Separately owned business entities cannot aggregate activities to share one entity's at-risk amount

Plain-English summary

An individual held minority interests in three S corporations and a partnership, each operating a similar business through a separate legal entity. The individual personally guaranteed the partnership's line of credit and sought to aggregate all four businesses under section 465 so that this at-risk amount could support losses from the S corporations as well. Chief Counsel advised that the businesses did not constitute a single integrated trade or business because they operated in different states, used separate franchise and financing arrangements, maintained separate books, had different ownership, and shared employees only to a limited extent. The advice also concluded that section 465(c)(3)(B) generally does not permit aggregation across multiple partnerships or S corporations, particularly when the entities limit their owners' liability. The section 469 passive-activity grouping rules did not change the result because those rules serve a different purpose and do not govern section 465. The S corporation losses therefore could not use the partnership guaranty as their at-risk amount.

Ruling snapshot

• Question: May an individual aggregate similar businesses conducted through one partnership and three S corporations so a guarantee of the partnership's debt supports losses from all four entities under section 465?
• Outcome: advice given, aggregation was not permitted
• Key authorities: IRC §§ 465, 469, and 1366(d); Treas. Reg. §§ 1.465-8, 1.465-20, and 1.469-4

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           Memorandum
           Number: 201805013
           Release Date: 2/2/2018
           CC:PSI:3:WMKostak                              Third Party Communication: None
           PRESP-113577-17                                Date of Communication: Not Applicable

 UILC:     465.00-00, 465.02-05, 465.03-00

  date:    October 31, 2017

     to:   Associate Area Counsel (Fort Lauderdale)
           (Small Business/Self-Employed)
           Attn: Kimberly Daigle

  from:    James A. Quinn
           Senior Counsel, Branch 3
           (Passthroughs & Special Industries)


subject:   Aggregation of Activities under Section 465(c)(3)(B)

           This Chief Counsel Advice responds to your request for assistance. This advice may
           not be used or cited as precedent.

           LEGEND

           A            =      ----------------------------
                               ------------------------

           B            =      ----------------

           M            =      -------------------------------------------
                               -----------------------

           X            =      ----------------------------------------------------
                               -----------------------

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

           Z            =      ---------------------------------------------
                               -----------------------

PRESP-113577-17                                     2

Bank           =      ----------------------

N1             =      -------------

N2             =      --

N3             =      ---

N4             =      ---

N5             =      ---

N6             =      -------------

N7             =      -----------

N8             =      -----------

N9             =      ---------

N10            =      -----------

State1         =      ---------

State2         =      -------------

State3         =      ---------------

Date1          =      ---------------------------

Date2          =      ---------------------------

Year1          =      ------

Year2          =      ------


ISSUE

       May business activities conducted through a partnership and three separate S
corporations be aggregated and treated as a single activity for purposes of the at-risk
rules of § 465 of the Internal Revenue Code under the facts as described below?

FACTS

         The facts submitted to us provide as follows:

PRESP-113577-17                                   3


        On Date1, A, an individual, signed three separate promissory notes payable to B
totaling $ N1 to purchase N2 percent (minority) ownership interests in three separate S
corporations, X, Y, and Z (one note for each corporation). B is the majority owner in
each of X, Y, and Z, and owns N3 percent of the ownership interests in X, N4 percent of
the ownership interests in Y, and N5 of the ownership interests in Z. In Year2, A
acquired a N2 percent ownership interest in M, an LLC treated as a partnership for
federal income tax purposes. Although it is not clear from the facts as submitted, this
N2 percent ownership interest in M was apparently given to A by B at least partially in
exchange for A’s personal guaranty of a line of credit of $ N6 between M and Bank
executed by A on Date2. The other minority owners in M, X, Y, and Z are third parties
unrelated to either A or B, and the ownership structure of M, X, Y, and Z are not
identical (i.e., there is no overlap of minority owners among M, X, Y, and Z, besides A).
The three promissory notes between A and B are each styled as “nonrecourse.” Each
promissory note provides that B’s sole and exclusive remedy for any default on each
respective note is to reclaim A’s stock in the respective S corporation. A also executed
Stock Pledge Agreements and Stock Restriction Agreements with respect to A’s
ownership interests in X, Y and Z, in favor of B. Under the Stock Pledge Agreements, A
pledged A’s stock in X, Y, and Z to B to secure the obligations of A under the three
promissory notes. The Stock Restriction Agreements place certain other restrictions on
the sale, assignment, gift, pledge, encumbrance or other disposition of A’s shares of X,
Y and Z, and include provisions for the disposition of the stock upon the death or the
termination of employment of A.

