Taxing Lessons From Court Decisions

Decisions – Flying into a Loss

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Image source: HL Carpenter
Image source: HL Carpenter

Now that passive activities are generally subject to the 3.8% Medicare surtax, one suggestion for tax planning is that you “group” activities. Generally, grouping means combining various activities and treating them as one collective activity. The idea is that by combining the activities—and the time you spend on them—you’ll more easily be able to meet the test of “material participation”, which allows you to deduct some losses currently.

But what activities can be grouped? For instance, does a company that trains automobile dealership employees how to handle phone calls belong in the same grouping as an airplane rental activity?

In T.C. Memo. 2014-158 (Williams), the taxpayer says yes. He owned and operated both businesses and reported the income and expenses from both on the same Schedule C (Profit or Loss from Business) on his 2007 federal income tax return.

The taxpayer purchased the plane to travel to the customers of the telephone training business. To help meet the cash flow requirements of owning the airplane, he leased the plane to flight schools and other “renters.” He also used the airplane occasionally for personal purposes.

The IRS reclassified the airplane activity to Schedule E (rental property), saying it was a passive activity that should not be included as part of the same Schedule C as the telephone training business.

In determining whether the taxpayer’s grouping was proper, the court considered first the question of whether the two businesses were an “economic unit.” That is, were they an interrelated and integrated single business unit? If so, they might qualify for an exception to the general passive activity loss rules.

The passive activity loss rules were added to the tax code in 1986 to prevent using losses from activities in which you do not materially participate (such as rentals) to offset income from other businesses. The passive activity loss rules classify business activities as either rental activities or “trade or business” activities.

Under the general rule, you can group various passive activities together and treat them as one unit. However, to combine passive and non-passive activities on your tax return, you must meet the requirements of an exception to the general rule (Regulation 1.469-4).

The exception consists of a two-part test. First, the activities must form an “appropriate economic unit,” based on the facts and circumstances, which include evaluating similarities and differences in types of trades or businesses, the extent of common control, the extent of common ownership, geographic location, and interdependencies between or among the activities.

Here’s how the court evaluated the five factors.

Similarities and Differences

The telephone skills training company was in the business of training the employees of automobile dealerships how to handle phone sales.

The airplane rental activity was in business to rent airplanes to other pilots and pilots-in-training.

Common Control, Ownership, and Geographic Location

The taxpayer owned and controlled the telephone skills training company, which in turn owned and controlled the airplane. The airplane was housed at two airports close to the telephone skills training company’s business location. Those airports were also convenient to the taxpayer. Neither airport was more than 30 miles from the taxpayer’s home or business address.


Most of the airplane’s use and income from the activity came from renting the airplane outside the telephone training skills company, which had no effect on the business of that company. Likewise, there was no indication the airplane activity depended on the telephone training skills company. That company was only an occasional user of the airplane.

There was no evidence the telephone training skills company and the airplane activity had any of the same customers or that the two activities were integrated in any meaningful way.

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The second part of the test requires that either the rental activity is insubstantial in relation to the trade or business activity or that the trade or business activity is insubstantial in relation to the rental activity.
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Right answer!
After review of the factors, the court concluded the commonalities began and ended with the taxpayer, and the airplane and the telephone training company did not constitute an appropriate economic unit.
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