REPORT # 585 TAX SECTION New York State Bar Association PRELIMINARY REPORT ON TEMPORARY AND PROPOSED REGULATIONS UNDER SECTION 469 by the Committees on Income from Real Property and Personal Income July 28, 1988 Table of Contents Cover Letter 1:... i I. Introduction.... 1 II. Outline of Statutory Provisions... 2 III. Overview of Temporary Regulations.... 13 IV. Major Conceptual Comments.... 15 V. Comments on Significant Policy Issues.... 20 VI. Technical Comments on Temporary Regulations.... 26 Paragraph -1T(e)(3)... 26 Paragraph -1T(e)(4)... 36 Paragraph -2T(c)(6)... 39 Paragraph -1T(e)(6)... 41 Paragraph -1T(f)(2)... 43 Paragraph -1T(g)... 44 Paragraph -1T(h)... 49 Paragraph -2T(c)(2)... 54 Paragraphs -2T(d)(1) and -2T(d)(8)... 56 Paragraph -2T(f)... 57 Paragraph -2T(f)(2)... 58 Paragraph -2T(f)(4)... 58 Paragraph -2T(f)(7)... 60 Paragraph -5T... 60
OFFICERS HERBERT L. CAMP Chair 1 Chase Manhattan Plaza New York City 10005 WILLIAM L. BURKE First Vice-Chair One Wall Street New York City 10005 ARTHUR A. FEDER Second Vice-Chair 1 New York Plaza New York City 10004 JAMES M. PEASLEE Secretary 1 State Street Plaza New York City 10004 COMMITTEES CHAIRS Alternative Minimum Tax Robert A. Jacobs, New York City Sherwin Kamin, New York City Bankruptcy Matthew A. Rosen, New York City Eugene L. Vogel, New York City Consolidated Returns Richard D'Avino, Washington, D.C Michael L. Schler, New York City Continuing Legal Education Richard F. Campbell, Buffalo Laraine S. Rothenberg, New York City Corporations Kenneth H. Heitner, New York City Richard L. Reinhold, New York City Criminal and Civil Penalties Robert S. Fink, New York City Michael I. Saltzman, New York City Depreciation and Amortization Bruce M. Montgomerie, New York City Arthur R. Rosen, New York City Employee Benefits Kenneth C. Edger, Jr., New York City Barbara D. Klippert, New York City Estate and Gift Taxes Linda B. Hirschson, New York City Jerome A. Manning, New York City Exempt Organizations Sherman F. Levey, Rochester Harry E. White, New York City Financial Institutions John A. Corry, New York City Robert J. McDermott, New York City Financial Institutions Peter C. Canellos, New York City Thomas A. Humphreys, New York City Foreign Activities of U.S. Taxpayers Sherry S. Kraus, Rochester Victor Zonana, New York City Income of Estates and Trusts Henry Christensen, III, New York City Carlyn S. McCaffrey, New York City Income From Real Property Michael Hirschfield, New York City Stuart L. Rosow, New York City Insurance Companies Irving Salem, New York City Michelle P. Scott, Newark. N.J. Interstate Commerce Robert E. Brown, Rochester Paul R. Comeau, Buffalo Net Operating Losses William F. Indoe, New York City Matthew M. McKenna, New York City New York City Tax Matters Carolyn Joy Lee lchel, New York City Robert J. Levinsohn, New York City New York State Tax Maters William M. Colby, Rochester Hugh T. McCormick, New York City Partnerships Steven C. Todrys, New York City R. Donald Turlington, New York City Personal Income Thomas V. Glynn, New York City William H. Weigel, New York City Practice and Procedure Richard J. Bronstein, New York City Sydney R. Rubin, Rochester Reorganizations James A. Levitan, New York City Stanley L. Rubenfeld, New York City Sales, Property and Miscellaneous E. Parker Brown, II, Syracuse Sterling L. Weaver, Rochester Tax Accounting Matters James S. Halpern, Washington, D.C. George E. Zeitlin, New York City Tax Exempt Bonds Henry S. Klaiman, New York City Steven P. Waterman, New York City Tax Policy Alan W. Granwell, Washington, D. C Richard O. Loengard, Jr., New York City Unreported Income and Compliance Victor F. Keen, New York City Richard M. Leder, New York City U.S. Activities of Foreign Taxpayers Cynthia G. Beerbower, New York City Charles M. Morgan Ill, New York City REPORT # 585 TAX SECTION New York State Bar Association MEMBERS-AT-LARGE OF EXECUTIVE COMMITTEE M. Bernard Aidinoff James S. Eustice Frank Green James Locke Mikel M. Rollyson Donald C. Alexander David C. Garlock Ely Jacobsen Stephen L. Millman Susan P. Serota David H. Brockway Patricia Geoghegan Edward D. Kleinbard Stephen M. Piga David E. Watts Dear Larry: Section 469 Regulations August 3, 1988 I enclose our preliminary report concerning the temporary and proposed regulations under Code Section 469, prepared by members of the Committees on Income from Real Property and Personal Income. The principal authors of the report were Thomas V. Glynn, James S. Halpern, Michael Hirschfeld and William H. Weigel. Helpful comments were received from Samuel Brodsky, William Burke, Carolyn Ichel, Robert Levinsohn, Donald Schapiro, David Watts and Ralph Winger. The report recognizes that the passive activity statutory rules are complex and that the regulations must be drafted in a manner that prevents taxpayers from manipulating their business activities so as to have the best of both worlds-- passive income in income years and active losses in loss years. We believe, however, that the final regulations would benefit from an increased use of objective standards and safe harbors. We also believe that, in general, whether an activity produces income or loss, the same standard should be applied for purposes of determining the active or passive character of the activity. We further believe the final regulations should devote some attention to the concept of positive income FORMER CHAIRMEN OF SECTION Howard O. Colgan Peter Miller Martin D. Ginsburg J. Roger Mentz Charles L. Kades John W. Fager Peter L. Faber Willard B. Taylor Carter T. Louthan John E. Morrissey Jr. Renato Beghe Richard J. Hiegel Samuel Brodsky Charles E. Heming Alfred D. Youngwood Dale S. Collinson Thomas C. Plowden-Wardlaw Richard H. Appert Gordon D. Henderson Richard G. Cohen Edwin M. Jones Ralph O. Winger David Sachs Donald Schapiro Hon. Hugh R. Jones Hewitt A. Conway Ruth G. Schapiro i
