Preface: If you are starting a new business, and you already have an existing business, then consult with your tax accountant regarding whether the businesses should be grouped for improved tax attributes.
To Group or not to Group
By Jacob M. Dietz, CPA
Are you a business owner? If so, how many different enterprises do you own? Frequently the owner of a business owns or partially owns more than one business activity. The other business activity or activities may be large or small.
In some of these situations, the owner may want to group these activities together to avoid passive treatment. If you own multiple activities, have you considered grouping them?
First, the IRS may consider 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 article, 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 could be exceptions, however.
For an example of how the passive activity rules could work, let us 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 bakery named Charlie, so John hardly does any work in that business. If the bakery and the restaurant were 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.
Depending on John’s taxes for the year, he may end up writing a large tax check to pay for his restaurant business while he is also investing more personal funds into the bakery to keep the money-draining bakery afloat. Such a scenario would not please John.
Grouping of Activities
The IRS, however, does allow grouping of activities that form an “appropriate economic unit.” If the bakery and the restaurant had been grouped into one, then John’s work in the restaurant would count as material participation for the entire activity, thereby making the bakery’s loss nonpassive and potentially offsetting that loss against the restaurant’s income.
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….”
Do you think John’s bakery and restaurant form an appropriate economic unit? The answer may not be 100% clear and involves some discretion, but John could probably honestly answer “Yes.” First, they both involve the business of food for human consumption. Second, John exercises control of both businesses, although he delegated daily responsibilities of managing the bakery to the able manager Charlie. Third, both companies have 100% common ownership by John. Fourth, the businesses are very close geographically since they are across the street from each other. Fifth, the operations of the bakery and restaurant are interdependent because the restaurant purchases baked goods from the bakery. John should have a strong case for grouping.
If John and his accountant had appropriately grouped the restaurant and bakery, then John might write a smaller tax check because the bakery loss would help offset the restaurant income.
As demonstrated in the hypothetical example about John, some taxpayers will want to group to offset losses against income. An entrepreneur that runs multiple businesses may find it hard to prove material participation in each venture to avoid the passive loss rules limiting passive losses to passive income. That same entrepreneur might be able to prove material participation in one venture. If appropriately grouped, then the entrepreneur materially participated in the whole group.
An entrepreneur might also group to avoid Net Investment Income Tax (NIIT) on the income. The NIIT was enacted as part of the tax changes that came with the Affordable Care Act. It charges a 3.8% tax on investment income for certain taxpayers.
Passive activities are classified as net investment income. Therefore, passive income from a second business could be subject to the NIIT. Let us go back to John’s bakery and restaurant. Now, assume that John did not group the bakery and restaurant, and assume that both businesses are profitable. In this hypothetical scenario, John now owes NIIT on the bakery income, which could be classified as passive. John may wish that he had grouped with the bakery, in which he materially participates, to possibly avoid the NIIT.
Why Not Group?
These groupings are 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.” Taxpayers should therefore exercise thought when considering grouping. It cannot be lightly changed.
One reason a taxpayer may wish to avoid grouping is if they already have an enterprise generating passive losses, and they want passive income generation. Remember the hypothetical bakery and restaurant owned by John? Now let us assume that the bakery and restaurant have been in business for several years, and they are not grouped. The bakery is passive, the restaurant is active. The bakery generates losses, but it is slowly moving towards profitability. Suppose John starts a new business, a coffee shop, that generates profits. It is run by a manager named George with little time from John.
John could potentially choose, in that first year, to group the coffee shop with the restaurant to make the coffee shop income active. John might choose, however, to let the coffee shop remain passive so that the passive loss from the bakery can be netted against the passive income from the coffee shop.
Timing of the Grouping
If you are starting a new business, and you already have an existing 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.
Although there can be exceptions available to group later, do not simply count on an exception being available for businesses to group when desired. No entrepreneur has perfect knowledge of the future. The unknowns could make the decision difficult to group or not to group, but the entrepreneur could benefit if they consider in the first year whether to group.
Disclosure of the Grouping
In Rev. Proc. 2010-13, the IRS lists disclosure requirements regarding tax groupings. If the original grouping was made before Rev. Proc. 2010-13 was effective, then no disclosure may be 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? The IRS does have a method that might work to remedy the failure to disclose. Contact your accountant 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 future accountants that there is a grouping in effect.
Are your business activities grouped? Should they be grouped? If you do not know, consider calling your accountant to discuss. If this is the first year for a new activity and you already have an existing activity, then think especially hard on the grouping decision.
This article is general in nature, and it does not contain legal advice. Contact your advisors to discuss your specific situation.