Archive for Passive Activity

Tax Implication of Publicly Traded Partnerships: Why Purveyors or the US Tax Code Snarl at Investment Brokers

My friend Roger Botterbusch recently put together a most excellent presentation on the tax implications of owning Publicly Traded Partnerships (PTPs), also commonly referred to as Master Limited Partnerships (MLPs). As a result I developed a new profound distaste for investment brokers pedaling these things for their ‘prospective’ fat returns whilst simultaneously poo-pooing the heavy, heavy administrative burden they bring at tax time.

The most interesting point of the presentation was that all but two PTP’s traded in the United States kick out incredibly complicated year end K-1′s to the owner for reporting on the 1040. In preparation for the presentation a ridiculous case study was bandied around about a taxpayer who engaged in ‘day trading’ PTP’s. The ‘trading’ activities on their face were moderately successful but when taking into consideration that the tax practitioner had to process in excess of 100 very complicated K-1′s creating an unbelievably large tax preparation bill the result was a marginal investment return so much so that the taxpayer would have been better off simply leaving his investments in a money market account for the tax year in question.

The second most interesting point is that PTP’s kicking off in excess of $1,000 in the tax year of Unrelated Business Income (UBI) to the owner requires that the owner of the PTP not only process a complicated K-1 but also prepare IRS Form 990-T, that’s right folks you read it correctly 990-T, usually reserved for 501(c) non-profits.

The following are the top 18 points garnered from the power point presentation delivered to the Colorado Society of Enrolled Agents:

1. By IRS Rules, PTPs are publicly traded partnerships tied to Natural Resources activities including Oil & Gas, Mining, Real Estate and Others.

2. PTPs can be invested in individual stocks, mutual funds, and ETFs

3. Most investors don’t realize they have invested in a PTP until tax time!!!!!!  Thanks to the wolves of wall street.

4. Reasons to Invest in a PTP:

◦High Yields (Mid to High Single Digits Plus)

◦Payments (usually Cash Distributions) have special tax treatment versus normal dividends

◦Some PTPs pay out distributions even monthly (most pay out quarterly)

4. Traditional PTPs:

◦Pay out Cash Distributions rather than Dividends

◦Cash Distributions are tax deferred until investment is sold (Note: Basis is decreased by Cash Distribution)

◦Under Investors SSN (1040), if investment held until death, no tax will be paid on Cash Distributions (not the case for retirement accounts or business entities)

5. Most Traditional PTPs Kick off Complex K-1s adding profound complexity (and headaches) to tax returns

6. Institutional PTPs Do Not Have K-1s. Cash Distributions paid are Stock Dividends that will be subject to Capital Gain rules at time of sale

7. Some Mutual Funds and ETFs pay Dividends rather than cash distributions which tend to pay lower yields than traditional PTPs

8. PTP K-1 Forms:

◦Generally come between Feb 15 and Apr 15

◦Some K-1 Forms from GP PTPs can run Apr 15+

◦Most PTPs provide web sites where you can get soft copies of K-1 packages when ready

◦Roger recommends using K-1 Support (out of Tulsa OK) for PTP tax issues or problems with K-1 forms as they are “Great Folks to Deal with on Problems.”

8. When PTPs are in Retirement Accounts most of the K-1 Form can be ignored.

–9. Unrelated Business Taxable Income (UBTI): Found on K-1 in Box 20, Code V. –If UBTI from ALL PTP K-1s in Retirement Account Adds up to $1000 or more, a Form 990 will be needed for the Retirement Account – Yes You Can End Up Paying Taxes on this UBTI each year. Note: Most Traditional PTPs will have UBTI < 0!

–Warning:  Many Financial PTPs tend to Throw Off Lots of Positive UBTI each Year

10. PTP K-1 Forms ‘Gotchas’:

◦Note IRC Statements need to be added to tax return as there is a possible Penalty per statement if missed

◦Note: If PTP in Pass-Thru Business Entity, Probably Good Idea to Pass-Thru IRC Statements to 1040

◦If PTP Investment Basis Drops below Zero, additional Cash Distributions are Taxed as Capital Gains (Raise Tax Basis to Avoid This Issue).