sources as that term is: used in the legislative history of Section 469, and that several of the per se non-passive rules should be revised to be more closely aligned with that standard. Please note that we have not commented on all aspects of the initial set of temporary and proposed regulations, in large part because we believe that the definition of the term activity will have such a significant impact that our comments will be more meaningful after that definition is proposed. Accordingly, we contemplate that we will be submitting additional comments as additional sections of the regulations are proposed. Sincerely, Herbert L. Camp The Honorable Lawrence B. Gibbs, Commissioner of Internal Revenue, 1111 Constitution Avenue, N.W., Washington, D.C. 20224 Copies w/encl. to The Honorable O. Donaldson Chapoton, Assistant Secretary of Treasury for Tax Policy, U. S. Treasury Department, 1500 Pennsylvania Avenue, N.W., Washington, D.C. 20220 Dennis E. Ross, Esq., Deputy Assistant Secretary for Tax Policy, Department of Treasury, Main Treasury Building, 1500 Pennsylvania Avenue, N.W., Washington, D.C. 20220 ii
Dana L,. Trier, Esq., Tax Legislative Counsel, Department of Treasury, Mein Treasury Building, 1500 Pennsylvania Avenue, N.W., Washington, D.C. 20220 Ronald A. Pearlman, Esq., Chief of Staff, Joint Committee on Taxation, 1015 Longworth, House Office Building, Washington, D.C. 20515 iii
REPORT # 585 PRELIMINARY REPORT ON TEMPORARY AND PROPOSED REGULATIONS UNDER SECTION 469 Prepared by the Committees on Income from Real Property and Personal Income New York State Bar Association Tax Section July 28, 1988
New York State Bar Association Tax Section Committee on Income from Real Property Committee on Personal Income Preliminary Report on Temporary and Proposed Regulations under Section 469 1 I. Introduction. Section 501(a) of P.L. 99-514, the Tax Reform Act of 1986 (the 1986 Act ), added Section 469 to the Internal Revenue Code. 2 Amendments to Section 469 were included in the Revenue Act of 1987, P.L. 100-203 (the 1987 Act ). In addition, certain amendments to Section 469 are currently pending in the Technical Correction Bills of 1988 (H.R. 4333 and S. 2238, referred to herein as the Technical Corrections Bills ). In general, Section 469 creates a new category of activities passive activities -- and provides that in the case of individuals, estates, trusts, personal service corporations and, in a modified manner, closely held C corporations, passive activity losses and passive activity credits generally may not be used to reduce tax liability 1 This report was prepared by Thomas V. Glynn, James S. Halpern, Michael Hirschfeld and William H. Weigel. Helpful comments were received from Samuel Brodsky, William Burke, Carolyn Ichel, Robert Levinsohn, Donald Schapiro, David Watts and Ralph Winger. 2 Except where otherwise specified, all Section references herein are to sections of the Internal Revenue Code of 1986 (the "Code") and all regulation paragraph references are to paragraphs of Temp. Treas. Reg. 1.469-1T through 1.469-11T. 1
relating to compensation income, portfolio income or active business income. Temporary regulations were issued (and also published for comment as a notice of proposed rule making) in the Federal Register on February 25, 1988 at pages 5686 and 5733 (T.D. 8175 and LR-14-88). 3 This report comments on certain aspects of the Temporary Regulations. A number of key provisions of Section 469 were not covered in T.D. 8175 and LR-14-88 and, accordingly, we anticipate that we will have further comments on the Temporary Regulations after further guidance on those reserved issues is published. II. Outline of Statutory Provisions. Section 469(a) of the Code applies to individuals, estates, trusts, 4 personal service corporations (and, in a modified manner, closely-held C corporations). It requires those taxpayers to identify their passive activities 5 and determine their aggregate losses and aggregate income from all passive activities for the taxable year, and provides that, with certain exceptions, any excess of such loss over such income 3 For convenience, the temporary and proposed regulations will be referred to herein as "Temporary Regulations." 4 The application of Section 469 to trusts, estates and their beneficiaries is reserved in the Temporary Regulations (Paragraphs -8T; - 5T(g)). 5 The term "activity" is not defined in the statute and is reserved in the Temporary Regulations (Paragraph -4T). 2
(the passive activity loss ) is not currently deductible. 6 Similarly, such taxpayers must determine the sum of their credits from all passive activities allowable for the taxable year; with certain exceptions, such credits are not allowed to the extent that they exceed the taxpayer's regular tax liability for the taxable year allocable to all passive activities. 7 Section 469(b) provides that suspended losses and suspended credits are treated as deductions or credits allocable to the same passive activities in the next taxable year. Section 469(c) defines the term passive activity to mean any activity that involves the conduct of any trade or business in which the taxpayer does not materially participate. The term passive activity includes any rental activity, regardless of whether the taxpayer materially participates in the activity, or whether it constitutes a trade or business. The 6 These losses will be referred to as "suspended losses." 7 These credits, referred to herein as "suspended credits," are those under Section 27(b) (the Section 936 credit), Section 28 (credit for clinical testing expenses for certain drugs for rare diseases or conditions), Section 29 (credit for producing fuel from a non-conventional source), and Section 38 (general business credits, including the investment credit determined under Section 46(a), the alcohol fuels credit determined under Section 40(a), the targeted jobs credit determined under Section 51(a), the credit for increasing research activities determined under Section 41(a) and the low income housing credit determined under Section 42(a)). 3