        M, X, Y, and Z are engaged in the business of ---------------------------------------------
Each entity operates a separate---------------. The ---------------------are conducted at
different locations (in State1, State2, and State3) and sell ------from different
manufacturers, and each -------------- has its own franchise agreement with the
manufacturer that appears independent of the other franchises held through the other
entities. M, X, Y, and Z each have their own lines of credit and ----------- (inventory
financing) arrangements provided from their respective manufacturers. M, X, Y, and Z
are accounted for using separate books and records, but the books and records for the
four entities are maintained at a central location. M, X, Y, and Z utilize the same
accounting method. It should further be noted that it appears that B is the majority
owner of a number of other --------------------, besides those conducted through M, X, Y
and Z, in which A has no ownership interest. A number of these other --------------- are
located in places other than State1, State2, and State3, and likely have ownership
structures that are different than M, X, Y, and Z.

          There is a limited amount of employee sharing among M, X, Y, and Z. A is one
of the small number of shared employees and, in addition, some employees of one
-------------- will fill in for others at another ------------- when needed. For example, a -------
-----manager working at one -------------- will fill in at another -------------- if the --------------
manager at that -------------- is unavailable. M, X, Y, and Z also share advertising,
information technology, and accounting services. Otherwise, M, X, Y, and Z do not

PRESP-113577-17                                 4

routinely purchase goods and services from each other. The customer base of each of
M, X, Y, and Z is the general --------------public, so it is not possible to state the extent
that ---------------------may share the same customers (other than point out that these -----
--------------- are located in different states and therefore it appears unlikely that the -------
--------------- would share the same customers in most cases). M, X, Y, and Z do not
carry on any other trades or businesses besides the --------------------, and M, X, Y, and Z
do not hold any other assets besides the --------------------.

         Each of M, X, Y, and Z employs one or more professional managers who have
authority to exercise independent judgment in managing the day-to-day operations of
their respective ---------------. However, all of these professional managers are overseen
by A on a day-to-day basis. A spends over 500 hours a year working in ---------- ----------
--------------- of M, X, Y, and Z. In addition, A is responsible for identifying, interviewing,
testing, recruiting, and hiring the operating managers and key personnel for the -----------
---------------, and monitoring their teams’ performance. A is also responsible for
determining compensation and adjustments to drive commission-related performance --
-------------------------------. A regularly reviews operations of ---------------------to maintain
revenue growth and expense control for variable and fixed operations. A’s time at ----- -
--------------- is generally split 80 percent directing general management issues and 20
percent working with front line employees to spot check customer service and sales
performance.

        As stated above, in Year1, A executed a Guaranty of Payment in favor of Bank
that personally guarantees a line of credit between M and Bank in the amount of $ N6.
A’s business assets as well as A’s personal assets are subject to this guaranty. The
line of credit is used for financing M’s -----------inventory and working capital. According
to the facts submitted, this line of credit has been utilized by M, and the amount
outstanding may vary over time, but generally most of the line of credit is currently
outstanding. However, the funds advanced to M from the line of credit are used only in
the -------------------business conducted through M, and none of the funds from this line of
credit have been directly or indirectly distributed to or used in X, Y, or Z. This line of
credit is also collateralized by M’s inventory --------------------.

        A filed an amended return for Year1 to claim losses from X, Y, and Z in the
aggregate amount of $ N7. While not clear from the facts as submitted, it appears that
these losses are treated as disallowed under § 465(a)(1) on A’s Year1 return, and
carried over to Year2 under § 465(a)(2). For Year2, A deducted losses of $ N8 from X,
Y, and Z and a loss of $ N9 from M, and claimed a net operating loss deduction of
$ N10 carried over from Year1 from X, Y, and Z. In addition, for Year2, A chose to
group the business activities of M, X, Y, and Z together as a single trade or business
activity for purposes of the passive activity loss rules under § 469. A argues that the
activity aggregation rules of § 465(c)(3)(B) also allow him to treat the business activities
of M, X, Y, and Z as a single activity for § 465 purposes. If this aggregation of business
activities is permitted under § 465(c)(3)(B), A likely would be allowed to treat all of the
losses from M, X, Y, and Z, as reported in Year2, as not subject to limitation under the

PRESP-113577-17                              5

at-risk rules of § 465 as a result of A’s personal guaranty of M’s line of credit from Bank
in Year2. A’s personal guaranty would cause A to be at risk in the aggregated business
activity in the amount of the outstanding balance of the line of credit (i.e., any remaining
unpaid amount that had been previously advanced to M under the line of credit) at the
close of each tax year, to the extent A remains personally liable for repayment of that
amount under the guaranty at that time.

