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:: Passive Activity Loss ATG - Exhibit 3.1: Passive Income
Exhibit
3.1: Passive Income
Large amounts
of passive income on Form 8582
line 1a and 3a should be
scrutinized carefully. Passive
income can be generated only by
a rental or a business in
which the taxpayer does not
materially participate. Both are
more apt to produce net losses
than net income. If Form 8582
reflects significant income on
line 1a or 3a, perform the
following:
_____ Verify
that income on Form 8582 is also
reflected on Schedule E lines 22
& 28(a) Col (h), Form
4797 or elsewhere.
Form 8582 is merely a
computational form which figures
the amount of allowable passive
losses (Form 8582 line 11).
Income on Form 8582 MUST also be
reflected on the appropriate
schedule to be properly
reported. If income on Form
8582 is not reflected elsewhere
on the return, the examiner has
an adjustment for unreported
income!
_____ Verify
that income is not interest,
dividends, royalties, or gains
on the sale of stock.
Portfolio income is not passive
income and should not be entered
on Form 8582.
Exception:
self-charged interest income.
See Reg. § 1.469-7.
_____ Verify
that income is not flowing from
a partnership or LLC
which a trader
or stocks,
bonds or other
securities. An activity
involving trading of stocks and
bonds is not a passive
activity. Thus, income would be
non-passive and should not be
reflected on Form 8582. See
Reg. § 1.469-1T(e)(6).
_____ Verify
that income is not from rental
of building to a partnership,
corporation, or business where
the taxpayer
materially participates
(unless there is written
currently binding lease signed
before 02/19/88). Rental income
from businesses in which the
taxpayer materially participates
(i.e. works on a regular basis)
is non-passive and does not
belong on Form 8582 line 1a.
See Reg. § 1.469-2(f)(6).
_____ Verify
that income is not from leased
of land or other
non-depreciable property.
Example:
leased field, parking lot,
ground rents for trailers or
mobile homes, leased land for
cell towers. See Reg. §
1.469-2T(f)(3).
_____ Verify
that income on Form 8582 line 1a
or 3a is not from the sale of
land. Investment income is
not passive income. See IRC §
469(e)(1)(A)(ii)(II). Passive
income must be generated by a
passive activity.
_____ Verify
that income is not from an
activity in which taxpayer
materially participates.
See Reg. 1.469-5T(a). Review
the worksheets of Form 8582 to
see if income is coming from an
in-state activity - an indicator
that the taxpayer is possibly
materially participating. Even
if the taxpayer does nothing, in
the current year, if
losses/income were
non-passive in any 5 of the
prior 10 years, income is
non-passive in the current
year. Reg. § 1.469-5T(a)(5).
Also if the activity is a
personal service activity
(doctors, attorneys,
accountants, financial planners,
actors, consultants, engineers,
etc.), income is non-passive if
the taxpayer materially
participated any
prior 3 years. See Reg. §
1.469-5T(a)(6).
_____ Verify
that income is not from an
investment such as lots,
the sale of a building never
rented or used in a business,
or the sale
of timber.
Investment income is not passive
income. See IRC §
469(e)(1)(a)(ii)(II). Passive
income only comes from a passive
activity, i.e. passive income
must be generated either by a
rental activity OR a business in
which the taxpayer does not
materially participate. If
income on Form 8582 is from
Schedule D, examiner should
consider the possibility that it
could be simply investment
income. Some real estate
developers have splintered their
projects into many separate
entities and entered net gains
on Schedule D, limiting their
tax rate to 20 percent. If
income is treated as investment
income (as opposed to business
income), it cannot be passive
income. The examiner should
consider whether the motivation
in creating multiple entities
was to circumvent IRC § 469.
If so, the examiner may want to
invoke the anti-abuse rule in
Reg. § 1.469-4(f) and regroup
the entities as one single
activity. Also consider whether
the taxpayer should be treated
as a dealer. Consequently,
property would be inventory and
taxed at ordinary rates versus
capital gain.
_____ Verify
that income is not compensation
for personal services such
as wages, guaranteed payments
from a partnership or Form
1099-Misc commission income.
See IRC § 469(e)(3), Reg. §
1.469-2T(c)(4).
_____ Verify
income is not from a covenant
not to compete. Reg. §
1.469-2(c)(7)(iv).
_____ If
there is a
Form 6252, Installment
Sale Income, for
an installment
sale of a passive activity,
verify that:
-
Income
entered on Form 6252 Line 24
ties to Form 8582; AND,
-
Current and
suspended losses are
deducted in same ratio as
gain is reported.
Note, however,
that passive losses will be
triggered up to the amount of
gain reported in the current
year. See IRC § 469(g)(3).
_____ Verify
that neither husband nor wife
materially participate in
a business
producing passive
income. The husband's
participation is attributed to
the wife and vice versa. Even
if one spouse does nothing, if
the other spouse materially
participates, income is
non-passive. Participation of
one spouse is treated as
participation of the other
spouse. IRC § 469(h)(5), Reg.
1.469-5T(f)(3), Reg. 1.469-1T(j)
_____ If
there was a gain on disposition
of a passive activity, verify
that the Form 4797 gain and
current and
carryforward
losses have
been entered on
Form 8582. If there was
a gain on sale, but current and
suspended operating losses
exceed the gain, nothing should
be entered on Form 8582. In
both instances, the full gain
should be entered on Form 4797.
Reminder: passive income is not
investment income under IRC §
163(d). The same type of income
should never be entered on both
Form 4952 and Form 8582.
_____ If
income is generated by an oil &
gas entity, ask the taxpayer if
there were losses in prior
years. If so, request prior
year returns. If losses were
claimed as non-passive
under the working interest
exception in any prior
year, income in subsequent years
is non-passive and should not be
in Form 8582. See IRC §
469(c)(3)(B).
CONCLUSION:
Passive income has/has not been
correctly reflected on Form
8582. Passive losses in the
amount of ____ have been
allowed/disallowed.
ADJUSTMENT:
Remove non-passive income from
Form 8582 L1a, or 3a, and
recompute. Adjustment to
allowable passive losses is
difference between Form 8582
L16 per return and Form 8582
L16 as corrected (without income
determined to be non-passive).
Report:
Disallowed Passive Losses.
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