term passive activity does not, however, include any working interest in any oil or gas property held by the taxpayer directly or through an entity that does not limit the liability of the taxpayer with respect to such interest. The term trade or business is not defined in Section 469, but includes any activity involving research or experimentation within the meaning of Section 174 and, to the extent provided in regulations, any activity in connection with a trade or business or any activity with respect to which expenses are allowable as a deduction under Section 212. Section 469(d) defines the terms passive activity loss and passive activity credit. Section 469(e) provides a number of special rules to be used in determining income or loss from a passive activity. First, there shall not be taken into account gross income from interest, dividends, annuities or royalties not derived in the ordinary course of a trade or business. Second, income or loss attributable to an investment of working capital is treated as not derived in the ordinary course of a trade or business. Third, interest expense properly allocable to the above categories of gross income, and expenses other than interest that are clearly and directly allocable to such gross income, are also not taken into account. Fourth, gain or loss attributable to the disposition of property producing a type of income described income described above or held for investment is not taken into 4
account, 8 but any interest in a passive activity is not treated as property held for investment. Fifth, in the case of closely held C corporations (other than personal service corporations), net active income for the year may be offset by passive activity losses for the taxable year, with a similar rule applying to passive activity credits. Finally, earned income (defined by cross reference to Section 911(d)(2)(A)) is not taken into account in computing the income or loss from a passive activity for any taxable year. Section 469(f) provides rules relating to the tax treatment of an activity that was a passive activity of the taxpayer for any prior taxable year but is not a passive activity of the taxpayer for the current taxable year. In general, those rules provide that any unused deductions allocable to such activity shall be offset against the income from such activity for the year; that any unused credits allocable to such activity shall be offset against the regular tax liability allocable to such activity for the taxable year; and that any deductions or credits remaining after the application of these offset rules shall continue to be treated as arising from a passive activity. 8 The Technical Corrections Bills would limit this exclusion to gain or loss not derived in the ordinary course of a trade or business. 5
Similarly, Section 469(f) also provides that if a taxpayer ceases for any taxable year to be a closely held C corporation or a personal service corporation, the passive activity limitations continue to apply to losses or credits to which they applied for any preceding taxable year, in the same manner as if the taxpayer continued to be a closely held C corporation or a personal service corporation, whichever is applicable. Section 469(g) provides that if during the taxable year a taxpayer disposes of his entire interest in any passive activity or former passive activity, then, in general, if the disposition is a fully taxable transaction, (i) any loss from the activity that had not previously been allowed as a deduction and (ii) (if the activity is a passive activity for the year of the disposition) 9 any losses realized on the disposition, are not treated as passive activity losses. Instead, the losses are allowable, first against income or gain from the passive activity for the taxable year (including any gain recognized on the disposition), second against net income or gain for the taxable year from all other passive activities, and third, against all other income or gain. This loss utilization rule does not apply to dispositions where the person acquiring the interest is 9 The Technical Corrections Bills would remove this limitation. 6
a related person within the meaning of Section 267(b) or Section 707(b)(1); in that event, the loss utilization provision does not apply until the year in which the related party disposes of the interest to an unrelated party. Where the interest in the passive activity is transferred at death, the loss utilization rule applies to the extent that the losses not previously allowed are greater than the basis increase that occurs with respect to the transferred property; any loss to the extent of the basis increase is not allowed as a deduction for any taxable year. The treatment of suspended losses where property is disposed of by gift is governed by Section 469(j), and is discussed below. Finally, Section 469(g) provides that where there is an installment sale of an entire interest in a passive activity, the loss utilization rule applies proportionately as income from the installment sale is recognized. 10 The loss utilization rule applies only to suspended losses; suspended credits generally expire if the disposition of the property does not generate sufficient passive tax liability to utilize them. Section 469(h) of the Code defines the term material participation. Section 469(h)(1) provides that a taxpayer 10 In general, the rules relating to treatment of losses on dispositions are reserved in the Temporary Regulations. (Paragraph -6T). 7
shall be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a regular, continuous and substantial basis. 11 Section 469(h)(2) provides that 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. Section 469(h)(3) provides rules relating to the material participation in farming activities of certain retired individuals and, surviving spouses. Section 469(h)(4) provides that a closely held C corporation or personal service corporation shall be treated as materially participating in an activity if 12 one or more shareholders holding stock representing more than 50% by value of the stock of the corporation materially participate in the activity or, in the case of a closely held C corporation other than a personal service corporation, (1) during the entire 12-month period ending on the last day of the taxable year, the corporation had at least one full-time employee substantially all the services of whom were in the active management of the business; (2) during that same time period the corporation had at least three full-time non-owner employees substantially 11 Certain items relating to the definition of material participation are reserved in the Temporary Regulations. (Paragraph -5T(b)(1)). 12 The Technical Corrections Bills would change this to "only if." 8