LAW

        Section 465(a) provides that in the case of an individual, and a closely held C
corporation, engaged in an activity to which § 465 applies, any loss from such activity
for the taxable year shall be allowed only to the extent of the aggregate amount with
respect to which the taxpayer is at risk (within the meaning of § 465(b)) for such activity
at the close of the taxable year.

        Section 465(b)(1) provides, generally, that for purposes of § 465, a taxpayer shall
be considered at risk for an activity with respect to amounts including (A) the amount of
money and the adjusted basis of other property contributed by the taxpayer to the
activity, and (B) amounts borrowed with respect to such activity (as determined under
§ 465(b)(2)).

       Section 465(b)(2) provides that, for purposes of § 465, a taxpayer shall be
considered at risk with respect to amounts borrowed for use in an activity to the extent
that he (A) is personally liable for the repayment of such amounts, or (B) has pledged
property, other than property used in such activity, as security for such borrowed
amount (to the extent of the fair market value of the taxpayer’s interest in such
property).

       Section 465(b)(3) provides, generally, that except to the extent provided in
regulations, for purposes of § 465(b)(1)(B), amounts borrowed shall not be considered
to be at risk with respect to an activity if such amounts are borrowed from any person
who has an interest in such activity or from a related person to a person (other than the
taxpayer) having such an interest.

      Section 465(b)(4) provides that, notwithstanding any other provision of § 465, a
taxpayer shall not be considered at risk with respect to amounts protected against loss
through nonrecourse financing, guarantees, stop loss agreements, or other similar
arrangements.

        Section 465(c)(1) provides that § 465 applies to any taxpayer engaged in the
activity of
        (A) holding, producing, or distributing motion picture films or video tapes,
        (B) farming (as defined in § 464(e)),
        (C) leasing any § 1245 property (as defined in § 1245(a)(3)),
        (D) exploring for, or exploiting, oil and gas resources, or
        (E) exploring for, or exploiting, geothermal deposits (as defined in § 613(e)(2))

PRESP-113577-17                              6

as a trade or business or for the production of income.

        Section 465(c)(3)(A) provides that § 465 also applies to each activity (i) engaged
in by the taxpayer in carrying on a trade or business or for the production of income,
and (ii) which is not described in § 465(c)(1).

       Section 465(c)(3)(B) provides that, except as provided in § 465(c)(3)(C), for
purposes of § 465, activities described in § 465(c)(3)(A) which constitute a trade or
business shall be treated as one activity if (i) the taxpayer actively participates in the
management of such trade or business, or (ii) such trade or business is carried on by a
partnership or an S corporation and 65 percent or more of the losses for the taxable
year is allocable to persons who actively participate in the management of the trade or
business.

      Section 465(c)(3)(C) provides that the Secretary shall prescribe regulations
under which activities described in § 465(c)(3)(A) shall be aggregated or treated as
separate activities.

        Section 1.465–8(a)(1) of the Income Tax Regulations provides that it applies to
amounts borrowed for use in an activity described in § 465(c)(1) or (c)(3)(A). Amounts
borrowed with respect to an activity will not increase the borrower's amount at risk in the
activity if the lender has an interest in the activity other than that of a creditor or is
related to a person (other than the borrower) who has an interest in the activity other
than that of a creditor. This rule applies even if the borrower is personally liable for the
repayment of the loan or the loan is secured by property not used in the activity. For
additional rules relating to the treatment of amounts borrowed from these persons, see
§ 1.465–20.

        Section 1.465-20(a) provides that the following amounts are treated in the same
manner as borrowed amounts for which the taxpayer has no personal liability and for
which no security is pledged—(1) amounts that do not increase the taxpayer’s amount
at risk because they are borrowed from a person who has an interest in the activity
other than that of a creditor or from a person who is related to a person (other than the
taxpayer) who has an interest in the activity other than that of a creditor; and (2)
amounts (whether or not borrowed) that are protected against loss.

