Federal Tax Watch
Grouping? Investors may want to take a second look
Taxpayers involved with passive activities should make sure they understand the ins and outs of the rules - especially in view of recent developments.
Medicare surtax in 2013. Under the 2010 healthcare act, a surtax on higher-income individuals' net investment income becomes effective in 2013. The surtax is 3.8 percent of the lesser of net investment income or the excess of the taxpayer's Form 1040 modified adjusted gross income over $200,000 ($250,000 if married filing jointly).
The definition of "net investment income" includes income from a business in which the taxpayer personally does not materially participate within the meaning of passive activity loss (PAL) rules. Exceptions to the definition include active business income, interest income and other working capital income attributable to an active business.
A passive activity is defined as any rental activity and any activity involving the conduct of a trade or business in which the taxpayer does not materially participate. Any passive losses not used in a current tax year are suspended and carried forward to future tax years.
Suspended losses may offset future passive income. Or, they may be recognized upon complete disposition of the taxpayer's interest in the passive activity.
Taxpayers should be concerned with the proper grouping of activities and should review every opportunity to group a passive activity with a materially participating business. Passive business income and rental income will be subject to the Medicare surtax, but active business income will not.
The proper grouping of activities could reduce or eliminate the surtax, beginning in calendar year 2013.
Grouping of activities. Treasury regulations permit one or more trade or business activities or rental activities to be treated as a single activity if the activities are an economic unit for measurement of gain or loss under PAL rules. The definition of an activity and the determination of whether a group of activities can be treated as a single activity depend on facts and circumstances.
The taxpayer can use any reasonable method to determine whether trade or business activities constitute an appropriate economic unit for measuring gain or loss and thus can be treated as a single activity.
The regulations identify the following factors to consider in determining an appropriate economic unit:
Defining an activity is important. It's the unit of measurement for determinations under PAL rules. Material participation is determined at the activity level.
If two activities are grouped together as a single activity, material participation must be shown in the activity as a whole. But if the activities are grouped separately, material participation must be shown in each activity.
Disclosure requirements. Once taxpayers have grouped activities, they must remain consistent in the grouping, unless the original grouping election was clearly inappropriate or facts and circumstances have changed.
In January 2010, the IRS issued Revenue Procedure 2010-13 on reporting activity groupings. It's applicable only to tax years beginning on or after Jan. 25, 2010 - essentially beginning with the 2011 Form 1040.
A written tax return statement is required for new groupings, the addition of a new activity to an existing grouping and regroupings for reasons such as an error or change in facts.
No written statement is required for:
If a taxpayer is engaged in two or more business activities or rental activities and fails to report whether they are grouped as a single activity, each business or rental activity is treated as a separate activity.
Although prior grouping elections are grandfathered in under Rev. Proc. 2010-13, the regulations require tax consistency. Therefore, documenting a grouping position on an annual basis with a written tax return statement may assist in the preparation of future tax returns.