all the services of whom were services directly related to such business; and (3) the amount of deductions attributable to the business that are allowable to the taxpayer solely by reason of Sections 162 and 404 for the taxable year exceeds 15% of the gross income from the business for the year. Section 469(h)(5) provides that in determining whether a taxpayer materially participates, the participation of the spouse of the taxpayer shall be taken into account. Section 469(i) of the Code provides rules pursuant to which individuals who actively participate in rental real estate activities will not be subject to the limitations of Section 469(a). This benefit is limited to $25,000 ($12,500 in the case of married individuals filing separate returns who do not live together at any time during the year, and zero otherwise) of deductions or the deduction equivalent 13 of credits and is phased out for taxpayers with higher incomes, with the phase out starting at $100,000 of adjusted gross income (excluding passive activity losses) and being complete when adjusted gross income reaches $150,000 (excluding passive activity losses). An individual will not be treated as actively participating for any period if at any time during the period the value of the 13 At a 28% tax rate, $25,000 of deductions equates to $7,000 of credits. 9
interest of the individual and his or her spouse in the activity in question is less than 10% of the value of all the interests in the activity. Section 469(i) also provides that no interest as a limited partner in a limited partnership is treated as an interest with respect to which the taxpayer actively participates; 14 that in determining whether a taxpayer actively participates, the participation of a taxpayer's spouse shall be taken into account; and, finally, that the active participation requirement does not apply to low income housing tax credits and rehabilitation investment tax credits, with a substitution of a $200,000 adjusted gross income phaseout threshold for those credits. Section 469(j) of the Code provides certain definitions and special rules. Section 469(j)(1) provides that the term closely held C corporation means any C corporation in which at any time during the last half of the taxable year more than 50% in value of its outstanding stock is owned directly or indirectly by or for not more than five individuals. (This definition is made by way of a cross reference to Sections 465(a)(1)(B) and then to 542(a)(2), and presumably incorporates the constructive ownership rules of Section 544.) Section 469(j)(2) provides that the term personal service corporation has the meaning 14 The Technical Corrections Bills would give the Secretary regulatory authority to change this rule. 10
given that term by Section 269(A)(b)(1) (with certain modifications), namely, a corporation the principal activity of which is the performance of personal services if such services are substantially performed by employee-owners. An employee-owner is any employee who owns, on any day during the taxable year, any of the outstanding stock of the personal service corporation. The attribution rules of Section 318 (with certain modifications) apply for purposes of determining stock ownership of a personal service corporation. A corporation is not treated as a personal service corporation unless more than 10% of the value of the stock in the corporation is held by employee-owners. Section 469(j)(4) provides rules for the allocation among activities of the passive activity loss and passive activity credit and the $25,000 amount provided in, subsection (i). Section 469(j)(5) provides rules for the calculation of the deduction equivalent of credits from passive activities. Section 469(j)(6) provides that the basis of any interest in a passive activity disposed of by gift is increased by the amount of any passive activity losses 15 allocable to such interest, and provides that such losses shall not be allowable as a deduction for any taxable year. Section 469(j)(7) provides that the passive activity loss of a taxpayer shall be computed 15 The Technical Corrections Bills clarify that this refers to suspended losses. 11
without regard to qualified residence interest. Section 469(j)(8) provides that the term rental activity means any activity where payments are principally for the use of tangible property. 16 Section 469(j)(9) provides for an election to increase the basis of property by the amount of any disallowed passive activity credits that had reduced the basis of the property, but only in the case of fully taxable dispositions. Section 469(k) of the Code, which was added by the 1987 Act, provides that the rules of Section 469 are applied on an entity-by-entity basis in the case of publicly traded partnerships, except that this separate entity rule does not apply to low income housing tax credits or rehabilitation investment tax credits, to the extent that those credits exceed the regular tax liability attributable to income from the partnership. 17 Section 469(1) provides that the Secretary shall prescribe regulations as may be necessary or appropriate to carry 16 The treatment of income, deductions and credits from certain rental real estate activities is reserved in the Temporary Regulations. (Paragraph - 9T). 17 The application of Section 469 to publicly traded partnerships is reserved in the Temporary Regulations. (Paragraph -10T). The Partnership Committee of the Tax Section submitted a report dated September 23, 1987 on Section 469(k)(3) of the Code. 12