ANALYSIS

       The promissory notes signed by A used to purchase stock in X, Y, and Z appear
to be sufficient to provide basis to A in X, Y, and Z for purposes of § 1366(d). However,
given that the promissory notes represent amounts borrowed from a person, B, with an
interest in the activities, A would not be at risk with respect to these borrowed amounts
pursuant to § 465(b)(3), § 1.465-8(a)(1) and § 1.465-20(a)(1). A does not dispute this
analysis. Instead, as stated above, A’s position is that the aggregation rules of
§ 465(c)(3)(B) allow A to treat the ---------------------conducted through M, X, Y, and Z as
a single activity for § 465 purposes. Accordingly, if the business activities of M, X, Y,

PRESP-113577-17                              7

and Z can be aggregated into a single activity for purposes of § 465, then all of the
losses from M, X, Y, and Z would likely be allowable in Year2 as a result of A’s personal
guaranty of the line of credit of M from Bank in Year2 (even though the funds advanced
under the line of credit is utilized solely by M). If A is not permitted to aggregate M, X,
Y, and Z into a single activity under § 465(c)(3)(B), then the losses allocable to A from
X, Y, and Z would be disallowed in Year2 under § 465(a)(1), since A would not be at
risk with respect to the separate business activities conducted through X, Y, and Z.

        The at-risk limitations of § 465 were added to the Code because of Congress’
concern that taxpayers were deducting losses from tax-sheltering activities far in excess
of their economic amount at risk in the activities. To prevent this abuse, § 465 limits the
amount of any deduction for losses from a § 465 activity to the aggregate amount that
the taxpayer is economically at risk in each such activity at the close of the taxable year.
See S. Rep. No. 938, 94th Cong., 2d Sess. 47-48 (1976), 1976-3 (Vol. 3) C.B. 85-86.
The thrust of § 465(a) is to allow a taxpayer to deduct losses only to the extent that the
taxpayer bears a real economic risk of loss which is associated with those tax losses.

       In order to determine whether A’s position is correct, a number of questions
regarding the proper interpretation of the statutory language under § 465(c)(3)(B) need
to be addressed. Specifically, these questions are:

   1) What is the proper definition of “activity” for purposes of § 465(c)(3)?
   2) What is the proper test for determining whether a taxpayer actively participates in
      the management of activities that constitute a trade or business for purposes of
      § 465(c)(3)(B)?
   3) Must multiple business activities constitute a single trade or business in order to
      be aggregated into a single activity under § 465(c)(3)(B)?
   4) May activities that are conducted through separate entities that provide limited
      liability to their owners be aggregated into a single activity under § 465(c)(3)(B)?

       Definition of Activity for Purposes of § 465(c)(3)

     The statutory language of § 465(c)(3) provides no guidance as to the scope or
meaning of the term “activity” (prior to the application of any aggregation rule).

        With respect to the activities described in § 465(c)(1) and (2), § 465(c)(2)(A)
provides that each such property as described will be treated as a separate activity,
subject to rules similar to those contained in § 465(c)(3)(B) that allows aggregation of
those activities if certain conditions are met. Accordingly, at least with respect to the
activities described in § 465(c)(1) and (2), it seems clear that Congress intended for the
definition of “activity” for § 465 purposes to be a relatively narrow and asset-specific
concept.

        The Staff of the Joint Committee on Taxation confirms this observation by stating
that “[b]y contrast, the at-risk rules, to the extent they define ‘activity,’ address issues

PRESP-113577-17                                     8

different from those that are relevant with respect to passive losses. See § 465(c)(2).
The at-risk rules define ‘activity’ in terms of narrow asset units, such as individual items
of property, in light of the goal of such rules to establish a relationship between each
such asset and financing attributable to it. In the passive loss context, unlike the at-risk
context, financing is not the relevant issue.” Staff of the Joint Comm. on Taxation,
General Explanation of the Tax Reform Act of 1986, 99th Cong., H.R. 3838, 99th Cong.
at 246 fn. 40 (Jt. Comm. Print 1987) (“1986 Blue Book”). Accordingly, we believe it is
reasonable to conclude that, similar to the definition of activity as applied to the activities
in § 465(c)(1) and (2), the term “activity” for purposes of § 465(c)(3) (prior to the
application of any aggregation rules contained or referenced in § 465(c)(3)) is intended
to mean the smallest indivisible piece or parcel of property, business asset, or
integrated business unit in which the taxpayer possesses an ownership interest.1

       Accordingly, under the facts as presented in this case, we believe that, at most,
the business activity of each entity (M, X, Y, and Z) comprises a separate activity for
purposes of § 465(c)(3)(A) (prior to the application of any aggregation rules contained or
referenced in § 465(c)(3)(B)).

