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Tax Court: Taxpayer Flies Unfriendly Skies

May 21st 2018
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As evidenced by a new case involving an airplane chartering business, there must be a valid justification based on passive activity loss (PAL) rules.

Despite the name, PAL rules generally aren’t friendly to taxpayers, but there are a few exceptions. Notably, you may be able to combine separate business activities for purposes of the “material participation” tests when it suits your purposes.

Under the PAL rules, an investor is generally allowed to only use losses from passive activities to offset income from other passive activities received during the year. Any excess loss must be suspended indefinitely.

These rules were initially created to crack down on heavily-promoted “tax shelters” that enabled investors to claim artificial losses. Essentially, a “passive activity” is defined as any kind of trade or business in which you do not materially participate, although there are several twists and turns.

For example, a rental real estate activity is automatically treated as a passive activity unless your level of participation qualifies you as a real estate professional. However, if you actively participate in the rental activity – you do much more than just rubber-stamp tenants – you may be entitled to claim a loss offset of up to $25,000, based on adjusted gross income (AGI).

This offset is phased out for an AGI between $100,000 and $150,000. In addition, you can avoid the PAL limits if you have a “working interest” in an oil and gas deal. Otherwise, other investments where you basically sit on the sidelines are treated as passive activities, unless you meet one of the material participation tests spelled out in the IRS regulations.

For example, if you participate in the activity for more than 500 hours during the year, you’re treated as a material participant in that activity. And here’s where the IRS gets downright chummy: If you own more than one business, you may be able to group them together for the material participation tests if certain requirements are met.

Obviously, it’s easier to increase the number of hours you spend working if multiple activities can be combined unto a single activity. The factors considered in this determination are:

  • Similarities and differences in types of businesses
  • The extent of common control
  • The extent of common ownership
  • Geographical location
  • Relationships between or among the activities

In the recent case of Brumbraugh TC Memo 2018-40, 4/3/18 the taxpayer in question, a resident of California, was a long-time real estate developer. He held an interest in one project where he was mainly involved in business logistics.

In 2007, he spent more than 500 hours at this business activity. In addition, to reduce his travel time for business meetings, the taxpayer acquired an aircraft. This evolved into a separate business where he charted flights.

However, the taxpayer spent less than 500 hours on the aircraft chartering activity. This business showed a loss in 2007.

Can the taxpayer combine the two businesses – the real estate development activity and the airplane chartering activity – for purposes of the material participation tests? After examining the factors discussed above, the Tax Court said “no.”

Here’s why: The businesses didn’t serve the same clientele. Nor did they offer a common product or service to the public. What’s more, the plane wasn’t utilized by the real estate businesses. Because the businesses were dissimilar in nature, the taxpayer could not combine them for the material participation tests. Thus, the loss was denied.

The taxpayer in this case was grounded, but your clients may have more leeway in grouping activities under the PAL rules. Examine the facts carefully for each situation before you concede a valuable tax loss.