◦Box 13J: Section 59(e)(2) Expenditures are generally for Oil & Gas or Mining Development Costs. –Either Amortize them over 5 or 10 years or –take in tax year, but AMT adjustment on Form 6251 for each year until Amortization would be done or Investment Sold.

This is a complete pain in the ass to track. Also the K-1 never seem to tell you if it is a 5-Year or 10-Year Expenditure Item  (Roger say always assume 10-Year)

11. For PTPs in Pass-Thru Business Entities:

◦Box 1 Income for PTP K-1 DOES NOT GO TO BOX 1 in Pass-Thru Business Entities K-1 to 1040 Clients. It goes to Box 10, Code E for Other Income

12. PTP Passive Losses:

◦Losses In PTPs Cannot be Mixed with Other LP Passive income or Other PTPs Losses.

◦Each PTP Loss must be carried forward separately in separate worksheets (no Form 8582) both for regular and AMT calculations

◦Most Software Packages will do this for you in a 1040 Return and you are probably on your own in a Business Entity Return.

◦Can only be taken at the time of investment sale AND Final K-1 received at the end of the Tax Year!

◦PTP Losses can cause trading Losses to become Passive Loss carryovers until time of sale – Sold PTP Stock could end up as SCH D Passive Loss Carry Forward if Client Doesn’t have Final K-1 at end of tax year (Usually 12/31).

13. What Happens when you Sell a PTP:

◦K-1 Form will generally show all adjustments for PTP units tax basis (Basis Adjustments on SCH D)

◦Many PTP Sales will have recapture of Cash Distributions via Section 1231 income

◦Sales of PTPs need to be reported on both Form 4797 and SCH D: Form 4797 for PTP Business Sale / Section 1231; SCH D to Reconcile Brokerage 1099s et al

14. State Taxation Issues

◦Not an Issue in Retirement Accounts

◦For 1040 returns:

–State non-resident tax returns may be needed for all states that PTP does business. ALL PTPs will send taxpayer information to all States where taxpayer received more than $500 or more in income from an individual PTP. Wash DC, Puerto Rico, US Virgin Islands, Guam, and Northern Mariana Islands income will require their own tax filings

15. –How to determine if state taxes Owed?

1040 Return Formula

IF (State Income < .0001 X Federal AGI), state taxes will be $0

Note: Some States want tax returns even for state income less than zero (Example OH)

16. For Business Entity Returns (1120, 1120S, 1065):

–Many States will want a business tax return for any business entity doing business in their state

–Some States have Franchise Fees (range $25 – $4500 per business entity return)

–Remember state tax ids for business entities. Some states require those state tax ids be registered for BEFORE you have investment income in the State  (This can be a problem with some PTPs who add states where they do business during the year and client does not find out until receipt of K-1 at tax time)

17. Some Special ETFs Investing in PTPs:

◦Some Pass on ALL PTP K-1 Forms together in one Huge Package to Client for Tax Return Issues due to Investing in a Basket of PTPs

◦Note Each PTP portion of the overall K-1 needs to be treated as separate PTP K-1 data for tax purposes

◦Sorting out these Mega K-1 packages can be a real challenge!

18. Examples of How Taxpayers Can Make a huge Mess:

◦Invest in Too Many PTPs in Retirement Accounts

◦Day Trade PTPs

◦Put Traditional PTPs into Business Entities

◦Do All of the Above at the Same Time and Dropping the Mess on the Tax Professionals Desk.

In conclusion as Roger so eloquently put it “It’s not a Circular 230 violation to assault your client or his/her broker.”

IRS Form 1040 Schedule C: Profit or Loss from Business

The sole proprietorship or Limited Liability Corporation (LLC) is in my opinion the easiest type of business entity to set up and begin operating. It is not separate from its owner with the income and expenses reported on IRS Form 1040 Schedule C.