out the provisions of Section 469, including regulations that specify what constitutes an activity, material participation or active participation; regulations that provide that certain items of gross income will not be taken into account in determining income or loss from any activity; regulations that require that income or gain from a limited partnership or other passive activity be treated as not from a passive activity; regulations that provide for the determination or the allocation of interest expense; and regulations that deal with changes in marital status and changes between joint returns and separate returns. Section 469(m) provides a limited phase-in of the disallowance of losses and credits for interests held on or before October 22, 1986. The 1986 Act and the 1987 Act also provide certain transition rules for low income housing that are not enacted as part of the Code. III. Overview of Temporary Regulations. Paragraph -1T contains rules relating to the disallowance of the passive activity loss and passive activity credits; identifies the taxpayers to which the restrictions apply; provides for the general effect of Section 469 under other provisions of the Code; contains definitions of essential terms, including passive activity, trade or business activity, and rental activity ; provides special treatment of certain losses 13
from oil and gas working interests; provides rules dealing with the trading of personal property and the rental of a dwelling unit; provides for the treatment of disallowed passive activity losses and credits; provides for the application of the passive loss and credit limitations to C corporations; and sets forth rules relating to the treatment of spouses filing joint returns. Paragraph -2T contains definitions of and rules for computing the passive activity income, deductions and losses; defines portfolio income; contains rules requiring that income from certain passive activities be treated as income that is not from a passive activity; provides rules for losses resulting from the disposition of an activity; coordinates the application of certain other disallowance provisions; provides special rules for partners and S corporation shareholders; and requires the recharacterization of passive income in certain circumstances. activity credit. Paragraph -3T contains rules for computing the passive participation. Paragraph -5T contains rules defining the term material Paragraph -11T provides rules relating to effective dates and transition rules. 14
A number of key issues are reserved for future regulations, including rules determining what is an activity, rules relating to the allowance of losses on dispositions of interests and activities, rules relating to the treatment of self charged expenses, rules relating to the application of Section 469 to trusts, estates and their beneficiaries, rules relating to the application of the $25,000 allowance under Section 469(i), rules relating to the treatment of publicly traded partnerships and rules relating to the application of the passive loss and credit limitations in the case of former passive activities that change status from year to year. IV. Major Conceptual Comments. 1. Complexity and Uncertainty. It is evident that Section 469 will add a substantial degree of complexity and uncertainty to the business and tax affairs of those engaging in transactions within its scope. The transactions to which Section 469 applies are by definition legitimate business transactions, not shams, tax motivated transactions or hobbies, because the suspension rules of Section 469 apply to deductions that have survived other disallowance rules, and Section 469 does not differentiate between so-called paper losses (e.g., losses attributable to depreciation, accrued interest and other noncash items) and actual out-of-pocket expenses. The complexity results from the layering of a complicated new set of concepts 15
on top of already complex rules, and applying those new concepts to existing transactions. The uncertainty results from the use of subjective standards. Because we believe that uncertainty in the tax law is undesirable, we believe that the basic orientation of the regulations should be, to the maximum extent possible, to establish objective standards and safe harbors and to minimize the use of undefined subjective standards. 2. Regulatory Discretion. Section 469(1) authorizes the Secretary to prescribe such regulations as may be necessary or appropriate to carry out provisions of this section.... The paragraphs that follow in Section 469(1), authorizing regulations inter alia, to define activity, material participation and active participation, to provide that certain items of gross income will not be taken into account in determining income or loss from an activity, and to require that net income or gain from a limited partnership or other passive activity be treated as not from a passive activity, are an admittedly broad grant of authority. However, we believe that the regulations exercising that authority must retain a focus on the fact that the purpose of Section 469 is to (a) permit the use of losses (and credits) from a passive activity against current or future income (and taxes) from other passive activities, and not only against future income from the loss- or credit-producing activity, and (b) prevent the use of such losses and credits against positive income sources, 16
such as compensation for services or portfolio income. 18 Stated differently, it is clear that apart from publicly traded partnerships, Section 469 does not limit the use of losses from one passive activity to income from that activity. Although we recognize that Section 469(1) authorizes legislative, not merely interpretative, regulations, and although we agree that it is appropriate that Section 469 be interpreted in a manner that prevents taxpayers from whipsawing the Treasury by generating active losses and then passive income from the same transaction, in a number of instances, the Temporary Regulations appear to impose such a limitation, and appear to conflict with clear statements in the legislative history in a manner' that may exceed the authority of the statute. For example, we question whether the Temporary Regulations exceed the Secretary's statutory authority in characterizing an activity as passive or non-passive on the basis of whether the activity produces a loss or income, rather than on the basis of the extent of the taxpayer's activities, and in attempting to identify potentially profitable new trades or businesses (such as equity financed lending, or trading intangible property) that might be arranged as investments for persons with suspended passive activity losses, and characterizing them as non-passive, without due 18 Report of the Committee on Finance, United States Senate, to accompany H.R. 3838 at 719; S. Rep. No. 99-313, 99th Cong., 2nd Sess. (May 29, 1986) (The "Senate Report"). 17
