COURT CASE TESTS PASSIVE ACTIVITY
GROUPING POWERS OF IRS
By Jerry Rosen, CPA
A recent case indicates that a taxpayer can be a passive investor in a facility and have a medical practice which is nonpassive, even though the facility is used by the taxpayer in his practice.
In Hardy, 113 TC Memo 1070 (2017), a plastic surgeon bought a minority interest in a surgical center (treated as a partnership), joining seven other physicians in the ownership. Dr. Hardy conducted his own medical practice as well in an office not located in the surgical center. Some procedures, such as those involving local rather than general anesthesia, were performed at the surgical center, but others, such as those involving general anesthesia or an overnight stay, were performed at hospitals.
The surgical center was professionally managed, and the taxpayer did not have any management responsibilities in the center nor were any management tasks of his practice shared by the center. It hires its own employees, none of whom are shared with Dr. Hardy’s own practice. Dr. Hardy is not paid by the surgical center for surgeries he performs at the center.
On prior income tax returns, the taxpayer has reported the center’s income as nonpassive. For the year in question, the taxpayer treated the income from the center as passive income, based on advice from taxpayer’s accountant. The prior year returns were not amended because the accountant believed the change not to be material. On Form 8582, the taxpayer also showed passive activity losses, which were allowed due to the passive activity income of the center.
The Commissioner disallowed the passive activity loss taken on taxpayer’s return, determining that the center’s income from its activities were nonpassive when considered with the medical practice, which was clearly nonpassive. The Commissioner was inferring (a term the court used) that the two activities, the surgical center and the medical practice, should properly be grouped together as a single nonpassive activity.
Regulations under Code Section 469 set forth the circumstances in which various trade or business or rental activities can be grouped into a single passive or nonpassive activity if they constitute an “appropriate economic unit”. The specific regulation, Reg. 1-469-4(c), provides a facts and circumstances test for what constitutes an appropriate economic unit. While the regulation states that any reasonable method of applying the facts and circumstances test, it also lists five factors (not all of which need be present) for determining the appropriate economic unit. They are: 1) similarities and differences in types if trades or businesses, 2) the extent of common control, 3) the extent of common ownership, 4) geographical location, and 5) interdependencies between or among the activities. Despite the listing of the factors, the regulation gives the taxpayer’s some additional flexibility in determining what constitutes an appropriate economic unit.
The regulation also states that once a taxpayer has grouped activities, the taxpayer may not regroup the activities in subsequent years unless grouping was clearly inappropriate. The regulation also gives the Commissioner a power to regroup to prevent tax avoidance.
The Commissioner argued that a grouping had occurred in 2006 and 2007, the years before the reported change of the center’s status to passive. The Court, however, was not going to infer that the taxpayer made any prior grouping at all. The mere reporting of the center’s income in prior years as nonpassive was not a grouping of the center and the medical practice, but merely a determination that the center was an economic unit separate from the medical practice and a nonpassive activity. The Court found no evidence of grouping or regrouping of activities by the taxpayer, concluding that the taxpayer treated and was permitted to treat the activities as separate economic units.
The Commissioner also argued that under his regrouping powers he could combine the center and the medical practice in an appropriate economic unit. The court emphasized the flexibility found in the regulation, concluding that there is more than one reasonable method of grouping the taxpayer’s activities. It concluded that the Commissioner may not regroup a taxpayer’s activities if that grouping is reasonable. The Court went on to cite Tech. Adv. Mem. 201634022, in which the IRS allowed a medical practice and surgical center to be treated as separate activities, indicating to the Court that the taxpayer’s grouping was not clearly inappropriate and thus not within the Commissioner’s power to regroup.