Some people have instant success with a venture that is profitable from the very beginning. However it is more common to be unprofitable in the first 24 to 36 months of operation. If you are loosing money it is important to remember that you MUST REPORT A PROFIT IN 2 OUT OF THE PREVIOUS 5 TAX YEARS TO AVOID BEING CONSIDERED BY THE IRS TO BE REALLY ENGAGED IN A HOBBY. For more details on the specifics of hobby versus business see my post at: http://johnrdundon.com/how-to-determine-what-is-a-business-vs-what-is-a-hobby/

When it comes to losses the other thing to keep in mind is that they can be limited basically in three different ways:

1. By the amount of your investment or basis limitation;
2. By the amount you have at risk or at-risk limitation; and
3. By the passive activity loss limitation.

Basis limitations do not apply to sole proprietors as they would with an S corporation shareholder or partner in a partnership. A sole proprietorship is predominantly financed by the proprietors own assets. Two obstacles must be overcome before a Schedule C loss is deductible as addressed in this particular order:

1. The at-risk limitations of IRC Sec. 465; and
2. The passive activity loss limitations of IRC Sec. 469.

The at-risk limitations apply before any loss is limited due to lack of material participation which is a threshold criteria of a passive activity. The proprietor’s at-risk limitation is calculated on IRS Form 6198. If a taxpayer cannot verify a material-participation level with respect to the Schedule C activity, then being at-risk for the loss is essentially immaterial. The at-risk concept is one that looks at the source of funds for the business. Usually sole proprietors would not be at-risk when:

• The business was financed with non-recourse loans – except for holding real property;
• A valid guarantee or stop-loss agreement is in force; or
• Amounts borrowed for use in the business are from a person with an interest in the business, other than a creditor, or who is
related to a person having an interest in the business under IRC Sec. 465(b)(3)(C).

Most all small businesses with gross receipts of $1 million or less are allowed to use the cash method of accounting (Rev. Proc. 2001-10). New proprietors generally begin using the cash method of accounting immediately. An existing business may qualify to change its accounting method by filing IRS Form 3115 – Application for Change in Accounting Method with its tax return under the automatic consent procedures. When changing from an accrual to a cash method of accounting usually a negative IRC Sec. 481(a) adjustment is deducted in the year of the change and a positive IRC Sec. 481(a) adjustment is generally reported in income over a four-year period.

Items withdrawn for contributions to charitable organizations are reported via to IRS Form 8283 Non-cash Charitable Contributions and finally to Schedule A Itemized Deductions.

Office-in-home deduction items are detailed separately on IRS Form 8829 Expenses for Business Use of Your Home rather than on the expense lines for rent, utilities, interest, etc.

Proper deduction of vehicle expenses includes a decision for utilizing the cents-per-mile deduction or the actual method. Both methods require maintaining a mileage log and an understanding
of which miles are business miles.

Additionally, an understanding of depreciation methods available, which includes knowing the weight of the vehicle, are important. IRC Sec. 179 deductions are limited to income, but regular depreciation, including bonus depreciation, can actually assist in creating or increasing an net operating loss (NOL).

IRS Proposes New Treatment of LLC Members, Limited Partners Under Passive Loss Rules

In November 2011 the IRS issued proposed regulations (REG-109369-10) that would redefine “interest in a limited partnership as a limited partner” for purposes of determining material participation under the Sec. 469 passive loss rules.

What that means in plain terms is that historically under Sec. 469(h)(2), losses from an interest in a limited partnership have been treated as passive losses because essentially no limited partner in a limited partnership is treated as materially participating in the management of the investment.

With these proposed regulations, the IRS is more narrowly defining when a partner’s interest will be treated as a limited partnership interest for purposes of the passive activity rules which I believe to be good. Under the proposed regulations, an interest in an entity will be treated as an interest in a limited partnership under Sec. 469(h)(2) if:

  1. The entity is classified as a partnership for federal tax purposes; and

  2. The holder of the interest does not have rights to manage the entity at all times during the entity’s tax year under the law of the jurisdiction in which the entity was organized and under the entity’s governing agreement. Rights to manage include the power to bind the entity.

