Regardless of what is being said in the news these days, the last major tax reform in the United States took place back in 1986. One of the key components of that reform was the addition of so-called Passive Activity Loss rules (PAL, though they are oftentimes not your pal). These rules are simple in theory – one cannot offset income in which they are fully involved in its generation with losses which they receive solely as a bystanding investor. However, like with many items of the U.S. Tax Code, it’s never quite that simple. Let’s look at a recent U.S. Tax Court case as an illustration of these rules.
In Hardy v. Commissioner, TC Memo 2017-16, the taxpayer was a doctor who owned his practice 100%, and had also invested in a separate outpatient surgery center for minor operations not requiring overnight care. He had no say in management decisions of the outpatient clinic, was not liable for any of the debts of that business, and was not related to any of the other investing doctors in any business sense. Given these facts, his tax preparer reclassified the income generated by the outpatient clinic to passive, which helped offset losses generated by an unrelated rental property owned by the doctor. (In prior years, the classification was incorrectly nonpassive, a change with which the court agreed and allowed.)
As mentioned above, the PAL rules will not allow losses from a passive activity (as defined by the code) to offset nonpassive income. The several factor tests for determining passive versus nonpassive status are beyond the scope of this article; however, consultation with your tax advisor will determine if your specific activities meet the definition of passive or nonpassive. Passive losses are carried forward until there is sufficient passive income, or the activity is disposed entirely.
The IRS asserted that because the taxpayer’s practice and the outpatient clinic were so closely related, they formed what’s known as an “Appropriate Economic Unit” (AEU), and therefore, were so interrelated as to both be nonpassive. The taxpayer, therefore, could not offset his rental losses with the clinic income. The Tax Court disagreed with the IRS, citing the taxpayer’s lack of management influence, among others, as reasons why the center could still be functionally independent of his practice.
Taxpayers should use this case as a refresher of the passive activity loss rules, along with the AEU grouping rules. The rules are incredibly complex, and should be discussed thoroughly with your tax advisor. We’re here to help with these or any other complex situations you may have!
Brock R. Yates, CPA, MT