regard to the dichotomy established in the legislative history of Section 469 between passive activities, on the one hand, and positive income sources, on the other hand. 19 Although the term positive income sources is unfortunately not defined in the statute or the legislative history, some specific references to the term in the legislative history that do shed some light on its meaning all incorporate the concept that positive income sources exclude income sources that bear or are likely to bear any significant deductible expenses: Salary and portfolio income are separated from passive activity losses and credits because the former generally are positive income sources that do not bear, at least to the same extent as other items, deductible expenses. (Emphasis added) (Senate Report at 719). 19 The propriety of entering into bona fide transactions structured in a manner that will minimize taxes is well established. See Commissioner v. First Security Bank of Utah, N.A., 405 U.S. 394 (1972): "4 Taxpayers are, of course, generally free to structure their business affairs as they consider to be in their best interests, including lawful structuring.... to minimize taxes. Perhaps the classic statement of this principal is Judge Learned Hand's comment in his dissenting opinion in Commission v. Newman, 159 F.2d 848, 850-851 (CA-2, 1947): 'Over and over again courts have said that there is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.'" 18
Portfolio investments ordinarily give rise to positive income, and are not likely to generate losses.... (Emphasis added) (Senate Report at 728). See also the clarification in the Conference Report 20 of the description of the Secretary's regulatory authority, which gives three limited examples of instances in which it would be appropriate to exercise the authority; (1) ground rents that produce income without significant expenses (a transaction that seems clearly to fall on the non-passive side of the abovedescribed dividing line); (2) related party transactions that in effect reduce active business income and increase passive business income (clearly a potentially abusive transaction because the transaction involves related parties); and (3) activities previously generating active business losses that would permit the taxpayer intentionally to seek to treat as passive at a time when they generate net income, in this fashion circumventing the rule (also a potentially abusive situation, with the taxpayer attempting to have the best of both worlds). Based on the foregoing, we question whether the regulations should (a) arrive at a different conclusion on the issue whether an activity is active/portfolio or passive when a 20 Conference Report to Accompany H.R. 3838, H.R. Rep. No. 99-841, 99th Cong., 2d Sess. (September 18, 1986) at II-147 (The "Conference Report"). 19
loss is produced than the conclusion would be if income were produced; (b) use a different active or material participation standard for losses than is used for income and gains; or (c) attempt to establish categories of trades or businesses that will be treated as portfolio, not passive, without basing that treatment on a conclusion that such investments are not likely to bear significant deductible expenses. 21 V. Comments on Significant Policy Issues. The preamble to the Temporary Regulations contains an extensive list of significant policy issues. This section of our report comments on some of those significant policy issues. 1. The effect of Section 469 on other provisions. A. Paragraph -1T(d)(1) provides that the characterization of items of income or deduction as passive does not affect the treatment of the items under any other provision of the Code, so that for example, an item of capital gain that is categorized as passive income is still treated as capital gain for purposes of determining the allowable capital loss for the year. We agree with this conclusion. B. paragraph -1T(d)(3) provides that, in general, a deduction that is disallowed under Section 469 is not taken 21 This third standard is not applicable to net leases of depreciable property because it is clear in the legislative history that such activities are passive. Conference Report at II-138. 20
into account as a deduction allowed for the taxable year for any other purpose of Subtitle A of the Code. We agree with this conclusion. 2. Definition of passive activity. A. The Internal Revenue Service (the Service ) is still studying the possibility of treating certain activities carried on in connection with the trade or business that do not themselves constitute the conduct of a trade or business, and certain Section 212 activities, as trade or business activities for purposes of Section 469. We do not have any comment on this issue at this time. B. Paragraph -1T(e)(3) provides six exceptions to the general rule defining rental activity. The second exception applies to activities involving the use of tangible personal property in which, (a) on average, the period for which each customer uses the property is greater than seven days but not greater than 30 days and (b) significant personal services are provided, excluding services not performed by individuals and certain excluded services that are considered to be customary. The third exception applies to an activity involving the use of tangible personal property where extraordinary personal services are provided. Although we have more specific comments on these provisions below, we note here that as a policy matter the use of standards that are not clearly defined, such as excluded 21