The IRS emphasizes that these rules are provided solely for purposes of the passive activity rules and not for any other provision that makes a distinction between a general partner and a limited partner. The IRS requested the change evidently because under the Revised Uniform Limited Partnership Act of 1985, many states have adopted laws that allow limited partners to participate in the management and control of the partnership without losing their limited liability. In addition, under state LLC laws, LLC members do not lose their limited liability by management participation in the LLC’s business. Nevertheless, the IRS has historically treated members of LLCs as limited partners for purposes of this rule. Various courts have disagreed with the IRS and have allowed LLC members to be treated as general partners and therefore allowed them to prove material participation under the passive loss rules.

Comments on the proposed changes are due Feb. 27, 2012. The regulations would apply to tax years beginning on or after the date of their publication in the Federal Register.

How to Report a Foreclosure to the IRS

A foreclosure on rental property technically involves the sale of the property back to the lender. Form 1099-A Acquisition or Abandonment of Secured Property reports that the lender has repossessed or foreclosed on the property. Box 2 is the amount of the outstanding mortgage debt, and box 4 is the fair market value of the property. If the value of the foreclosed property exceeds the amount of outstanding debt, the debt is considered fully satisfied because the value of the property exceeds the outstanding debt meaning that there would be no debt to cancel after the lender acquires the property.

However if the lender also cancels debt associated with the transaction, there may be income to report from the cancellation of debt on IRS Form 1099-C.

When a foreclosed property is ‘sold’ back to the lender the gain or loss on that transaction is realized by the property owner or taxpayer. The gain or loss is the difference between the amount realized when the property is sold and the taxpayer’s adjusted basis or cost in purchasing and upgrading the property. IRS Publication 551 Basis of Assets is a good source of information on how the basis in the property might be increased or decreased during ownership.

The realized amount is contingent on whether the debt is recourse debt or non-recourse debt. If the debt is non-recourse debt the lender essentially cannot claim assets of the debtor if the secured property does not fully satisfy the outstanding debt. If the debt is recourse debt the lender essentially claims assets of the debtor when the secured property does not fully satisfy the outstanding debt.  When the foreclosure involves recourse debt the amount realized is the smaller of the outstanding debt immediately before the foreclosure reduced by any amount of recourse debt for which the taxpayer was liable, or the fair market value of the property.

It is important to remember that Sec. 1245 property in the rental unit may be subject to depreciation recapture which is taxed as ordinary income and also that Sec. 1250 property does not necessarily require depreciation recapture particularly if the straight-line method is used. Sec. 1231 basically says that if the property is foreclosed or ‘sold’ at a loss, the loss is categorized as an ordinary loss not a capital loss.

The sale of the property is reported on IRS Form 4797 Sales of Business Property. The sale of the building is reported in Part I of Form 4797 if sold at a loss and in Part III if sold at a gain. Report the sale of the land separately in Part I, whether sold at a gain or loss. Any non-recaptured Sec. 1250 gain is entered in Part III of Schedule D Form 1040 Capital Gains and Losses.

Amortization of Intangible Costs

Also commonly referred to as 197 Intangibles, the following costs must be amortized (deducted as an expense) over 15 years (180 months) starting with the later of (a) the month the intangibles were acquired or (b) the month the trade or business or activity engaged in for the production of income begins:

  • Goodwill;

  • Going concern value;

  • Workforce in place;

  • Business books and records, operating systems, or any other information base;

  • A patent, copyright, formula, process, design, pattern, know-how, format, or similar item;

  • A customer-based intangible (e.g., composition of market or market share);

  • A supplier-based intangible;

  • A license, permit, or other right granted by a governmental unit;

  • A covenant not to compete entered into in connection with the acquisition of a business; and

  • A franchise, trademark, or trade name (including renewals).

A longer period may apply to section 197 intangibles leased under a lease agreement entered into after March 12, 2004, to a tax-exempt organization, governmental unit, or foreign person or entity (other than a partnership). See section 197(f)(10).

A section 197 intangible is treated as depreciable property used in your trade or business. When you dispose of a section 197 intangible, any gain on the disposition, up to the amount of allowable amortization, is recaptured as ordinary income. If multiple section 197 intangibles are disposed of in a single transaction or a series of related transactions, calculate the recapture as if all of the section 197 intangibles were a single asset. This does not apply to section 197 intangibles disposed of for which the fair market value exceeds the adjusted basis.  In some cases based on the exit strategy of your investment and how the investment fits into your portfolio you may be best served from an overall tax strategy to NOT amortize particularly considering the amortization expense is recaptured as ordinary income when the investment is disposed.