        Active Participation in Management of Activities that Constitute a Trade or
        Business

        The statutory language of § 465(c)(3)(B) provides no definition or other specific
guidance regarding the proper test for determining whether a taxpayer actively
participates in the management of activities that constitute a trade or business.
However, according to the legislative history for § 465(c)(3), Congress intended this
inquiry to be a facts and circumstances based determination, stating that “[f]actors
which tend to indicate active participation include participating in the decisions involving
the operation or management of the trade or business, actually performing services for
the trade or business, or hiring and discharging employees (as compared to only the
person who is the manager of the trade or business). Factors which tend to indicate a
lack of active participation include lack of involvement in management and operation of
the trade or business, having authority only to discharge the manager of the trade or
business, or having a manager of the trade or business who is an independent
contractor rather than an employee.” H.R. Rep. No. 95-1445, at 69 (1978) (“1978
Committee Report”); See also Staff of the Joint Comm. on Taxation, General
Explanation of the Tax Reform Act of 1978, H.R. 13511, 95th Cong., 29, 131 (Jt. Comm.
Print 1979) (“1978 Blue Book”).




1
  See also Proposed §§ 1.465-42(c)(1) and (2), 1.465-43(c), 1.465-44(c), and 1.465-45(c) which provide,
in general, that a taxpayer’s interest in each piece of property comprising an activity described in
§ 465(c)(1) will be treated as a separate activity of the taxpayer. In cases where the property is held
through a partnership or S corporation, all of the property of the same type held through the partnership
or S corporation will be treated as one activity of the taxpayer. There is no provision in the proposed
regulations that allows the aggregation of activities across multiple partnerships or S corporations.

PRESP-113577-17                               9

       Section 465(c)(3) provides two separate tests with respect to active participation
in the management of activities that constitute a trade or business. Section
465(c)(3)(B)(i) provides that activities that are described in § 465(c)(3)(A) that constitute
a trade or business shall be treated as one activity if the taxpayer actively participates in
the management of such trade or business. Section 465(c)(3)(B)(ii) otherwise provides
that activities that are described in § 465(c)(3)(A) that constitute a trade or business
shall be treated as one activity if such trade or business is carried on by a partnership or
an S corporation and 65 percent or more of the losses for the taxable year is allocable
to persons who actively participate in the management of the trade or business. In this
case, A’s position is that the activities of M, X, Y, and Z should be aggregated as a
single activity under § 465(c)(3)(B) because they are all engaged in the same line of
business (--------------------) and actively managed by A. A relies on both
§ 465(c)(3)(B)(i) and (ii) to advance this argument.

        With respect to the test under § 465(c)(3)(B)(ii), A would have the burden of
showing that the person (in this case B) who is allocated more than 65% of the losses
from M, X, Y, and Z actively participates in the management of the business activities
conducted through those entities. A has made no such showing, and we find it doubtful
that A would be able to make such a factual showing given the large volume of duties
and responsibilities that B delegated to A in order for A to manage those businesses on
B’s behalf. Accordingly, we conclude that A does not meet the requirements of
§ 465(c)(3)(B)(ii), because A has not shown (and probably cannot show) that B actively
participates in the management of these business activities.

        The application of § 465(c)(3)(B)(i) to the facts of this case is less clear.
Section 465(c)(3)(B)(i) requires the taxpayer, A, to be the person who actively
participates in the management of the trade or business. We believe A may be able to
demonstrate active participation in the management of each of M, X, Y, and Z, given A’s
claimed duties and responsibilities in managing their day-to-day operations, if this were
the only requirement of that provision (which it is not). Even in that regard, it is not clear
to us how A can be actively engaged in the day-to-day management and operations of
Y and Z, which are located in State2, and of M, which is located in State3, as A claims,
when A lives and works in State1. However, in any event, it is not clear whether
§ 465(c)(3)(B)(i) was intended to apply to business activities conducted indirectly
through partnerships or S corporations, rather than activities conducted directly by the
taxpayer. This latter question will be explored in more detail below.

       Component Activities Constituting a Trade or Business

       The flush language in § 465(c)(3)(B) allows component activities which constitute
a trade or business to be aggregated if the requirements in §§ 465(c)(2)(B) and
465(c)(3)(B) are satisfied. However, §§ 465(c)(2)(B) and 465(c)(3)(B) do not permit a
taxpayer to use an amount at risk in one trade or business to support losses flowing
from a wholly separate and distinct trade or business in which the taxpayer has no
economic risk of loss, even if the taxpayer actively participates in the management of

PRESP-113577-17                               10

both businesses. The aggregation provisions allow aggregation only within a SINGLE
trade or business. There is no provision in § 465 that would permit aggregation of
activities between two or more trades or businesses. Accordingly, activities that
comprise or constitute two separate and distinct trades or businesses may not be
aggregated into a single activity under § 465(c)(3)(B).