customary services, significant services and extraordinary services can be expected to create a substantial degree of uncertainty for taxpayers and the Service, and it is reasonable to anticipate difficult administrative problems in evaluating the types of services that will fall into these three categories because the Temporary Regulations are attempting to separate into discrete categories what is essentially a continuum of services. The sixth exception applies to property provided by a partner, S corporation shareholder or joint venture to the partnership, S corporation or joint venture for use by that entity in a non-rental activity, where the taxpayer does not rent the property to the entity but provides it to the entity in the taxpayer's capacity as an owner. We agree with this characterization. 3. Special rules treating certain activities as nonpassive. A. Paragraph -1T(e)(4) provides rules relating to working interests in oil or gas properties that the taxpayer holds directly or through an entity that does not limit the taxpayer's liability with respect to such interest. Initially, Paragraph -1T(e)(4)(i) applies this rule on a well-by-well basis, so that, for example, in the case of a taxpayer who owns a working interest in one part of a tract through a limited 22
partnership and owns a working interest in another portion of the tract directly or through a general partnership, the working interest exception would apply to the expenses incurred in drilling a well on the second tract, but would not apply to the expenses incurred in drilling a well on the first tract. Given that the working interest exception is intended to apply only to those who are exposed to the unlimited economic risk of the drilling activity, we agree with the well-by-well approach. We suggest that the proposed regulations be clarified to indicate that ownership of a working interest through a series of entities that do not limit liability (e.g., through an investment in a general partnership that invests in a joint venture to drill a well) is also eligible for the working interest exception. Paragraph -2T(c)(6) abandons this well-by-well approach to provide that income from any oil and gas property, the value of which is directly enhanced by activities benefiting from the working interest exception is treated as not from a passive activity. As is noted below in Section VI, we have some comments on the scope of this rule. Paragraph -1T(e)(4)(ii) also deviates from the wellby-well rule by providing that notwithstanding the working interest exception, a portion of the taxpayer's deductions from an oil and gas well will be treated as passive activity 23
deductions (and a corresponding portion of any gross income from the well for such year will be treated as passive activity gross income) if (a) the taxpayer has a net loss for the year from the well and (b) economic performance occurs with respect to expenses deducted for the taxable year, at a time when the taxpayer holds the interest through an entity that limits liability. We agree with this general rule. However, we believe that the rule should provide even-handed treatment for a transaction in which the taxpayer has net income from the property for the year and that in those circumstances a portion of the gross income from the property for the year should be treated as passive activity gross income. 4. Treatment of Spouses Filing a Joint Return. Paragraph -1T(j) adopts a general rule that married persons filing a joint return are considered as one taxpayer for purposes of Section 469, including specifically the material participation test in Section 469(h)(5) and the active participation test in Section 469(i)(6)(D). There are two exceptions to this general rule. First, if any deductions or credits are disallowed, the disallowed deductions and credits attributable to each spouse's activities must be separately identified. Second, for purposes of the working interest exception, married persons are treated as separate taxpayers. The reasons stated for this latter result is that the unlimited liability of one spouse, which renders 24
that spouse eligible for the working interest exception, does not result in unlimited liability for the other spouse and thus should not render the other spouse eligible for the working interest exception unless that other spouse also incurs unlimited liability as a result of his or her own investment vehicle. We agree with the general rule and with the exceptions. We suggest that the regulations be clarified to state explicitly that the second exception does not apply to the income characterization rule of Paragraph -2T(c)(6). 5. Identification of Items of Gross Income and Deduction from Passive Activities. Part VIII of the preamble to the Temporary Regulations invites comment on the question whether the regulations should address how particular items of gross income and deduction are allocated to passive activities. We agree that the approach taken by the Temporary Regulations is appropriate. Any attempt to codify rules governing such allocations is likely to be either enormously complex and confusing to taxpayers, practitioners and the IRS or to be too vague to be useful. The recently issued interest allocation regulations already provide guidance concerning the one item of deduction which is perhaps most easily manipulated. If any effort in this direction were to be made, we suggest that one or more safe harbors be established. Thus, for example, expense 25
allocations might be respected if based upon the relative revenues derived from different activities, or upon the relative unadjusted basis, or relative fair market value of assets used in the activities. VI. Technical Comments on Temporary Regulations. Paragraph -1T(e)(3). Rental Activity: (A) General Rule: A passive activity includes any rental activity regardless of whether the taxpayer materially participates in the activity. Section 469(c)(2). The term rental activity means any activity where payments are principally for the use of tangible property. Section 469(j)(8). This term excludes the lease of intangible property. Recommendation: The regulations should clarify that a sublease of tangible property constitutes a rental activity, even though the lessee-sublessor's interest may constitute intangible property. The term principally should be quantitatively defined, and the basis on which the determination is made should be specified. As is noted below, one of the Examples includes a situation in which the value of the services provided exceeds 50% of the amount charged. Under a common meaning of the term principally, the payments in this Example would not be principally for the use of the property. Nevertheless, the Exam- pie concludes that the activity is a rental activity. This apparent conflict should be reconciled. We recommend consideration of a 50% safe harbor, 26