For those of you that are partial owners of a tenants in common (TIC) real estate investment take care to discuss the amortization of intangible as well as start up expenses with someone that has gone through the whole cycle before from a tax perspective the benefits and drawbacks of electing to amortize.

 

Passive Activities and the Real Estate Professional – IRC 469(c)(7) and Reg. 1.469-9

A qualifying real estate professional may deduct rental real estate losses for each rental in which he/she materially participates provided 3 tests are passed:

  1. More than one half of the taxpayer’s personal services must be in real property business.  ‘Real property’ trade or business activity includes: development, construction, acquisition, conversion, rental, management, leasing, and brokerage.  Examples, a real estate agent is considered to be in the real property trade or business but a construction sub-contractor is not.

  2. Taxpayer must work more than 750 hours annually in the ‘real property business.  A rental activity is considered to be in the ‘real property business’ but the taxpayer must materially participate in the activity for time to be counted.

  3. Taxpayer must materially participate in each separate rental real estate activity unless a written election was filed with an original return to treat all real estate rentals as one single activity.  Once this election is filed it binds all future years.  Be sure to keep a copy of the election in your permanant tax file.

Notes:

  1. One spouse alone must satisfy both tests one and two above.  Spouses cannot divide the tests amongst themselves.

  2. Even if the taxpayer is a real estate professional rental losses are passive and are reported on Form 8582 unless taxpayer materially participated in the rental activity

Common Mistakes with Passive Activities – 469 Form 8582

  1. Not grouping related activities as one activity

  2. Treating equipment leasing as non-passive by placing the revenue from such on Schedule ‘C’ or Schedule K-1 line 3.  Rentals are passive even if the taxpayer materially participated

  3. Deduct rental real estate losses when AGI is more than $150,000.  The $25,000 Passive Activity Loss Limitation offset is phased out when modified adjusted gross income exceeds $150,000

  4. Real estate professional has 10+ rentals listed all as non-passive.

  5. Schedule ‘E’ net income is reported on Form 8582 as property leased to taxpayer’s corporation or partnership.  Self rented property income is not passive

  6. Reg 1.469-4(d) prohibits grouping a rental activity and a business unless each activity is owned in identical percentage and property is leased to the business.  A rental can never be grouped with a ‘C’ corp.

Passive Asset Disposition

There are two distinct issues to evaluate when disposing of a passive  asset:

  1. Is the disposition considered to be a qualifying disposition under reg 1.469 making the losses deductible?

  2. Is the gain on the sale truly passive income and entered on IRS form 8582 triggering deductibility of unrelated passive losses?

Current and suspended losses are deducted in a ‘qualified disposition’ if:

  1. The disposition is in its entirety.

  2. The disposition is to an unrelated party.

  3. The transaction with buyer is fully taxable.

A ‘related party’ for tax purposes is:

* Mother or Father

* Son or Daughter

* Partnership or Corporation that taxpayer owned more than 50%

A disposition of an asset is considered not fully taxable if it is:

* Converted to personal use.

* Given as a gift or charitable contribution

* A like/kind exchange of real estate

* An installment sale

* In bankruptcy

Upon death of a taxpayer his/her suspended losses in an activity are allowed only to the extent losses exceed transferee’s basis.

If taxpayer materially participates in the operations of an activity that he/she owns, income is not passive and should not be reported on IRS form 8582.

If after applying current and suspended losses against the net gain on the disposition of the activity, neither loss nor gain goes on form 8582.  Losses generally go on schedule ‘E’ and gains go on IRS form 4797 and or Schedule ‘D’ of the 1040

What happens with suspended prior year losses when a now non-passive activity generates net income?