       In this case, A would have the burden of showing that the business activities
conducted through M, X, Y, and Z comprise a single trade or business for purposes of
§ 465(c)(3)(B). Under the facts as presented, M, X, Y, and Z each operate a separate
and independent -------------------. The ---------------------are conducted at different
locations in three states located in different regions of the U.S., and sell ------ from
different manufacturers. Each -------------- has its own franchise agreement with the
manufacturer independent of the other ---------------. Each -------------- has its own line of
credit and ----------- (inventory financing) arrangement. There is a limited amount of
employee sharing among M, X, Y, and Z. M, X, Y, and Z do share advertising,
information technology, and accounting services, but otherwise do not routinely
purchase goods and services from each other. M, X, Y, and Z are accounted for using
separate books and records, even though the books and records are maintained at a
central location.

       Accordingly, in this case, we believe the facts and circumstances as presented
weigh against treating the business activities conducted through M, X, Y, and Z as a
single integrated trade or business for purposes of § 465(c)(3)(B).

       Aggregation of Activities Conducted Through Separate Entities

        In this case, A’s position is that the ---------------------that are conducted through
three separate S corporations and an LLC treated as a partnership should be
aggregated as a single activity for § 465 purposes because the activities conducted
through these entities comprise a single trade or business. As stated above, A is
relying on both § 465(c)(3)(B)(i) and (ii) to advance this argument. Therefore, the
remaining question is whether either § 465(c)(3)(B)(i) or (ii) permits or requires a
taxpayer to aggregate activities that are conducted through more than one partnership
or S corporation. With respect to § 465(c)(3)(B)(ii), the statutory language by referring
to “a partnership or an S corporation” limits the aggregation of activities to activities
conducted through a single partnership or a single S corporation. We believe the
legislative history for the Revenue Act of 1978 supports this interpretation. See 1978
Committee Report at 69; 1978 Blue Book at 131. As the 1978 Blue Book states, “with
respect to these newly covered activities, those activities conducted by taxpayers other
than partnerships and subchapter S corporations, and which together constitute a trade
or business shall be treated as one activity if the taxpayer actively participates in the
management of the trade or business; the same treatment would apply to those cases
where the trade or business is carried on by a partnership or subchapter S corporation
and 65 percent or more of the losses from the taxable year is allocable to persons who
actively participate in the management of the trade or business.” 1978 Blue Book at

PRESP-113577-17                                      11

131. We believe this legislative history for the Revenue Act of 1978 also supports the
proposition that § 465(c)(3)(B)(i) was only intended to apply to business activities
conducted directly by taxpayers (other than through partnerships or S corporations).

        It should also be noted that, while not as explicit as the 1978 Blue Book, the 1978
Committee Report states that “[e]xcept for the [five] activities to which the specific at risk
rule applies, neither of the at risk rules applies to direct investments (i.e., investments
made directly, not through partnerships). Essentially, the committee believes that the
lack of any application of the at risk principles to direct investments constitutes a major
gap in the tax law in dealing with tax shelter abuses. Thus, the bill provides a revised at
risk rule which would apply to investments (direct or indirect) in all activities except real
estate. Examples of tax shelter investment activities to which the revised at risk rules
would apply would include the direct sale to individuals of master phonograph records,
lithographic plates, books, coal mining, and research and development.” 1978
Committee Report at 68. We believe this provision in the Committee Report supports a
reading that § 465(c)(3)(B)(i) was intended to apply to business activities directly held
by the taxpayer (not held through a partnership or S corporation), whereas
§ 465(c)(3)(B)(ii) applies to any other business activities held through partnerships and
S corporations.

