Cost Segregation and Passive Activities

When considering the use of Cost Segregation in your or your client’s business, there is an obstacle in the way of fully realizing the potential tax savings afforded under the law. Typically, rents paid is a passive activity. A business you merely invest in, but do not materially participate in is a passive activity for tax purposes. Making a distinction between passive and active income is important because the taxpayer can claim a passive loss only against income generated from passive activities. This creates a unique problem for the business owner. The purpose of this post is to provide a solution to this problem.

The problem is best described using an example. Imagine a taxpayer with a significant active income generated from a business. The business owns a property. Qualified property improvements were made to the property at move in. Both the purchase of the property and the qualified property improvements are depreciated over 39 years, or approximately 2.56% per year. Depreciation is an accounting method applied to real and personal property to more accurately track the use and disposal of such property. Basically, it accounts for the wear and tear of the property over its lifetime. For a business with $1,500,000 in revenue and a $1,000,000 property (after excluding land), $25,600 in depreciation (2.56% x $1,000,000) is not a very significant amount. Additionally, passive losses from rental activities are limited to $25,000 for income under $100,000 phasing out up to $150,000. As a result, the depreciation benefit to a business owner is severely limited.

(An example from the Internal Revenue Service (IRS) is included at the end of this paper.)

Cost Segregation offers a detailed itemization of the real and personal property, which allows property owners to accelerate their depreciation schedules. Cost Segregation offers the ability to use a combination of 5-year, 7-year, 15-year, and 39-year property depreciation schedules. On average, the depreciation schedule will accelerate to 7.5 years, or approximately 13%. In our above example, this would create approximately $130,000 of annual depreciation. If the hypothetical business owner could take $130,000 off their taxable income, it would reduce their tax expense and increase their cash flow due to the lower tax expense.

Why would a business owner need, or better yet, pay for an accelerated depreciation if they are unable to take advantage of the losses? The answer is found within the Internal Revenue Code, specifically 26 U.S. Code § 469 Passive Activity Losses and Credits Limited (“IRC 469”). IRC 469 details the use and categorization of activities that are deemed to be passive. For our purposes, we will be looking at Section 8 Grouping Activities.

We have used sections from the IRS Audit Techniques Guide (ATG) on Passive Activity Losses as a framework to follow. ATG sections are italicized and highlighted below. Following the guidance in the ATG gives the business owner the best defense in the event of an IRS audit.

• Exhibit 8.1: Activities (Grouping Entities)
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• ISSUE: Does the grouping form an appropriate economic unit? In other words, in a realistic sense, does the grouping form an interrelated, integrated economic unit? Taxpayers may group related business entities into one single activity in order to meet the 500-hour test for material participation in Reg. § 1.469-5T(a)(1). Conversely, some taxpayers may attempt to separate inherently related activities in an attempt to create purported passive income which would trigger otherwise unallowable passive losses. In abusive situations, particularly with passive income, the Government may regroup activities to prevent the taxpayer from circumventing IRC § 469.
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• LAW: Under Reg. § 1.469-4, if businesses form an economic unit, the taxpayer may group Schedule C/F, C or S Corporation and partnerships/ LLCs into a single activity. Rentals may not be grouped with a business unless owned in identical percentages as the business or insubstantial in relation to the business.

When grouping activities, the IRS is looking for both improper “grouping” (how activities are aggregated) and “separating” of activities. For our purposes, this is advantageous because the bar to group activities is low. For owner-occupied businesses, the 500-hour test for material participation is a not very difficult to meet. The test specifically states that rentals may be grouped with the business for tax purposes, if they are owned identically by percentage. For a large majority of business owners, the building and the business fall into this category.

• _____ At the initial appointment or first IDR, ask if entities were grouped. Request statement as to how activities are grouped, which entities or undertakings are grouped, and why they form an appropriate economic unit.

During an audit, the IRS is supposed to inquire about the appropriateness of the economic unit. There must be an economic reason to group activities. A strong argument is to state that a business needs a property to operate economically.

• _____ If the taxpayer states that he has grouped activities, ask when the grouping decision was made and request tax work papers or other documents addressing the entities grouped. While not absolutely critical to the issue, the failure to provide any written documentation generated at the time of return filing (either in current or prior years) is an indicator that taxpayer did not group his activities. In other words, each activity is separate. The decision to group or not group is not made at the time of an audit. It is a decision which generally should have been made in 1994 or in the year the interest in the activity was acquired, whichever is later. The Reg.§1.469-4(e)contains a consistency requirement from year to year and provides that taxpayer may not regroup (unless original grouping was inappropriate or there is a material change). The Reg. § 1.469-4(g) does not permit losses to be deducted under the "substantially all" provision unless the taxpayer can establish amount of deductions and credits allocable to that part of the activity. Obviously, in both instances, it is critical to know what constitutes the "activity".

There are two key items in this part of the code. First, the decision to group or not to group is not made at the time of the audit. The taxpayer must have made the decision to group as an economic unit and must provide documentation. A Cost Segregation report could be included as part of the documentation requirement.

The second key item and more important point is in reference to “partial dispositions.” Below is the IRC’s rule.

• (g) Treatment of partial dispositions. A taxpayer may, for the taxable year in which there is a disposition of substantially all of an activity, treat the part disposed of as a separate activity, but only if the taxpayer can establish with reasonable certainty—

The above is addressing carry forward losses on a property that cannot be used unless “substantially all” of the group is disposed or ungrouped. Typically, this is a minor issue for business owner’s due to passive losses being limited because of the 39-year depreciation schedule. It can be a bigger issue when grouping a business with multiple properties that are currently carrying forward substantial losses.

