Preface: Grouping activities is a way to reduce net investment income taxes. This blog shows practical ways grouping can lead to perennially lower tax costs.
Grouping Passive and NonPassive Activities
Taxpayers can merge one or more trade or business activities, or rental activities, into a single activity if those activities qualify as an appropriate economic unit for measuring gain or loss under the passive activity rules measuring tax attributes.
The benefit of grouping activities, such as two business activities into one economic unit for tax purposes, is that you only need show material participation as a whole, and not individual interests to avoid suspension of losses or net investment income tax.
Appropriate economic units take into consideration all the tax characteristics of the activities. These grouping characteristics include:
- Similarities and differences in the types of trades of businesses
- The extent of common control
- Extent of common ownership
- Geographical location
- Interdependence between or among activities, i.e.
- buy or sell goods between or among themselves
- involve products or services that are provided together
- same customers
- same employees
- single set of financial books
Disadvantages of grouping interests on the other hand are evident in that disposition of one interest, when grouped, your activities are only disposed in part, and loss may be suspended.
The benefit of grouping activities for 2015 is that if you reach Net Investment Income Tax (NIIT) thresholds for the tax year with your businesses, you can group activities to avoid the addition 3.8% net investment tax on investment income. Grouping can adjust this income from a passive activity to a non passive activity.
For example: Let’s say Lancaster Foods is an S corporation and Lancaster Holdings is a partnership and owns the real estate rented to Lancaster Foods. David holds equal ownership in Lancaster Holdings and Lancaster Foods. The grouping holds an economic unit with common ownership, common control, and geographical location and therefore can be grouped into a single trade or business activity. For instance if the rental income from Lancaster Holdings was $350,000, grouping could save up to $13,300 of additional net investment income tax from a grouping to a nonpassive activity, vs. a standard passive activity.
Groupings decisions should be discussed with your tax professional given the complexity. Regulation Section 1.469-4 provides rules and limits on grouping activities with fact and circumstance tests to determine the appropriate of grouping for your activity.
For another example of grouping lets consider Galen who owns manages a local agribusiness. To reinvest cash profits that business, let’s say Galen purchases all the stock in a second agribusiness in a nearby town. Let’s say he plans to relocate the business in that town with a new real estate partnership on the property. An associate is managing the entire project and business and it will be a passive activity to Galen. If the new building has a cost-segregation study with accelerated depreciation it could have a loss for the year. Galen’s tax accountant could potentially group the three entities into one economic unit for tax purposes qualifying all activities as nonpassive, and in addition netting the tax benefits on the cost segregation study on the real estate partnership. Grouping would net the gain and losses on the interests and avoid net investment income tax on the real estate.
Summary: Grouping activities has advantages and disadvantages. Talk with your CPA to see if it can work for your business.