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The IRS has released a Technical Advice Memorandum (TAM)[1] addressing the question of whether, for passive loss limitation purposes, an activity qualifies as a significant participation activity in a taxable year where the taxpayer previously satisfied the significant participation activity test for material participation with respect to that activity in five of the preceding ten taxable years.

Background of Section 469

Under Section 469 of the Internal Revenue Code, losses from “passive activities” may only be deducted against income from passive activities. Passive losses that exceed passive income in a taxable year are suspended and may be deducted against passive income in later years. The passive loss limitation rules apply to individuals (including partners and S corporation shareholders), estates, trusts, personal service corporations, and closely held C corporations.

The term “passive activity” means, generally, any activity that involves the conduct of any trade or business in which the taxpayer does not “materially participate” during the tax year. The term “passive activity” also includes any rental activity unless the taxpayer is engaged in the rental activity as a real estate professional.

With respect to activities other than rental activities (which are subject to different requirements), a taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis that is regular, continuous and substantial. The rules under Treas. Reg. 1.469-5T(a)(1)-(7) contain seven tests to determine whether the taxpayer materially participates in an activity.

Two of the seven the tests are as follows:

The SPA Test – Treas. Reg. 1.469-5T(a)(4) provides that an individual shall be treated as materially participating in an activity for the taxable year if the activity is a significant participation activity for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours. An activity is a significant participation activity of an individual if and only if such activity (i) is a trade or business activity in which the individual significantly participates for the taxable year (by participating in the activity for more than 100 hours during such year) (“SPA Requirement 1”); and (ii) would be an activity in which the individual does not materially participate for the taxable year if material participation for such year were determined without regard to the SPA Test (“SPA Requirement 2”).

The 5/10 Test – Treas. Reg. 1.469-5T(a)(5) provides that an individual shall be treated as materially participating in an activity for the taxable year if the individual materially participated in the activity for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year.

Issue and Facts of the TAM

As noted above, under the TAM, the taxpayer requested the IRS address the question of whether an activity qualifies as a significant participation activity in a taxable year for purposes of the SPA Test where the taxpayer meets the requirement for material participation in an activity under the 5/10 Test by previously having satisfied the SPA Test for material participation in five of the preceding ten taxable years.

There, the taxpayer through multiple grantor trusts wholly owned an S corporation. The taxpayer reported each trust’s allocable share of the corporation’s income on the taxpayer’s individual income tax return. The corporation owned multiple entities. For Year 1 through Year 2, the taxpayer reported the activities of the entities as nonpassive. For those activities in which the taxpayer asserted he participated more than 100 hours and less than 500 hours, the taxpayer reported those activities as having satisfied SPA Requirement 1 and SPA Requirement 2. Based on the aggregate of all time the taxpayer spent on significant participation activities, the taxpayer claimed to have materially participated in those activities under the SPA Test. For the remaining activities, the taxpayer acknowledged having participated less than 100 hours in each of the activities for the year at issue, but reported them as nonpassive based on the 5/10 Test.

The IRS’s Conclusion

During an examination, the IRS concluded that certain activities of the taxpayer, which the taxpayer classified as having met the SPA Test, instead met the 5/10 Test for material participation in the reviewed year by virtue of those activities having satisfied the SPA Test in five of the preceding ten years. Based on this conclusion, the IRS reclassified those activities because the activities no longer satisfied SPA Requirement 2. This reclassification reduced the number of significant participation activities in the audit year, such that the taxpayer’s aggregate hours for the remaining significant participation activities failed to meet the 500 hour requirement of the SPA Test. Thus, the taxpayer was no longer treated as materially participating in those activities and they were passive activities under Section 469.

The IRS held that with respect to SPA Requirement 2—which states that an activity is a significant participation activity only if it is an activity in which the individual does not materially participate for the taxable year—the taxpayer cannot satisfy SPA Requirement 2 for those activities in which the taxpayer materially participated under the SPA Test in any five years during the preceding ten years, because the taxpayer is otherwise treated as materially participating in each of those activities under the 5/10 Test. The IRS held that the language of SPA Requirement 2 specifies that the relevant inquiry is whether the taxpayer materially participated for “the taxable year” and that determination is being made “for such year” without regard to the SPA Test. Contrary to the taxpayer’s argument (in order to avoid the application of the 5/10 Test), SPA Requirement 2 does not say to disregard the SPA Test for every previous year where a taxpayer was treated as having materially participated under that test.

Thus, an activity that met the requirements of the SPA Test in any five of the last ten taxable years satisfies the 5/10 Test for material participation in the taxable year and no longer satisfies SPA Requirement 2. However, once the activity no longer meets the 5/10 Test, the activity may again be classified as a significant participation activity to satisfy the SPA Test.

Impact on Taxpayers

The IRS acknowledged that its ruling with respect to SPA Requirement 2 imposes an additional requirement on significant participation activities, one that potentially removes an activity from being treated as a significant participation activity in the current tax year based on participation in prior years, as was the case in the TAM. The additional requirement in SPA Requirement 2 results in a significant participation activity shifting out of the SPA Test and into the 5/10 Test because under SPA Requirement 2 an activity cannot be both a significant participation activity and satisfy another material participation test.

The IRS’s ruling can create adverse tax consequences for taxpayers who have been meeting the material participation requirement under the passive loss rules by use of the SPA Test. The activities which have been aggregated under the SPA Test may be removed from the SPA Test and instead placed under 5/10 Test (or another material participation test), potentially disqualifying other activities of the taxpayer from qualifying under the SPA Test making them passive activities. In addition to those activities being subject to the passive loss limitations, the determination that an activity is a passive activity may have collateral tax consequences. For example, the net investment income tax generally applies only to investments and to trades or businesses that are passive activities, as determined by reference to the passive loss rules and their material participation standards.

It is important that taxpayers who rely on the SPA Test to prove material participation ensure that, if any significant participation activities are reclassified under the 5/10 Test (or under any one of the other six tests for material participation) for any taxable year, any remaining significant participation activities continue to meet the SPA Test or another test to satisfy material participation requirement for that year.

 

[1] IRS TAM 202229036, July 22, 2022.