If the current year non-passive activity triggers deductibility of prior year suspended passive activity losses, IRC 469(f) permits a prior year passive loss to offset current year income from the same activity, even though that income might be non-passive in the current year. While net income or gain on sale is non-passive, it may be used to trigger prior year passive losses (or credits) from the same rental or business activity.   Stated differently, non-passive income cannot offset any passive loss except a prior passive loss from the same activity. What the law does makes inherent common sense.  It permits a netting of prior year passive losses against income from the same business (or rental).  Note:  interest income, dividends, royalties, annuities and gains on stocks and bonds will virtually always be non-passive and cannot be used to trigger former passive losses.

Common scenarios where prior year losses are triggered due to the former passive activity rule:

· Self-rented property produces net income in current year and is treated as non-passive under Reg. 1.469-2(f)(6).  In prior years, there were losses from the same activity, which were passive under IRC 469(c).

· TP materially participates in the current year in a business, but did not materially participate in prior years.  Material participation means meeting the 500-hour test in Reg. 1.469-5T(a) or one of the other tests.

· TP is a real estate professional and elected to group his rentals.  When he/she sells even one property, since the rentals are all considered a single activity, gain from that rental will trigger deductibility of prior year losses from any of the rentals.

· There is gain on sale of a rental activity, but not a fully taxable transaction.  While all losses are not triggered as the transaction fails the qualifying disposition requirement of IRC 469(g), prior year suspended losses are triggered to the extent of net income reported and taxed in the current year.

Form 8582 Instructions (page 6) Former Passive Activities

A former passive activity is any activity that was a passive activity in a prior tax year, but is not a passive activity in the current tax year.  A prior year un-allowed loss from a former passive activity is allowed to the extent of the current year income from the activity.

If current year net income from the activity is less than the prior year un-allowed loss, enter the prior year un-allowed loss and any current year net income from the activity on Form 8582 and the applicable worksheets.

If current year net income from the activity is greater than or equal to the prior year un-allowed loss from the activity, report the income and loss on the forms and schedules you would normally use; do not enter the amounts on Form 8582.

If the activity has a net loss for the current year, enter the prior year un-allowed loss (but not the current year loss) on Form 8582 and the applicable worksheets.

Grouping Passive Activities – IRS Rev Proc 2010-13

This new IRS Revenue Procedure is hugely important. Beginning in tax years after 1/24/2010 the IRS is requiring a written statement to accompany the tax return that lists how passive investment activities are grouped. The statement must include your name, address, employer ID #, and/or social security #, and it must state clearly ‘grouped activities are an appropriate economic unit.’ This statement is only required once in the initial year of the grouping. But the statement must be kept with a copy of your tax return. This rule applies to IRS forms 1040, 1041, 1065, 1120S. Basically taxpayers avoid passive loss limitations by grouping business or rentals as one activity. Reg 1.469-4 allows for related businesses or rentals to form a single activity.

Why group?

If several business entities form a single activity it is easier as an owner to materially participate. It is easier to work over 500 hours in a tax year among several entities if they are grouped together. If each entity is a separate activity, you may not have enough hours to materially participate in each. Grouping may mean that you escape passive loss limitations. Interestingly enough you only need one or two interdependency factors to demonstrate proper grouping. If there are no interdependencies found however the activities cannot be grouped.

When you might want to group activities:

  1. If you have related businesses where one has losses

  2. When you have a business and related rental real estate (only if both investments are owned in identical percentage or are insubstantial)

  3. If you have a business and related equipment lease such as an airplane (only if both investments are owned in identical percentage or are insubstantial)

  4. If you have several condo units in the same complex

When you might not want to group activities:

  1. If you have a business with passive income and you do not materially participate

  2. IF you have a business that is expected to be profitable in the near future.

  3. If you have a business and rental real estate if the rental real estate has net income. Remember self rented income is always non-passive.

  4. If you have a business with suspended losses and net income not anticipated.

John R. Dundon, EA – 720-234-1177 – jddundon@comcast.nethttp://prep.1040.com/jd/DEFEND YOURSELF AGAINST THE IRS - Enrolled with the United States Department of Treasury to Practice before the IRS – Enrolled Agent # 85353. Under contract with the IRS as a Certified Individual Taxpayer Identification Number (ITIN) Acceptance Agent – I am a Federally Authorized Tax Practitioner (USC 31 Section 330 + IRC 7525a.3.A) regulated under US Treasury Cir. 230.