        When Congress expanded the scope of § 465 in 1986 to include real estate
activities, the legislative history included a comment stating that “[t]he present law at-
risk aggregation rules (§ 465(c)(3)(B)) generally apply to the activity of holding real
property. Under these rules, it is intended that if a taxpayer actively participates in the
management of several partnerships each engaged in the real estate business, the real
estate activities of the various partnerships may be aggregated and treated as one
activity with respect to that partner for purposes of the at-risk rules.” S. Rep. No. 313,
99th Cong., 2d Sess. 750 (1985), 1986-3 (Vol. 3) C.B. 750; H.R. Rep. No. 426, 99th
Cong., 1st Sess. 295 (1985), 1986-3 (Vol. 2) 295. This statement appears contrary to
the statement contained in the 1978 Blue Book discussed above. Nevertheless, we
believe that this language was included in the legislative history of the Tax Reform Act
of 1986 to suggest that special aggregation rules should be adopted specific to activities
of holding real property conducted through partnerships, but that such special rules
otherwise might not be generally applicable to other types of trade or business activities
or other types of entities.2 It should also be noted that Congress did not discuss the
possibility of aggregating real estate activities conducted through multiple S
corporations, only those conducted through several partnerships.


2
  In this context, it should be noted that, in 1986, Congress also enacted § 465(b)(6) to provide that, in the
case of an activity of holding real property, a taxpayer shall be considered at risk with respect to the
taxpayer's share of any qualified nonrecourse financing which is secured by real property used in such
activity if the requirements therein are satisfied. This exception for qualified nonrecourse financing is only
available to taxpayers engaged in the activity of holding real property. We believe this is further indication
that Congress likely believed that special rules (including rules for aggregation) should apply with respect
to real estate partnerships, that otherwise would not be available to other types of business activities,
when it expanded the scope of § 465 to include real estate activities in 1986.

PRESP-113577-17                                        12

        In addition, we note that the Tax Reform Act of 1986 was enacted prior to the
proliferation of state limited liability company (LLC) statutes and their formal treatment
as partnerships or disregarded entities for federal tax purposes. In 1986, the only types
of partnerships in existence were general partnerships (including common law
partnerships) and limited partnerships. Partners in general partnerships almost always
had unlimited liability with respect to partnership debt. Limited partners, of course,
generally were accorded limited liability with respect to partnership debts, but were
usually prohibited under state partnership laws from actively managing the businesses
of the partnership. Therefore, in 1986, it was likely universally accepted that only
general partners with unlimited liability could actively manage a partnership real estate
activity. Since general partners would have unlimited liability with respect to partnership
recourse liabilities, Congress likely saw little harm in allowing real property held through
multiple partnerships to be aggregated by their general partners that actively managed
each of the various properties. Congress therefore likely recognized that limited
partners generally would be precluded from aggregating real estate activities held
through multiple partnerships since they could not actively participate in the
management of those activities.3

         We understand that A has grouped the ---------------------conducted through M, X,
Y, and Z for purposes of § 469 and may contend that the activity grouping rules of
§ 1.469-4 are (or should be) applicable in determining whether multiple activities may be
aggregated under § 465(c)(3)(B) for purposes of applying § 465. We reject this
contention. As previously stated, Congress recognized that there was a significant
difference in how § 465 and § 469 would operate. The at-risk rules were intended to
address issues different from those that are relevant with respect to passive losses.
The at-risk rules were intended to define ‘activity’ in terms of narrow asset units, such as
individual items of property, in light of the goal of such rules to establish a relationship
between each such asset and financing attributable to it. In the passive loss context,
financing is not the relevant issue. See 1986 Blue Book, at 246 fn. 40. Moreover, the
literal structure of the § 469 activity grouping rules is at odds with the statutory language
of § 465(c)(3)(B). Under § 465(c)(3)(B), multiple activities may be aggregated into a
single activity only in situations where the combined activities constitute a single trade
or business. In contrast, the rules in § 1.469-4(c) contemplate and permit the grouping
of multiple activities that may otherwise comprise two different and separate trades or
businesses, as long as those activities form an appropriate economic unit for the
measurement of gain or loss for purposes of § 469. In addition, § 1.469-4(c) permits the
grouping of activities that are conducted through separate partnerships or S
corporations, even though creditors of one entity usually cannot reach the assets of the
other entities to satisfy legal claims. Section 469 allows such groupings because the

3
  See generally 1986 Blue Book, at 214, discussing limited partnerships and tax shelter activity:
“[a]dditional considerations were viewed as relevant with regard to limited partnerships. In order
to maintain limited liability status, a limited partner generally is precluded from materially
participating in the business activity of the partnership; in virtually all respects, a limited partner
more closely resembles a shareholder in a C corporation than an active business entrepreneur.”

