10.5 Classifying Business Activities as One or Several
If you are in more than one activity, determining aggregate or separate treatment is important for:
Deducting suspended losses when you dispose of an activity. If the activity is considered separate from the others, you may deduct a suspended loss incurred from that activity when you dispose of it. If it is not separate from the others, the suspended loss is deductible only if you dispose of substantially all of your investment (10.13).
Applying the material participation rules (10.6). If activities are separate and apart from each other, the material participation tests are applied to each activity separately. If the activities are aggregated as one activity, material participation in one activity applies to all.
Determining if you meet the 10% interest requirement for active participation (10.2).
Grouping activities together.
You may use any reasonable method under the facts and circumstances of your situation to determine if several business activities should be grouped together or treated separately. To be grouped together, the IRS says that the activities should be “an appropriate economic unit” for measuring gain or loss. For making this determination, the IRS sets these general guidelines: (1) similarities and differences in types of business; (2) the extent of common control; (3) geographic location; (4) the extent of common ownership; and (5) interdependencies among the activities. Interdependency is measured by the extent to which several business activities buy or sell among themselves, use the same products or services, have the same customers and employees, or use a single set of books and records.
The IRS will not require that all five factors be present for grouping for multiple activities.
Rental activities.
Rental activities may not be grouped with business activities unless one of the exceptions discussed in 10.1 applies.
EXAMPLE
Lance Jones has a significant interest in a bakery and a movie theater at a shopping mall in Baltimore and in a bakery and a movie theater in Philadelphia. The IRS does not explain what constitutes a significant interest. In grouping his activities into appropriate economic units based on the relevant facts and circumstances, Jones could: (1) group the theaters and bakeries into a single activity; (2) place the two theaters into one group and the bakeries into a second group; (3) put his Baltimore businesses into one group and his Philadelphia businesses in another group; or (4) treat the two bakeries and two movie theaters as four separate activities.
Once he chooses a grouping, he must consistently use that grouping for all future years unless a material change makes the grouping inappropriate. His decision is also subject to IRS review and, if questioned, he must show the factual basis for his grouping.
IRS may regroup activities.
The IRS may regroup your activities if your grouping does not reflect one or more appropriate economic units and a primary purpose of the grouping is to circumvent the passive loss rules.
EXAMPLE
Five doctors operate separate medical practices and also invest in tax shelters that generate passive losses. They form a partnership to operate X-ray equipment. In exchange for the equipment contributed to the partnership, each doctor receives limited partnership interests. The partnership is managed by a general partner selected by the doctors. Partnership services are provided to the doctors in proportion to their interests in the partnership and service fees are set at a level to offset the income generated by the partnership against individual passive losses. Under these facts, the IRS will not allow the medical practices and the partnership to be treated as separate activities as this would circumvent the passive loss limitations by generating passive income from the partnership to offset the tax-shelter losses. The IRS will require each doctor to treat his or her medical practice and interests in the partnership as a single activity.
Partnerships and S corporations.
A partnership or S corporation must group its activities under the facts and circumstances test. Once a partnership or S corporation determines its activities, the partners or shareholders are bound by that decision and may not regroup them. The partners and shareholders then apply the facts and circumstances test to combine the partnership or S corporation activities with, or separate them from, their other activities.
Special rule for certain limited partners and limited entrepreneurs.
A limited entrepreneur is a person with an ownership interest who does not actively participate in management. A limited entrepreneur or limited partner in films, videotapes, farming, oil and gas, or the renting of depreciable property generally may combine each such activity only with another of such activities in the same type of business, and only if he or she is a limited entrepreneur or partner in both. Grouping of such activities with other activities in the same type of business in which he or she is not a limited partner or entrepreneur is allowed if the grouping is appropriate under the general facts and circumstances test.
