passive activity," for purposes of being subject to the Code Sec. 469 passive-loss limitations, in general means any activity that involves the conduct of any trade or business in which the taxpayer does not materially participate. Persons under this rule include any individual, estate or trust, any closely held C corporation, and any personal service corporation.

Thus, both a trade or business and the absence of material participation by the taxpayer are generally required to trigger the Code Sec. 469 passive-loss rules. Exceptions for real estate, certain investments and R&E activities, however, complicate matters and may call for different strategies.

Material participation. A taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis that is regular, continuous and substantial (Code Sec. 469(h)). Material participation is determined for each tax year. Material participation in an activity depends generally on the facts and circumstances. Safe harbor provisions exist under the regulations.

Treatment of rents and real estate. Real estate receives special treatment under Code Sec. 469 - primarily through the application of more restrictive requirements to exempt rents from real estate from the passive-loss rules. Thus, Code Sec. 469(c) provides that the term "passive activity" generally includes any rental activity, irrespective of whether the taxpayer materially participates (or, for that matter, whether or not such real estate holding technically qualifies as a trade or business). A real estate professional exception, however, does save the day for those taxpayers who make real estate management an occupation.

The "real estate professional" exception under Code Sec. 469(c)(7)(B) provides that if more than one half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and that taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates, gain and losses are not considered passive. When testing here, the aggregation of activities by the taxpayer is counted, but service of an employee who is a less-than-5-percent owner are not counted, nor is participation with respect to an interest in any rental real estate activity that is less than 10 percent by value of all interests in such activity.

Grouping under Code Sec. 469. Under Code Sec. 469, one or more trade or business activities or rental activities may be treated as a single activity if the activities constitute an "appropriate economic unit for the measurement of gain or loss." Whether activities make up an "appropriate economic unit" for this single-activity grouping depends upon all the "relevant facts and circumstances."

Further, in the case of pass-through entities, and closely held C and personal service corporations, the combination or separation of activities is made at the entity level and is binding on the shareholders and partners. Therefore, each shareholder or partner needs to be aware of what combination or separation of activities best suits their interests, especially since they generally may combine their share of the entity's activity or activities with other activities they own individually or though another entity. Once the entity opts for a certain grouping, however, a shareholder or partner cannot undo the choice.

Likewise, once the taxpayer combines activities into one or treats each separately as the facts and circumstances may support, they must continue treating them the same way in the future, unless facts and circumstances change materially, or unless the IRS determines that the original grouping was clearly inappropriate.

Rental activities. Rental activities, as is the case with the basic passive-loss rules, carry their own set of grouping rules. A taxpayer may group trade or business activities with rental activities only if one is insubstantial in relation to the other and they constitute an appropriate economic unit. "Insubstantial" for this purpose has not been clearly defined, although prior proposed regulations that are now lapsed have suggested that up to a 20 percent level was insubstantial.

In another rental variation, a taxpayer may also combine the portion of a rental activity that involves the rental of property to the taxpayer's trade or business with the trade or business activity, regardless of whether one activity is insubstantial in relation to the other, if each owner of the trade or business activity has the same proportionate ownership in the rental activity.



For tax years beginning after Dec. 31, 2012, the net investment income tax on individuals equals 3.8 percent of the lesser of: net investment income for the tax year, or the excess, if any, of the individual's modified adjusted gross income for the tax year, over the threshold amount.

The threshold amount, in turn, is equal to: $250,000 in the case of a taxpayer making a joint return or a surviving spouse, $125,000 in the case of a married taxpayer filing a separate return, and $200,000 in any other case.

Trusts and estates are also subject to the NII surtax, to the extent of the lesser of: undistributed net investment income, or the excess of adjusted gross income over the dollar amount at which the highest tax bracket begins (which, for 2013, is $11,950).

Net investment income defined. Much of the space of the proposed regs is taken up with elaborating on the definition of "net investment income." In doing so, it becomes clear that net investment income does not equal passive-activity income by a long shot, despite the proposed regulations' lip service to the regulations' applying Code Sec. 469 unless otherwise appropriate. The code itself (Code Sec. 1411(c)(1)) defines net investment income as the sum of:

  • Category (i) income: Gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business not described in Code Sec. 1411(c)(2);
  • Category (ii) income: Other gross income derived from a trade or business described in Code Sec. 1411(c)(2); and,
  • Category (iii) income: Net gain attributable to the disposition of property, other than property held in a trade or business not described in Code Sec. 1411(c)(2); over,

Deductions properly allocable to such gross income or net gain.
A Code Sec. 1411(c)(2) trade or business includes a passive activity under Code Sec. 469 with respect to the taxpayer or trading in financial instruments or commodities.



