Preface: Tax groupings of business activities can solidify tax positions in certain instances. What is a grouping, and when may it may be applicable?
To Group or not to Group
Credits: Jacob Dietz, CPA — firstname.lastname@example.org
The IRS considers a business activity to be passive if the taxpayer does not “materially participate.” The full complexities and the details of passive activities are beyond the scope of this blog, but generally the IRS will not allow the deduction of passive losses unless there is offsetting passive income of an equal or greater amount, or the activity is entirely disposed.
There are exceptions, however. For an example of how the passive activity rules could work, let’s imagine John owns two businesses. Business A is a restaurant, and John works full-time in the restaurant. Business B is a bakery across the street from the restaurant, and the bakery provides the restaurant with food. John hired an able manager for the baker, so he hardly does any work in that business.
If the bakery and the restaurant are treated as separate activities, then John would be active in the restaurant but may be passive in the bakery. If the restaurant made money and the bakery lost money, then John might not be able to deduct the bakery’s loss until future years if he had no other passive income.
The IRS, however, does allow grouping of activities that form an “appropriate economic unit.” If the bakery and the restaurant had been grouped, then John’s work in the restaurant would count as material participation for the entire activity, thereby making the bakery’s loss nonpassive.
What constitutes an “appropriate economic unit?” There is some discretion in making this determination, but below are some factors from IRS Reg. 1.469-4 detailing some of the considerations.
“(i) Similarities and differences in types of trades or businesses;
(ii) The extent of common control;
(iii) The extent of common ownership;
(iv) Geographical location; and
(v) Interdependencies between or among the activities (for example, the extent to which the activities purchase or sell goods between or among themselves, involve products or services that are normally provided together, have the same customers, have the same employees, or are accounted for with a single set of books and records).”
These groupings are then permanent per the IRS regulations unless “a taxpayer’s original grouping was clearly inappropriate or a material change in the facts and circumstances has occurred that makes the original grouping clearly inappropriate.” If you are starting a new business, and you already have a business, then consult with your accountant regarding whether the businesses should be grouped. If you fail to group them now, and later try to group them, the IRS might disallow that grouping. There is an exception to the regrouping rule which allows taxpayers to regroup the first time the taxpayer is subject to the net investment income tax.
In Rev. Proc. 2010-13, the IRS lists disclosure requirements regarding tax groupings. If the original grouping was made before 1/25/2010, then no disclosure is required until a change is made. New groupings or regroupings after that date must be disclosed. If there is no disclosure, the IRS can generally treat them as separate activities. What if it is discovered that a grouping has not been disclosed? If the taxpayer discloses the grouping in the first year the omission is discovered, and all previous returns were consistent with that grouping, then the IRS considers it a timely disclosure.
If the IRS discovers the omission of the disclosure, then the taxpayer must have “reasonable cause” for omitting the disclosure. Contact our office if you think you may have some undisclosed groupings on your tax return which should be disclosed.
Even when the disclosure has already been made, the taxpayer may want to continue to disclose that grouping in each tax return. If done correctly, this may help inform the taxpayer and IRS and future accountants that there is a grouping in effect.
This blog is not tax advice. If you would like help walking through your options, please contact our office.