United States

IRS rejects taxpayer aggregation of activities for at-risk loss rules

‘Activity’ for at-risk activity aggregation rules defined by IRS

TAX ALERT  | 

In a recent IRS Legal memorandum, see ILM 201805013, the IRS concluded that a business owner who purchased interests in multiple business entities – all of which were in the same type of business – failed to demonstrate that the separate entities should be aggregated for purposes of the at-risk loss limitations. In reaching this conclusion, the IRS addressed four main questions, the most interesting of which related to the definition of an “activity” for purposes of the at-risk loss aggregation rules.

Generally, individual taxpayers may only deduct losses from certain activities to the extent the taxpayer is considered “at-risk” for those activities. Usually, each activity is considered separately for purposes of these rules, but in some instances the taxpayer may aggregate certain activities. A taxpayer’s at-risk amount usually includes the amount of money or adjusted basis of property contributed to an activity, in addition to amounts borrowed with respect to that activity. However, it is important to note that taxpayers are only considered “at-risk” for borrowed amounts if they are personally liable for the repayment, or have pledged property – other than property used in the activity – as security.       

In this ILM, the taxpayer purchased stock in three separate S corporations with three separate nonrecourse promissory notes. In addition, the taxpayer acquired an interest in a limited liability company (LLC) for which he personally guaranteed a line of credit between the LLC and a bank. The entities were all engaged in similar businesses and shared certain employees, in addition to advertising, computer support, and accounting services. However, each business was in a separate location (different state) had separate lines of credit, maintained separate books and records, and had separate franchise agreements. 

The taxpayer contended that the operations constituted only one ‘activity’ for the purposes of the at-risk rules – even though they were conducted through separate entities. Accordingly, the taxpayer sought to aggregate the four entities and utilize the at-risk basis attributable to his personal guarantee on the LLC line of credit in order to recognize losses from the other entities. The IRS ultimately disagreed with this position.

Perhaps the most interesting question the IRS addressed in its analysis was how to define ‘activity’ for purposes of the at-risk rules. Since the statutory language regarding the aggregation of activities provides no guidance as to the meaning of activity, the IRS looked to surrounding statutory language and legislative history to make their determination.

First, the IRS noted that the surrounding statutory language seems to clearly indicate that Congress intended the definition to be “a relatively narrow and asset-specific concept.” They went on to note that the legislative history supports this concept of a narrow definition – as opposed to the much broader definition of activity contained in the passive activity rules – citing the Staff of the Joint Committee on Taxation’s observation that “the at-risk rules, to the extent they define ‘activity,’ address issues different from those that are relevant with respect to passive losses.” The IRS goes on to cite the Committee’s statement that “the at-risk rules define ‘activity’ in terms of narrow asset units, in light of the goal of such rules to establish a relationship between each such asset and financing attributable to it.” Accordingly, the IRS concluded that the term ‘activity’ for the purposes of aggregating activities under the relevant at-risk rules, meant the “smallest indivisible piece or parcel of property, business asset, or integrated business unit in which the taxpayer possesses an ownership interest.”

Applying this definition and logic to the aggregation of activities conducted across multiple entities, the IRS concluded that such a narrow definition of ‘activity’ generally prohibited cross entity aggregation. In reaching this conclusion, they also noted that the passive activity grouping rules were “irreconcilable” with this narrow definition of the term as well as the underlying purpose of the at-risk rules, and therefore had no bearing on the aggregation of activities for the at-risk rules. They did note that in certain instances cross entity aggregation could be possible, but that this would require compelling facts and circumstances supporting such an aggregation.

Taxpayers subject to the at-risk rules, or those considering the at-risk aggregation rules, should pay particular attention to this ILM, as it provides useful insight into the Service’s position regarding the definition of ‘activity’ as well as the aggregation of activities for the purpose of the at-risk rules.

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