TAM 1035016: Passive activity recharacterization is not an accounting-method change

Plain-English summary

This Technical Advice Memorandum considers whether changing the characterization of a nursing-home activity from nonpassive to passive under IRC § 469 is a change in accounting method under IRC §§ 446(e) and 481(a). The IRS concluded that the characterization depends on whether the taxpayers materially participated in the activity during the particular year and does not determine the timing of an income or deduction item. Because the characterization is not an accounting method, correcting the taxpayers’ treatment for 1994 did not require a Form 3115 or a section 481(a) adjustment. The memorandum assumes that the taxpayers did not materially participate in 1994 and addresses only the accounting-method question.

Ruling snapshot

• Question: Is recharacterizing the taxpayers’ nursing-home activity from nonpassive to passive under IRC § 469 a change in accounting method under IRC §§ 446(e) and 481(a)?
• Outcome: Advice given
• Key authorities: IRC §§ 446(e), 469, and 481(a); Treas. Reg. §§ 1.446-1(a)(1), 1.446-1(e), and 1.446-1(e)(2)(ii); IRC § 6110(k)(3) not-precedent notice

Full text (IRS public release)

                        INTERNAL REVENUE SERVICE
              NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

                                              June 03, 2010

                                                  Third Party Communication: None
                                                  Date of Communication: Not Applicable

Number: 201035016
Release Date: 9/3/2010

Index Nos.: 446.03-00, 446.04-00, 469.00-00
Control No.: TAM-118359-98

--------------------

     Taxpayers' names:                           ------------------------------------
     Taxpayers' address:                         ------------------------
                                                 ----------------------------------
     Taxpayers' EINs                             -----------------
                                                 ---------------------
     Year involved:                              -------
     Date of conference:                         -------------

Legend: X = ----------------------

              Y                 =        -----------------------

              taxpayers         =        ------------------------------------------------------------------

     Partnership =              ---------------------------------------

      State         = ------------

             Company            =        ---------------------------------------

Issue: Is a recharacterization of the taxpayers' activities from nonpassive to passive for
purposes of the passive activity loss and credit limit rules of § 469 of the Internal
Revenue Code a change in a "method of accounting" for purposes of §§ 446(e) and
481(a)?

TAM-118359-98 2

Conclusion: The recharacterization of the taxpayers' activities from nonpassive to
passive for purposes of the passive activity loss and credit limit rules of § 469 is not a
change in a method of accounting for purposes of §§ 446(e) and 481(a).

Facts: X owns a one percent general partner interest and X and Y (collectively, "the
taxpayers") own a 99 percent limited partner interest, through their living trust, in
Partnership, a State limited partnership. Partnership developed a nursing home in
State and hired a management company, Company, to operate the nursing home in
exchange for a fee plus a portion of the profits. The nursing home became fully
operational in 1990.

   The taxpayers determined that they materially participated in the nursing home

from 1990 through 1994, and therefore, they treated the majority of the losses flowing
from the partnership as not being subject to the passive loss limitation rules under
§ 469. Treatment of the losses for the 1990 through 1994 tax years as nonpassive
resulted in the losses either being carried back to prior years or offsetting other income
in those years. This treatment allowed the taxpayers to offset their ordinary income with
the losses from the nursing home on their tax returns from 1990 through 1994.

  Taxpayers' 1994 tax year is under examination. An examiner has questioned

whether the taxpayers were correct in deciding that their ownership of the nursing home
was not a passive activity in 1994. Specifically questioned is whether the taxpayers were
correct when they decided that they "materially participated," as defined in
§ 469(h), in the nursing home activity in 1994.

    The examiner's position is that the taxpayers did not materially participate in the

activity in 1994 and that the nursing home ownership was a passive activity, which
resulted in the taxpayers being subject to the passive activity loss and credit limit rules
of § 469 in 1994. The examiner has requested guidance with respect to whether a
recharacterization of the taxpayers' activities from nonpassive to passive for purposes of
§ 469 is a change in a method of accounting for purposes of § 446(e), requiring the
computation of an adjustment under § 481(a).

    The taxpayers do not agree with the examiner's § 469 position. However, the

taxpayers and the examiner have agreed that only the change in a method of accounting
issue would be submitted to the national office for consideration. Both the taxpayers
and the examiner have agreed that the national office should assume for purposes of
answering the change in a method of accounting issue that the examiner is correct in
regard to the taxpayers' lack of material participation in the nursing home activity. Thus,
for purposes of this technical advice memorandum, the national office will assume that
the taxpayers did not materially participate in the nursing home activity

TAM-118359-98 3

in 1994 and were therefore subject to the passive activity loss and credit limit rules of
§ 469 in that year.

Law and Analysis: Section 446(a) states the general rule that taxable income shall be
computed under the method of accounting on the basis of which the taxpayer regularly
computes income in keeping its books. See § 1.446-1(a)(1) of the Income Tax
Regulations.

   Section 1.446-1(a)(1) provides in pertinent part that the term "method of

accounting" includes not only the over-all method of accounting of the taxpayer but also
the accounting treatment of any item. Examples of such over-all methods are the cash
receipts and disbursements method and an accrual method.

