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:: New Vehicle Dealership Audit Technique Guide 2004 - Chapter
12 - Passive / Non-Passive Considerations (12-2004)
Introduction
Many taxpayers involved with
auto dealerships have interests
in other entities and
activities. As a result of their
complex financial affairs, the
compliance with passive loss
rules and regulations of IRC
section 469 should be verified.
Please recall that due to the
rules of that section, generally
only passive income can offset
passive losses. This means that
the taxpayers will have losses
from passive activities that are
not deductible in a particular
year unless income from other
sources is properly
characterized as passive income.
Should
this issue be considered?
It is important for the agent
look at the individual and
related entity returns to
determine if the taxpayer is in
compliance with the passive loss
rules. The only way to determine
compliance with this complex
section of the law is to gain an
understanding of the
relationships of the various
entities and activities the
taxpayer has an interest in.
Example
The taxpayer, who is also a
shareholder in a large
C-Corporation auto dealership
owns several rental properties
(passive by definition, with
some exceptions, under IRC
section 469(c)(2)). Making over
$150,000 per year, taxpayer is
not entitled to the $25,000
passive loss offset for rental
real estate. The taxpayers’
rental losses for the year are
about $100,000. The taxpayer
creates a partnership that
purchases assets from the
C-Corporation and then rents the
dealership the land and building
at a rent that produces
partnership net income of
$100,000. Taxpayer flows this
$100,000 partnership net income
through to his 1040 as passive
income. The taxpayer is
attempting to offset his passive
loss of $100,000 against this
income.
Under Treas. Reg. section
1.469-2(f)(6), the rental income
is recharacterized as
non-passive. This means that the
taxpayer cannot offset passive
losses from other activities
against the rental profit. Any
rental income generated from the
rental of property by the
taxpayer to a trade or business
in which the taxpayer materially
participates is treated as
non-passive income.
In this
situation, the $100,000 profit
would be recharacterized as
non-passive and the $100,000
passive loss would be carried
forward.
Audit
Techniques
-
Secure all lease agreements.
-
Inspect Shareholder's Forms
1040 to determine if the
issue is viable.
-
Question the taxpayer
directly where circumstances
warrant such action.
If
after inspecting Forms 1040,
passive income is seen to be
offsetting passive losses, it
should be scrutinized. Make sure
the income is not subject to the
recharacterization rules of
Treas. Reg. sections 1.469-2 and
1.469-2T as well as the material
participation rules of Treas.
Reg. section 1.469-5T.
Treas. Reg. section 1.469-2T(f)
sets forth specific criteria for
recharacterizing income from
passive to non-passive. The most
pertinent to auto dealerships
follow:
Law
-
Treas. Reg. section
1.469-2T(f)(3)
Net income from the rental
of property in which less
than 30 percent of the
unadjusted basis of the
property is subject to
depreciation is considered
NON-PASSIVE.
-
Treas. Reg. section
1.469-2(f)(6)
For tax years ending after
May 10, 1992, the net income
from the rental of any
property to a closely held
C-Corporation, an
S-Corporation, a
partnership, is considered
NON-PASSIVE if the taxpayer
to whom this income flows to
materially participates in
the activities of the
lessee.
Note: It is unclear where in
the regulations that a trust
is included in these rules.
A trust is included as a
pass through entity in
Treas. Reg. section
1.469-4T(b)(2)(i) which is
applicable only to that
section. Treas. Reg. section
1.469-4T(b)(2)(ii)(B) is no
longer included as a
temporary regulation.
Note: That for 1992 and
before, this rule applied
for all except a closely
held C-Corporation (Treas.
Reg. section
1.469-4T(b)(2)(ii)(B)).
Treas. Reg. section
1.469-2T(f)(8) limits
recharacterization if the
taxpayer is required to
recharacterize gains from
significant participation
activities and also gains
from the rental of
nondepreciable property, the
maximum amount of gain to be
recharacterized is the
greater of the two
computations.
If
the rental income producing
entity is not clearly connected
to the dealership, it may
still be necessary to pursue the
issue.
If
the taxpayer materially
participated in an activity
other than rental activity, then
the income is non-passive per
IRC section 469. Treas. Reg.
section 1.469-5T sets forth the
criteria for determining
material participation.
In
identifying the correct
treatment of income from an
activity, it may be necessary to
question the taxpayer directly.
Whenever an agent encounters a
Passive / Non-Passive situation
it is suggested the MSSP guide
on Passive Activity Losses be
referenced for a more detailed
discussion of the passive loss
rules and suggestions for audit
techniques of passive loss
issues.
Conclusion
The most efficient way of
looking for a passive issue is
by securing all related returns.
Verify the taxpayer did not
mitigate his tax liability with
respect to a passive loss. If
so, a close scrutiny of the
means by which this was
accomplished is warranted.
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