• Verify the grouping forms an appropriate economic unit based on: 8-7
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• __Similarities __Location __Ownership __Common control and
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• __Interdependencies (purchase or sell goods between themselves, involve products or services that are generally provided together, the same customers, the same employees, or use a single set of books and records to account for the activities).
• Not all factors are necessary, and there is no factor which is required to be present. Instead, the appropriateness of the grouping should be based on all the facts and circumstances. It is important that examiner address the 5 factors and anything else that points to the appropriateness or inappropriateness of the grouping

The above section is extremely important. It is the test to see if grouping activities as an economic unit is appropriate. The five factors are not all required, but if multiple factors are satisfied there is a very strong argument that the activities are one economic unit. If the business owner satisfies some factors, but not all, risk tolerance and judgement needs to be stringently applied. In our example, because it is an owner-occupied business the owner could easily state that Location, Ownership, Common Control, and Interdependencies would be appropriate. Similarities would not apply.

• _____ Ensure the taxpayer has not grouped rentals with businesses unless:
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• · Insubstantial; OR,
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• · Owned in the same percentage and the rental is leased to the business.

The above is a straightforward and immensely important section. We are grouping rentals with a business. The rental needs to be “insubstantial” or “owned in the same percentage”. The IRS does not leave this open to interpretation, but it can be used to the business owner’s advantage. Little of the IRC is black and white. If the business owner conforms, there can be confidence that they are in compliance.

• _____ Review prior and subsequent year returns for passive and non- passive losses and income to verify that the same grouping has been used consistently. Do a comparative analysis of three years (or more) on an entity by entity basis. Reg. § 1.469-4(e) provides that once the taxpayer has grouped activities he cannot regroup in subsequent years unless the original grouping was clearly inappropriate or a material change makes the original grouping inappropriate.

Consistency is addressed in this section of the IRC. The IRS wants to see consistent application of the code. Once activities have been grouped, absent extenuating circumstances, they must remain grouped. Ungrouping activities can be appropriate if there are material changes or the original group is “clearly” inappropriate. In our example, a material change in the business can happen if a change of ownership deems the original grouping inappropriate.

• _____ To verify material participation, request written documentation, explaining the activities performed and hours the taxpayer applied to each entity. Also, inquire how much time the taxpayer applies to his rental activities, on portfolio activities, on hobbies, on vacation, etc. See Log at end of Chapter 4.

In the above section of the ATG, the auditor is to verify the written documentation of the 500-hour test. We suggest using the log provided at the end of Chapter 4 in the ATG. In our example, it would not be challenging to document 500 annual hours of work, including rental activities.

• _____ Always inquire whether the spouse is involved in business activities, which ones, and how much time. Both spouses’ time counts. Furthermore, one spouse's participation is attributed to the other spouse. Even if the spouse does nothing, if the other spouse materially participates, income or losses are non-passive. See IRC § 469(h)(5) and Reg. § 1.469-5T(f)(3)

The above section is a great example of how the IRS is looking for appropriate grouping and “non-grouping” of activities. The IRS will count a spouses’ time regardless of the activity participated in. In our example, this is a benefit. If the spouse is involved at all, those hours will add to the 500-hour test.

• CONCLUSION: In accordance with Reg. § 1.469-4, the taxpayer's businesses have/have not been properly grouped.

The IRS auditor will then make a determination if the business owner has properly grouped their activities or not. Although there is always room for interpretation in the IRC, this paper presented a situation that follows the IRS ATG and prepares the business owner for what will occur if selected for an IRS audit. Case studies show that attention to detail and preparedness are paramount for a successful audit. Additionally, the benefits of Cost Segregation are numerous and monetarily significant. This paper has illustrated that an owner-occupied business can, with a modicum of planning, use Cost Segregation to reduce its tax bill and increase cash flow. Subsequently, reducing costs of capital and increasing the valuation of the business.

The following example is pulled directly from the IRS:

• Example 1. (i) H and W are married and file a joint return. H is the sole shareholder of an S corporation that conducts a grocery store trade or business activity. W is the sole shareholder of an S corporation that owns and rents out a building. Part of the building is rented to H’s grocery store trade or business activity (the grocery store rental). The grocery store rental and the grocery store trade or business are not insubstantial in relation to each other.
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• (ii) Because they file a joint return, H and W are treated as one taxpayer for purposes of section 469. See §1.469–1T(j). Therefore, the sole owner of the trade or business activity (taxpayer H–W) is also the sole owner of the rental activity. Consequently, each owner of the trade or business activity has the same proportionate ownership interest in the rental activity. Accordingly, the grocery store rental and the grocery store trade or business activity may be grouped together (under paragraph (d)(1)(i) of this section) into a single trade or business activity, if the grouping is appropriate under paragraph (c) of this section.
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• Example 2. Attorney D is a sole practitioner in town X. D also wholly owns residential real estate in town X that D rents to third parties. D’s law practice is a trade or business activity within the meaning of paragraph (b)(1) of this section. The residential real estate is a rental activity within the meaning of §1.469–1T(e)(3) and is insubstantial in relation to D’s law practice.

Sources: IRC 469 Passive Activities Loss Audit Guide; https://www.rcgvaluation.com/costseg-numbers

Government Publishing Office; https://www.gpo.gov/fdsys/pkg/CFR-2012-title26-vol6/pdf/CFR-2012-title26-vol6-sec1-469-4.pdf