    Section 1.446-1(e) provides the rules governing the adoption or change of a

method of accounting. See also Rev. Proc. 97-27, 1997-1 C.B. 680 (which provides the
general procedures for obtaining the consent of the Commissioner of Internal Revenue
to change a method of accounting for federal income tax purposes). Section 1.446-
1(e)(2)(ii)(a) states that a change in the method of accounting includes a change in the
over-all plan of accounting for gross income or deductions or a change in the treatment
of any material item used in such over-all plan. Although a method of accounting may
exist under this definition without the necessity of a pattern of consistent treatment of an
item, in most instances a method of accounting is not established for an item without
such consistent treatment.1 A material item is any item which involves the proper time
for the inclusion of the item in income or the taking of a deduction.

   Section 1.446-1(e)(2)(ii)(b) provides in pertinent part that a change in method of

accounting does not include correction of mathematical or posting errors, or errors in
the computation of tax liability. Also, a change in method of accounting does not
include adjustment of any item of income or deduction that does not involve the proper
time for the inclusion of the item of income or the taking of a deduction. A change in the
method of accounting also does not include a change in treatment resulting from a
change in underlying facts.

  Rev. Proc. 97-27, section 2.01(1), explains that in determining whether a

taxpayer's accounting practice for an item involves timing, generally the relevant

   1
      Rev. Rul. 90-38, 1990-1 C.B. 57 explains that the treatment of a material item

in the same way in determining the gross income or deductions in two or more
consecutively filed tax returns represents consistent treatment of that item for purposes
of § 1.446-1(e)(2)(ii)(a). However, if a taxpayer treats an item properly in the first return
that reflects the item, it is not necessary for the taxpayer to treat the item consistently in
two or more consecutive tax returns.

TAM-118359-98 4

question is whether the practice permanently changes the amount of the taxpayer's
lifetime income. If the practice does not permanently affect the taxpayer's lifetime
income, but does or could change the tax year in which the income is reported, it
involves timing and is therefore a method of accounting.

   Rev. Proc. 97-27, section 2.01(3), states that a change in the characterization of

an item may also constitute a change in method of accounting if the change has the
effect of shifting income from one period to another.

   Section 481(a) provides in pertinent part that when computing a taxpayer's

taxable income for any tax year if such computation is under a method of accounting
different from the method under which the taxpayer's taxable income for the preceding
tax year was computed, then there shall be taken into account those adjustments that
are determined to be necessary solely by reason of the change in order to prevent
amounts from being duplicated or omitted.

    Section 469(c) generally defines "passive activity" as any activity which involves

the conduct of a trade or business in which the taxpayer does not materially participate
and any rental activity.

    Section 469 denies certain taxpayers the use of deductions arising from passive

activities to offset income from personal services, portfolio income and income from a
trade or business which is not a passive activity ("nonpassive income"). Generally,
deductions arising from passive activities may only be used to offset the income arising
from passive activities. If in any tax year a deduction arising from a passive activity can
not be fully used against the income from the passive activity and the net income from
other passive activities, the taxpayer is permitted to carryforward the unused portion of
the deduction. When the taxpayer disposes of its interest in the passive activity in a fully
taxable transaction with an unrelated party, if any unused deduction from the disposed of
activity remains after first being used to offset income from the disposition of the
activity and net income from other passive activities, the taxpayer may apply the excess
deduction to offset other income.

    Thus, § 469 divides certain taxpayers' activities into two categories--passive or

not passive. Then, § 469 places special restrictions on the use of losses arising from
activities characterized as passive.

  For a number of years, including 1994, the taxpayers have been required to

determine whether the nursing home activity was a passive activity subject to the
passive activity loss limit rules of § 469. Basically, this has required that the taxpayers
determine whether, based on the facts for that year, they materially participated in their
nursing home activity. If they materially participated, the nursing home activity was not

TAM-118359-98 5

a passive activity that year and any loss for that year would not be limited by § 469. In
contrast, if they did not materially participate, the nursing home activity was a passive
activity that year and any loss for that year could not be freely used to offset income.
Because the determination of whether the nursing home activity is a passive activity is
based on each year's facts, the taxpayers' nursing home activity could be considered
passive in one year but not in the next year.

   Assuming that the examiner is correct that, in 1994, the taxpayers did not

materially participate in their nursing home activity and, therefore, the taxpayers' nursing
home activity should be recharacterized from nonpassive to passive for purposes of
§ 469, the issue to be decided by the national office is whether this recharacterization is
a change in a method of accounting under § 446(e). This issue involves only the
characterization of an activity as either nonpassive or passive.

