United States

IRS precluded from regrouping activities under PAL rules


Responding to a request for technical advice from the IRS Office of Appeals, the IRS Office of Chief Counsel in TAM 201634022 advised that a medical doctor’s grouping of activities for purposes of the passive activity loss rules of section 469 was not subject to adjustment by the IRS.

Generally, individual taxpayers may only deduct losses from so-called ‘passive activities’ to the extent that they have income from other passive activities. Taxpayers may group certain activities together if they form an appropriate economic unit with each other, in which case a unified passive or non-passive activity determination is made for the group.

The goal of taxpayers is typically clear. Those with loss activities will try to group those activities with profitable or non-passive activities in order to utilize the losses, and those with profitable activities may try to carve off any passive components of those activities to create passive income that can be used to offset passive losses from other unrelated activities.

But, the IRS and Treasury are aware of these taxpayer goals, and they have an avenue to address potential abuse. The Internal Revenue Code and associated regulations provide the IRS with the ability to overrule a taxpayer’s grouping decision (including a decision not to group) if 1) any of the activities resulting from the taxpayer's grouping is not an appropriate economic unit, and 2) a principal purpose of the taxpayer's grouping (or failure to group) is to circumvent the underlying purpose of the passive activity rules.  

The IRS tried to utilize that provision in the situation addressed by Chief Counsel in TAM 201634022. The taxpayer was a medical doctor who had interests in and employment relationships with two different S corporations. The taxpayer also held an indirect interest in an outpatient surgical center where he regularly, although not exclusively, performed surgeries. The doctor did not group the activities, which resulted in passive income from the surgical center that he offset against passive losses from unrelated rental activities.

Chief Counsel noted in the memorandum that the taxpayer’s income from the interest in the surgical center did not depend on the number of surgeries he performed there and that the surgical center was managed by an unrelated third party.

Chief Counsel concluded that these facts did not indicate that the taxpayer’s grouping decisions were made with a principal purposes of circumventing the passive activity rules. Furthermore, Chief Counsel also concluded that the decision to not group the activities was not clearly inappropriate (under a five-factor test set out in regulations), also precluding a regrouping.

Although in this particular instance the taxpayer’s grouping decision was upheld, it nevertheless highlights that the IRS is scrutinizing these decisions. When faced with grouping decisions, taxpayers should consult with their tax advisors to ensure groupings are appropriate based on all relevant facts.


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