so that if the cost of the services provided exceeds 50% of the total costs incurred, the activity would not be a rental activity. six 22 (B) Exceptions: Paragraph -1T(e)(3)(ii) sets forth exceptions to the definition of rental activity: (1) Seven Day Rule: If the average period of customer use is seven days or less, then the property is not rental property. Paragraph -1T(e)(3)(ii)(A). This could include a parking lot or video rental store. While most hotels have an average room rental period of seven days or less, certain hotels (such as those in resort areas as well as condominium hotels) have an average room rental period of more than seven days and may turn out to be rental activities unless they come within the other exceptions noted herein. We believe that such a result would be inappropriate. We suggest that some consideration be given to the possibility of combining the seven day and thirty day tests into one category. (2) Thirty Day and Significant Personal Services Rule: Property will not be considered rental property if the average period for which each customer uses the property is greater than seven days but not greater than thirty days and significant personal services are provided by or on behalf of the 22 We anticipate that we may have comments in a subsequent report on the fourth, fifth and sixth exceptions, which are not discussed herein. 27
owner of the property in connection with making the property available for use by customers. Paragraph -1T(e)(3)(ii) (B). This could include a hotel. Recommendation: An example should be included indicating that the operation of a traditional resort hotel does not constitute a rental activity even if the average period of customer use exceeds 7 days. Such an example could provide as follows: Example (N). The taxpayer is engaged in an activity of owning and operating a resort hotel. For the taxable year, the average period of customer use exceeds seven days but does not exceed 30 days. In addition to cleaning public entrances, exits, stairways, and lobbys, and collecting and removing trash, the taxpayer provides daily maid and linen services, restaurant, bar and room service and recreational facilities, including swimming pools, tennis courts and other athletic facilities, either at no additional charge or subject to a user charge. The cleaning of public areas and collecting and removing trash are excluded services (within the meaning of Paragraph (e)(3)(iv)(b) of this section), because such services are similar to those commonly provided in connection with long-term rentals of high grade residential real property. However, the personal services performed in connection with a traditional resort hotel constitute significant personal services within the meaning of Paragraph (e)(3)(iv) of this section. Accordingly, the activity is not a rental activity. In determining whether personal services provided to customers are significant, all of the relevant facts and circumstances shall be taken into account. Relevant facts and circumstances include the frequency with which said services are provided, the type and amount of labor required to perform such services, and the value of such services relative to the amount charged for the use of the property. Paragraph -1T(e)(3)(iv)(A). 28
Example (2) in Paragraph -1T(e)(3)(viii) indicates that where the average period of use is 30 days or less and the value of the services exceeds 50 percent of the amount charged for the use of the equipment, significant services are provided in connection with the rental of the property and therefore the activity is not deemed a rental activity. Example (4) in Paragraph -1T(e)(3)(viii) notes that when the value of the services performed is less than 10 percent of the rental charged, the services are not significant and a rental activity exists. Recommendation: We recommend that the percentage tests be established as safe harbors and be moved into the regulatory definitions of significant personal services in Paragraph - 1T(e)(3)(iv)(A). We recommend that the test be changed to a comparison of the cost of providing the services to the total costs incurred, because of the difficulty of determining the value of the services provided. Furthermore, we recommend that Example (2) be clarified to indicate that the activity would also be characterized as non-passive under the general rule of Paragraph -1T(e)(3)(i)(B), because the amount paid cannot be principally for the use of tangible property where the value of the services exceeds 50% of the amount charged. For services that comprise 10 percent or more but do not exceed 50 percent of the total value of the rental, there is uncertainty as to how to meet the significant services test. 29
Recommendation: We recommend that a narrower window be drawn or a bright line test be adopted so as to allow taxpayers greater certainty in knowing the tax consequences of their operations. Furthermore, it is difficult to determine whether the valuation of services approach in the Examples is workable, since the regulations have not yet defined activity. For example, does the activity of running a hotel encompass the operation of the hotel restaurants, room service, health club and sports (such as tennis, golf, swimming and skiing) and entertainment facilities? Should this be the result even where there may be a separate charge for such facilities, since the hotel customer may nevertheless be paying a premium for the presence of such services? Accordingly, we may have further comments on this issue after the activity regulations are proposed. However, even in advance of clarification on that issue, we recommend that the percentage safe harbor for establishing significant services be reduced below the 50% figure cited in Example 2. In determining whether significant personal services are rendered, the regulations exclude: property, (1) Services necessary to permit the lawful use of the (2) Services performed in connection with the construction of improvements to the property or in connection 30