    Each year the taxpayers review their facts and decide whether during that year

they materially participated in their nursing home activity. If the taxpayers did not
materially participate, their nursing home activity must be classified as passive under the
§ 469 rules. Based on the facts present in one year, the activity may be nonpassive
in that year, while in another year, under the facts present in that year, the activity may
be passive. Under the argument advocated by the examiner, each year that the activity
changed from nonpassive to passive, or vice versa, the taxpayers would be required to
file a Form 3115, Application for Change in Accounting Method. In each year of
change, the taxpayers would be required to compute an adjustment under § 481(a). If,
for example, a taxpayer materially participated in an activity in 1997, but did not in 1998,
the examiner would have the taxpayer file a Form 3115 for 1998. Any amounts that
were properly deducted in 1997 because the activity was nonpassive, that would have
been deferred had the activity been passive would be included in the computation under
§ 481(a). Similarly, in the instant case, the examiner believes that if the taxpayers did
not materially participate in 1994, the examiner may bring into income in 1994 any
amounts that were deducted in prior years, that would not have been deductible in
those years if the taxpayers had not materially participated in those years. The
examiner believes that this may be done, by virtue of § 481(a), without regard to
whether the taxpayers materially participated in the nursing home activity in the prior
years. The examiner notes that this is because, if a change from determining that a
taxpayer materially participated in an activity to determining that it did not materially
participate in the activity is a change in method of accounting, § 481(a) authorizes
necessary adjustments to prevent amounts from being duplicated or omitted.

    We do not believe that a determination of whether a taxpayer materially

participates in an activity is a method of accounting. In this case, the taxpayers'
determination of whether they materially participate in their nursing home activity does
not determine into which period an item of income or deduction will be placed. The

TAM-118359-98 6

taxpayers' determination does not involve the treatment of a "material item." Simply,
determining whether the taxpayers materially participated in their activity for purposes of
classifying the activity as passive or not is not an "item"--it is not a recurring incidence of
income or expense. Instead, the taxpayers' determination establishes the character of
their activity for that year--it is either passive or it is not passive. Once the character of the
activity is determined, then if the activity is passive, the taxpayers must apply the
statutorily mandated rules of § 469 to any existing loss.

   The issue involved in this technical advice request is distinguishable from that

addressed in Knight-Ridder Newspapers, Inc. v. United States, 743 F.2d 781 (11th Cir.
1984), a case cited by the examiner in support for the conclusion that a method of
accounting will be changed when the treatment of the taxpayers' activities is changed
from nonpassive to passive under § 469. As discussed in the examiner's submission,
the taxpayer in Knight-Ridder used a reserve accounting method for its advertising
revenue. Advertising customers that met certain criteria were entitled to a rebate of a
portion of their advertising payment. Knight-Ridder accrued advertising revenue as
income and deducted an estimate of the amount that would be refunded under its
rebate program. Knight-Ridder was not obligated to pay, and was therefore not entitled
to deduct, the advertising rebates until the advertiser met the rebate criteria. The
Government proposed to change Knight-Ridder's method of accounting to the correct
method. Knight-Ridder agreed that its reporting was improper, but argued that it was
not a method of accounting subject to the provisions of §§ 446 and 481(a). Knight-
Ridder argued that since it was deducting amounts that might never be deductible, the
proper time for the taking of deductions was not at issue. The court concluded that
Knight-Ridder's reserve method of accounting would have reported excess deductions
as income when Knight-Ridder terminated its affairs, thus the proper time for the taking
of deductions was at issue.

    In Knight-Ridder, unlike the instant case, the treatment of an item of expense (the

advertising rebates) was at issue. The instant case involves no item of income or
expense, but, rather the factual determination of whether the taxpayers materially
participated in an activity during a given year. Recently, the United States Tax Court
was presented with the argument that § 469 was an accounting method provision. St.
Charles Investment Co. v. Commissioner, 110 T.C. 46 (1998). Although the case was
decided on other grounds, the Court gave some indication that it did not believe that
§ 469 was an accounting method provision. For example, the Court stated-

   we note that, although Congress placed section

469 in a part of the Code entitled "Methods of Accounting",
the legislative history indicates that such treatment is not as significant as
petitioner would have us believe. The statute

TAM-118359-98 7

itself and the legislative history treat
section 469 separately from the provisions
dealing with accounting matters. Compare
title V, entitled "Tax Shelter Limitations;
Interest Limitations", which includes the
provisions of section 469, with title VIII
"Accounting Provisions" of the Tax Reform
Act of 1986, Pub. L. 99-514, 100 Stat. 2085,
2233-2249, 2345-2375; H. Conf. Rept. 99-841
(Vol. II), supra, 1986-3 C.B. (Vol. 4) at
134, 285.

Id. at 53-54. Similarly, the Court rejected the taxpayer's attempt to reinforce its method
of accounting argument with language in the § 469 regulations. Id. at 54.

    Assuming that the taxpayers did not materially participate in the nursing home

activity in 1994, the taxpayers mischaracterized their nursing home activity in 1994
when they failed to treat the nursing home activity as a passive activity under § 469
rules. The taxpayers made an error in 1994 and the correction of this error is not a
change in a method of accounting.

Caveat: A copy of this technical advice memorandum is to be given to the taxpayers.
Section 6110(k)(3) provides that it may not be used or cited as precedent.

                                      -End-