A group of unicorns may or may not be called a blessing, but one thing is certain: owners of multiple business activities seldom use that word to describe IRS inquiries into how those activities are grouped.
“Grouping” is a tax strategy that taxpayers can elect to use to treat multiple trade or business or rental activities as one unit. For example, you may want to group several business activities together as a single activity for tax purposes while keeping the ventures separate from a legal standpoint. Assuming you’re not creating a group merely to avoid passive activity loss rules, doing so can help you meet the tax law requirement of having enough hours of participation in the grouped businesses to be able to offset losses from one (or more) of the activities against gains from the others. The drawback is that once you have grouped activities, you generally cannot change the grouping.
But what if you don’t actually create a group? Can the IRS say you did?
In T.C. Memo. 2017-16 (Hardy), the taxpayer, a plastic surgeon specializing in pediatric reconstructive surgery, conducted his medical practice through a single member professional limited liability company.
In 2006, the taxpayer purchased a 12.5% interest in an existing surgery center in which other practicing physicians were also partners. The taxpayer paid $163,974 for his interest. He never managed the surgery center, had no day-to-day responsibilities or input into management decisions, and was not involved in hiring or firing decisions. He did meet with the other members quarterly, and he received a distribution from the surgery center regardless of whether he performed any surgeries there. His distribution was not dependent on how many surgeries he performed at the center, and the center did not have a minimum surgery requirement to receive a distribution.
For tax years 2006 and 2007, the taxpayer’s accountant reported the income from the surgery center as nonpassive. The preparer made the determination by relying on the Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc. received from the surgery center. The Schedule K-1 stated that the income was from a trade or business and included self-employment tax. The preparer did not group the taxpayer’s ownership interest in the surgery center with his medical practice activity.
In 2008, the taxpayer’s accountant learned that the taxpayer was not involved in the management of the surgery center and was not liable for the debts of the surgery center. He went through a checklist of passive activity criteria and obtained corroborating information from the taxpayer, determined that the income from the surgery center was passive, and began reporting it as such. He did not amend the taxpayer’s return for 2006 or 2007 because he did not believe the change would be material.
The income from the surgery center was reported as passive in 2008, 2009, and 2010, and the taxpayer used the income to offset passive losses from other activities.
The IRS challenged the passive tax treatment for years 2008, 2009, and 2010. The IRS said the income from the surgery center was nonpassive because the taxpayer had reported it that way for 2006 and 2007. The IRS argued that by reporting the income as nonpassive in the first two years, the taxpayer had effectively grouped the surgery center activity with his medical practice activity and could not ungroup the activities in later years.
The tax court said the taxpayer had not filed a formal grouping statement during 2006 and 2007, and under the rules at the time was not required to do so.
The IRS then argued that even if the taxpayer had not grouped the activities in prior years, under the passive activity rules, the IRS could group the activities into a single unit if the taxpayer’s grouping (or lack of grouping) was not an appropriate economic unit.
Here is the rule that allows the IRS to group (or regroup) activities into an appropriate economic unit.
From federal income tax regulation 1.469-4(f)(1): The IRS can regroup a taxpayer’s activities if “any of the activities resulting from the taxpayer’s grouping is not an appropriate economic unit and a principal purpose of the taxpayer’s grouping (or failure to regroup under paragraph (e) of this section) is to circumvent the underlying purposes of section 469.”
The IRS says the taxpayer’s medical practice services and the services provided by the surgery center are an appropriate economic unit.
The taxpayer says his ownership interest in the surgical center and his medical practice do not constitute an appropriate economic unit as a single activity because the activities are different types of businesses. The surgical center is a rental surgical facility and the taxpayer’s practice is an active medical practice.
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The IRS’s principal argument is that the taxpayer originally grouped his medical practice with the surgical center. However, when the taxpayer reported the surgical center income as nonpassive for 2006 and 2007, he did not group the ownership interest in the surgical center and his medical practice into a single economic unit.
While some facts support treating the taxpayer’s ownership interest in the surgical center and his medical practice as a single economic unit, the weight of the evidence supports treating them as separate economic units.
The taxpayer is the sole owner of his medical practice and only a minority owner of the surgical center. Although he actively manages his medical practice, he does not have any management responsibilities in the surgical center. His medical practice and the surgical center do not share any building space, employees, billing functions, or accounting services. The taxpayer performs services different from the surgical center. The taxpayer is a surgeon providing care, and the surgical center is a surgical center providing space and associated services.
The distribution from the surgical center is unrelated to whether the taxpayer performs surgeries there. In contrast, the taxpayer will receive income from his medical practice only if he performs procedures. Thus, the income the taxpayer receives from the surgical center is not linked to his medical practice.
Accordingly, the taxpayer’s ownership interest in the surgical center and his medical practice may be treated as separate economic units.
Additionally, federal income tax regulation 1.469-4(f)(1) is conjunctive; each requirement must be met in order for the court to determine that the taxpayer must regroup (that is, the grouping is not an appropriate economic unit and a principal purpose of the taxpayer’s grouping (or failure to regroup) is to circumvent the underlying purposes of section 469.)
The taxpayer did not have a principal purpose of circumventing the underlying purposes of section 469 when he treated the activities as separate. The taxpayer did not form an entity to generate passive activity losses. The surgery center was already established when he became a member.
The taxpayer’s grouping was not a “clearly inappropriate” one which would require him to regroup his activities under treasury regulation 1.469-4(e) and (f)(1).
The IRS may not regroup the taxpayer’s activities for the years in issue.