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Tuesday, June 17, 2014

Through The Hoops

Update

The Tax Cuts and Jobs Act has added a new hoop.  It conveniently comes at the end.  Code Section 461(l) disallows excess business losses, Here is an example form RIA
 In 2018, T, a single taxpayer, has deductions of $500,000 from a business. T's gross income from the business is $200,000. T's excess business loss is $50,000 ($500,000 – ($200,000 + $250,000)). The $50,000 excess business loss is treated as part of the taxpayer's net operating loss (NOL) carryfoward in later years.

Originally published on Passive Activities and Other Oxymorons on February 23rd, 2011.
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A lot of our time was spent training in January as we geared up for another tax season.  I'm going to share with you one of the little talks I always give.  I know you all love to see lots of Code references and the like, but I'm going to gloss over them.

A lot of people think that the complexity in the in the tax law comes from special tax breaks and deductions and we can enter into an era of simplicity by having some sort of flat tax with a low rate and minimal deductions.  What that viewpoint fails to recognize is that the taxation of income, as opposed to gross receipts, is inherently complex.  It may be that if you looked at the Code you would be able to pare it down substantially by eliminating provisions that encourage affordable housing or historic renovation or the like.  All that would not touch the inherent complexity.

You could view the history of tax reform since the mid seventies as largely a war against tax shelters.  If you look at your Form 1040 you will see that "Taxable Income" is on Line 43.  The really interesting number, though, is on Line 22 "Total Income". The numbers that go into making up Line 22 (Line 7 through Line 21) have an interesting feature.  Some of them can be negative numbers.  If you are in a very lucrative profession you might have a very big positive number on Line 7 (Wages, salaries, tips, etc.).  If that number drops unharmed down to Line 22  the various deductions that will start whittling it down are for the most part subject to a host of limitation and pretty much require a direct dollar for dollar cash outlay for each dollar of deduction.  Speaking in very broad generalities to seriously carve away at the Line 7 number as it hurtles towards line 43, you need a big negative number before you hit Line 22 (total income).  The most likely place for that big negative number is Line 17 (Rental real estate, royalties, partnerships, S corporations, trusts, etc.)   Other possibilities are Line 12 (Business income or (loss)) and Line 18 (Farm income or (loss)).  Much of the complication in tax rules can be viewed as trying to prevent you from legitimately putting in those negative numbers.

Of course all the rules that have been put in place to stop those negative numbers are generally applicable and have to be dealt with by people who really aren't trying to get away with anything.  Also, the rules have been put into place over a period of time.  When a set of rules was put into place to stop abuse and abuse continued, it was not replaced by a new set of rules.  It was supplemented by additional rules.  To make sense of this both for the purpose of planning and also to do returns correctly I have used the metaphor of a series of hoops to jump through.  In order to get that negative number onto your return the hoops must be jumped through in order.  If you don't get through the second hoop, it doesn't matter what a good job you do on the third.  The only flaw in the analogy is that the hoops are not necessarily pass fail.  A step might limit your loss, without eliminating it.  When that happens there is that much less to jump through the next hoop with.

You could write a book about each of the hoops (As a matter of fact multiple books have been written about them).  I will only discuss each of them very briefly.  The point of my lesson on this is that despite some relationships among them, they operate independently and as I noted above in order.  So, here are the five hoops:

                                               1. For Profit
                                               2. Allocation
                                               3. Basis
                                               4. At-risk
                                               5. Passive Activity Loss Rules
                                               6. Excess business losses (TCJA)

1. For Profit - The activity generating a deductible loss has to be an activity that you enter into with the expectation or at least the hope of making a profit.  This is a pass/fail hoop.  The IRS seems to think that anybody who loses money in any business having anything to do with horses is just doing it for fun.  The Tax Court is sometimes persuaded otherwise.  Complex foreign currency swapping transactions that have a remote chance of producing a stupendous return are an example of something the IRS seems to be able to win on.

2.Allocation - Assuming that there is a loss being generated in an entity of some sort in a business that is trying to make a profit, does a share of that loss really go to you ? If we are talking about Schedule C or Schedule F, the question would be whether the business is really your business.  S corporations allocate loss on a per share per day method unless the shareholders agree to an interim closing of the books.  That's pretty straight forward.  Then we come to partnerships, which we will see as we progress, is where the real action is.  Partnership allocations have to have or be deemed to have "substantial economic effect".  This is governed by the infamous 704(b) regulations.  Just to give you a feel for them, I was going to reproduce the table of contents.  I thought better of it.  Trust me. The regulations get incorporated either directly or by reference into most partnership agreements.  There is a huge understanding gap between the drafters - attorneys who never look at tax returns and return preparers - CPA's who don't always read the agreements.

3.Basis - If all you ever do is put money into a business, have losses, have income and take money out basis is simply the net of all those (Money in and profits are plus, money out and losses are minus).  It you contribute property or obtain an interest by gift or inheritance it gets more complicated.  This is the area where partnerships shine.  The thing that many people do not understand is that basis can never go below zero.  Never.  If there is a loss in excess of your basis that loss is suspended.  If you withdraw funds in excess of your basis you recognize gain.  The thing about partnerships though is that your share of the partnership's liabilities is included in your basis.  So you can have losses greater than the amount of money that you put in.  When this is referred to as "negative basis" what is really meant is that your share of the liabilities is greater than your basis.  The correct term is "minimum gain".  Minimum gain is the amount of gain that you would have to recognize if you abandoned your partnership interest, because, in that event, your share of the liabilities would be a deemed distribution to you. The one good thing about the nasty allocation rules is that generally a partnership will not allocate a loss to somebody who doesn't have basis to absorb it.  That happens all the time with S corporations.

4.At-risk - This is frequently confused with basis but it is a different concept.  Probably the best way to think of it is basis lite.  If you incur a liability that gives you basis but you are somehow insulated from loss, as is the case of a non-recourse liability, you are not at-risk for that amount.  If you are dealing with real estate, however, most conventional financing that is non recourse will be considered "qualified non-recourse" and exempt from the at-risk rules.

5. Passive Activity Loss Rules - Hoops 2 through 4 are somewhat interrelated. The final hoop is another whole system. The Passive Activity Loss rules (Code Section 469) were part of the Tax Reform Act of 1986 (Note that that act was epic in its scope such that we now have The Internal Revenue Code of 1986.  Previously it was 1954. )  The PAL rules require us to put our trade our business activities into buckets.  (There are some wonderful regs about how big the buckets can be and what can go into each of them).  Then the buckets are classified as to whether we materially participate in them.  Rental activities are per se passive.  There is a lot to these rules and by my lights they really did kill tax shelters, at least as I knew them in my youth.  Sometimes people will say that you can offset passive income with passive losses.  This is a dangerous thought trap.  Gains and loss retain their character so that the sale of a passive activity at a capital gain will release previously suspended ordinary losses.

6. Excess business losses - See above.

I have only very lightly touched on each of these areas.  The point of the post, though, is that you must remember that they are separate sets of rules that must be independently evaluated.

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