How activities are grouped can have a major impact on a taxpayer’s ultimate tax liability under the passive activity regulations provided under IRC §469. Generally, a proper grouping is governed by Reg. §1.469-4(c)(2).
That regulation provides the following test for proper grouping of activities:
(2) Facts and circumstances test.
Except as otherwise provided in this section, whether activities constitute an appropriate economic unit and, therefore, may be treated as a single activity depends upon all the relevant facts and circumstances. A taxpayer may use any reasonable method of applying the relevant facts and circumstances in grouping activities. The factors listed below, not all of which are necessary for a taxpayer to treat more than one activity as a single activity, are given the greatest weight in determining whether activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of section 469--
(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).
While the taxpayer has the right to designate an appropriate grouping, the IRS has the right to regroup activities on exam if the IRS can show that the current grouping is “inappropriate” as provided for in Reg. §1.469-4)(f)(1):
(f) Grouping by commissioner to prevent tax avoidance
The Commissioner may regroup a taxpayer's activities if any of the activities resulting from the taxpayer's grouping is not an appropriate economic unit and a principal purpose of the taxpayer's grouping (or failure to regroup under paragraph (e) of this section) is to circumvent the underlying purposes of section 469.
In Technical Advice Memorandum 2016334022 the IRS National Office was asked to determine if the agency could force a physician to combine an activity that was being reported as passive with his medical practice. If the IRS could succeed in doing that the income from the activity would no longer be passive—and presumably the physician would no longer able to deduct losses from other passive activities.
The physician owed a small interest in a partnership which itself owned an interest in a partnership that operated outpatient surgery services. Although the physician was not allowed to refer patients directly to that facility. Despite this fact, patients often chose this facility over a hospital due to lower costs.
The memorandum goes on to describe the arrangement as follows:
According to the taxpayers’ submission, the income generated from H's indirect ownership in R (through P) is not tied to the number of surgeries he performs at R's facility or to the revenue generated by those surgeries. Moreover, even if H did not perform any surgeries at R, he would still receive the same proportionate share of R's profits allocable to his ownership interest in P. Prior to the opening of R in Year3, the surgeries that could not be performed in H's practice office were performed at the local Hospital. The opening of R did not affect H's income from his medical practice, but his patients were given a choice as to where to have the surgery performed. Moreover, the taxpayers argue that there are no interdependencies between X, Y, and R. H was compensated for his surgical services to patients through medical charges made by X or Y. The revenue generated by R through facility charges are separate from the charges for medical services rendered by H to his patients.
The examining agent believed that this situation was similar to one described in Reg. §1.469-4(f)(2) and the activities must be grouped together:
Example. (i) Taxpayers D, E, F, G, and H are doctors who operate separate medical practices. D invested in a tax shelter several years ago that generates passive losses and the other doctors intend to invest in real estate that will generate passive losses. The taxpayers form a partnership to engage in the trade or business of acquiring and operating X-ray equipment. In exchange for equipment contributed to the partnership, the taxpayers receive limited partnership interests. The partnership is managed by a general partner selected by the taxpayers; the taxpayers do not materially participate in its operations. Substantially all of the partnership's services are provided to the taxpayers or their patients, roughly in proportion to the doctors' interests in the partnership. Fees for the partnership's services are set at a level equal to the amounts that would be charged if the partnership were dealing with the taxpayers at arm's length and are expected to assure the partnership a profit. The taxpayers treat the partnership's services as a separate activity from their medical practices and offset the income generated by the partnership against their passive losses.
(ii) For each of the taxpayers, the taxpayer's own medical practice and the services provided by the partnership constitute an appropriate economic unit, but the services provided by the partnership do not separately constitute an appropriate economic unit. Moreover, a principal purpose of treating the medical practices and the partnership's services as separate activities is to circumvent the underlying purposes of section 469. Accordingly, the Commissioner may require the taxpayers to treat their medical practices and their interests in the partnership as a single activity, regardless of whether the separate medical practices are conducted through C corporations subject to section 469, S corporations, partnerships, or sole proprietorships. The Commissioner may assert penalties under section 6662 against the taxpayers in appropriate circumstances.
The National Office did not agree that this case was of the type described in the above example, noting that a key issue was that the doctor did not control the entity and had not established the entity to take an activity that he had been conducting in the practice and put it in an entity aiming to skirt the passive activity rules:
In this case, an unrelated entity, Q, is majority owner of R and controls the day-to-day management of the surgical facility. H and the other partners of P do not have any direct or indirect control over the day-to-day operations of R, unlike H’s clear control over Y. In addition, the services provided by R to patients of P's partners likely do not comprise substantially all of R's patient services, and it is even less clear that the services provided by R to the patients of P’s partners will be roughly in proportion to the partners’ interests in P (or their indirect interests in R).
The memorandum, noting that the reclassification regulation requires showing a principal purpose is avoiding the passive activity rules, thus concludes:
Thus, while the example in § 1.469-4(f)(2) concludes that the partnership's activities do not separately constitute an appropriate economic unit, it is not necessarily inappropriate to treat P's activity as a separate economic unit in this case. Furthermore, we do not believe that the facts clearly demonstrate that H acquired his interest in P with a principal purpose of circumventing the underlying purpose of § 469. Accordingly, we conclude that the Commissioner would not have the authority to regroup the taxpayers' interests in X, Y, and P as a single activity under § 1.469-4(f) to prevent tax avoidance, even if we were to otherwise conclude that taxpayers' other groupings of activities do not constitute appropriate economic units under § 1.469-4(c).
The memorandum goes on to find, in addition, that the taxpayer’s grouping in this case creates appropriate economic units, noting:
We further conclude that an analysis under the five-factor test of § 1.469-4(c) demonstrates that there may be more than one reasonable method for grouping the taxpayers' activities into appropriate economic units in this case. While the trade or business activities of X, Y, and R (held by H through P) are similar in that they are all in the medical industry and involve the provision of medical services to patients, X, Y, and R provide different types of medical services. Certain surgeries cannot be performed at X's or Y's practice office, and diagnostic and post-operative care is not provided through P or R. H does not have the same kind of management control over R that H exercises over his own medical practice conducted through X or Y. H has different ownership interests among X, Y, and P. It also appears from the facts that X, Y, and R are in different locations and do not share employees or recordkeeping. Accordingly, we conclude that an analysis of the facts and circumstances of this case under § 1.469-4(c) does not result in a determination that the taxpayers’ grouping of the interests in X, Y, and P as separate activities is clearly inappropriate for purposes of either § 1.469-4(e)(2) or § 1.469-4(f).
The memorandum provides some insight into applying the appropriate economic grouping provisions in the regulations, and a reminder that agents have to both show an intent to evade §469’s limitations and an inappropriate economic grouping if the agent seeks to regroup activities on exam. It also provides a reminder that just because a case or example seems somewhat similar to a taxpayer’s situation, an analysis must always be undertaken to note any differences in the taxpayer’s facts and those in case/example—and then decide if those differences would lead to a different result.