The language used by the code to describe the three categories or buckets of net investment income is far from straightforward and has made implementation difficult. For some taxpayers, the attempt by the proposed regs to better explain these provisions has only led to further complications.

For example, the preamble states that passive activity under Code Sec. 1411 is narrower than under Code Sec. 469. However, the regulations do not elaborate. Other practitioners have recommended that, for simplicity's sake, final regulations apply the passive-activity rules under Code Sec. 469 consistently and across the board for use under Code Sec. 1411, rather than carving out exceptions in an effort to thwart every possible tax avoidance strategy.

Self-rentals. There is also concern that the preamble to the proposed regs may be read to mean that, despite any grouping under Code Sec. 469, each rental activity on its own must rise to the level of a Code Sec. 162 trade or business in order to escape the NII tax. To quote the preamble: "...a proper grouping under § 1.469-4(d)(1) (grouping rental activities with other trade or business activities) will not convert gross income from rents into other gross income derived from a trade or business described in proposed § 1.1411-5(a)(1)."

If a grouping is deemed proper under Code Sec. 469, it should be acceptable under Code Sec. 1411, taxpayers have commented. Practitioners are concerned by the preamble where it states that combining a trade or business activity with a rental activity does not necessarily cause the rents to be "derived in the ordinary course of a business."

Regrouping elections. The proposed regs permit taxpayers subject to the NII surtax to elect to regroup their activities for passive-loss purposes in 2013 or 2014. This regrouping election allows taxpayers a fresh start to accommodate the new NII surtax. Without permitting regroupings, taxpayers would be bound by their original grouping decisions, some of which may have been made as many as 20 years ago, under the consistency rules of Reg. Sec.1.469-4(e).

The American Bar Association Section of Taxation, in a recent comment letter, recommended two changes to the regrouping election as it has existed under Code Sec. 469. First, S corps and partnerships should be allowed to change their regrouping election because of Code Sec. 1411 for any tax year that begins during 2013 or 2014. Second, all taxpayers, irrespective of whether they hold net investment income or MAGI above the threshold, should be permitted a fresh start to change a Code Sec. 469 grouping for 2013 or 2014.

Participation of a trustee. In TAM 201317010, the issue arose whether a particular trust materially participated in the activities of two S corporations for purposes of applying Code Sec. 469 material participation rules to an Alternative Minimum Tax adjustment for R&E expenditures under Code Sec. 56(b). There, the IRS declined to attribute the trustee's activities as president and participating shareholder in the S corps in assessing material participation within the S corps businesses.

While there are no regulations regarding material participation by trusts, the legislative history indicates that a trust materially participates if "a fiduciary, in his capacity as such, is so participating." Case law is also relatively scant. Mattie K. Carter Trust, 2003-1 USTC ¶50,418, held that the activities of a trust's fiduciaries, employees and agents should all be considered in determining whether the trust materially participates.

However, the TAM confirms that the IRS continues to refuse to read into the Carter Trust decision any leeway that would allow a trustee's activities to be included beyond the narrow role of doing so only wearing the hat of the fiduciary. The fact that the task gets done by the same person, whether as an employee or trustee, apparently is irrelevant according to the IRS's position in the TAM. "Formalities" in designating who is doing what for which entity therefore should be a part of tax planning in this area. In the TAM, for example, the arrangement might have called for the S corporation hiring the individual "as trustee" to "materially participate" under his fiduciary responsibility to preserve trust corpus. While the TAM addresses only Code Sec. 469, the same issue seems to resonate in applying the NII tax under Code Sec. 1411: Can the trustee be considered to materially participate?

A different approach? The need to make 469 work for 1411 purposes, with exceptions, has been challenged by the introduction of a number of different proposals. One simplification suggestion calls for changing Code Sec. 1411 to be a tax of exclusion. That is, net investment income would be defined as taxable income, adjusted to exclude income subject to the self-employment tax, wages, retirement benefits, and other specified items.

Another suggestion to simplify application of Code Sec. 1411 is to create a rule that automatically finds "trade or business" under Code Sec. 1411 when either the real estate professional exception exists or the self-rental exception exists. Under Code Sec. 1411, two tests in essence must be met for income to avoid being subject to the NII tax:

1. The income is not passive under Code Sec. 469, and,

2. The income must be derived in a trade or business.



The Treasury and the IRS have their work cut out for them in trying to address all the concerns being voiced over application of the new NII tax. Although the proposed regulations were issued as "reliance regs," many taxpayers are hard pressed to move forward with certain tax strategies without being exactly sure about what the reliance regs say. In dealing with both Code Sec 469 and 1411, having a taxpayer materially participate in an activity seems to be a safe harbor upon which everyone can agree. The issue remains, however, in defining the extent of that activity and how various combinations of "activities" can either make or break a particular strategy.



George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.

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