PRESP-113577-17                                13

passive activity loss rules generally are not concerned about financing arrangements
that protect taxpayers against loss. Unlike § 469, the at risk rules are primarily
concerned about financing arrangements that protect taxpayers against loss, and
conducting activities through multiple entities that limit the liability of their owners would
be one such arrangement. Accordingly, we believe that the §1.469-4 grouping rules are
irreconcilable with the statutory language contained in § 465(c)(3)(B) and with the
underlying purpose of at risk rules under § 465, and therefore those activity grouping
rules have no application for purposes of § 465.

        Nevertheless, while we believe that the statutory language and legislative history
for § 465(c)(3)(B) support disallowing aggregation of activities across multiple entities as
explained above, we recognize that there has been a lack of regulatory and other
guidance under § 465, along with a significant lapse of time and substantial changes in
the fundamental nature of how taxpayers conduct business that have occurred since the
enactment of § 465(c)(3)(B). Therefore, even though we believe § 465(c)(3)(B)(i) and
(ii) generally should be applied to prohibit aggregation of activities across multiple
entities, we recognize that there may be compelling cases where the facts and
circumstances clearly indicate that the activities conducted through separate entities do
comprise a single integrated trade or business for § 465 purposes (such as situations
where the multiple entities are owned and managed by the same persons that share the
same lenders and creditors who may have legal claims against the assets of all of the
entities and their owners). We nonetheless believe that such compelling situations
would be rare.

        While the conduct of the activities through separate legal entities might not be a
dispositive factor that, in itself, would prohibit aggregation of those activities under
§ 465(c)(3)(B)(i) and (ii), we believe that conducting activities through separate legal
entities that limit the liability of their owners is a probative factor that should weigh
heavily against aggregation. Accordingly, we believe that conducting activities through
separate entities that limit the liability of their owners generally will be strong evidence
indicating that the activities do not comprise a single trade or business for purposes of
§ 465(c)(3)(B), except when the facts and circumstances otherwise weigh heavily in
favor of viewing the activities as a single integrated trade or business.

         In this case, we believe the organization of the four ---------------------into separate
legal entities that limit the liability of their owners weighs heavily against treating the four
---------------------conducted through M, X, Y, and Z as a single trade or business that
would allow M, X, Y, and Z to be aggregated and treated as a single activity for
purposes of § 465, and we see no countervailing factors in this case that would weigh
heavily in favor of aggregation.

CONCLUSION

      In this case, based on the facts presented, the ---------------------conducted
through M, X, Y, and Z operate independently from each other. There are few

PRESP-113577-17                              14

interdependencies among them. Ownership among the entities is not identical. Each ---
--------------sells ------ from different manufacturers and has separate franchise
agreements and financing arrangements. Although the books and records of the ---------
--------------- are all located at a central location, each --------------maintains separate
books and records. The ---------------------operate in different, non-contiguous states in
different regions of the country. Employees generally work for a single --------------, and
employees are shared among the --------------- only in limited circumstances. The fact
that the -------------- - are conducted through separate entities that limit the liability of
their owners, and the lenders and other creditors of the entities do not appear to have
any claims against the assets of the --------------- conducted through other entities,
further supports our conclusion that the ---------------------conducted through M, X, Y, and
Z do not comprise a single trade or business for purposes of § 465(c)(3)(B)(i) and (ii).

       In addition, even though A may be able to show that A actively participates in the
management of each of the ---------------------for purposes of applying § 465(c)(3)(B)(i),
we conclude that § 465(c)(3)(B)(i) does not allow aggregation of the business activities
of M, X, Y, and Z because A does not conduct --------------------------directly, but rather
each -------------- is conducted through either a separate partnership or S corporation,
and there are no other facts present that would weigh heavily in favor of viewing the
separate ---------------------as a single integrated trade or business.

       Finally, A would have the burden of showing that B actively participates in the
management of each of the ---------------------conducted through M, X, Y, and Z, for
purposes of applying § 465(c)(3)(B)(ii). Given that A has made no such showing, and
given that we find it doubtful that A would be able to make such a factual showing for
the reasons stated above, this would be another reason why § 465(c)(3)(B)(ii) does not
allow aggregation of the business activities of M, X, Y, and Z.

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

       This writing may contain privileged information. Any unauthorized disclosure of
this writing may undermine our ability to protect the privileged information. If disclosure
is determined to be necessary, please contact this office for our views.

Please call (202) 317-5279 if you have any further questions.


                                         _____________________________
                                         James A. Quinn
                                         Senior Counsel, Branch 3
                                         Office of the Associate Chief Counsel
                                         (Passthroughs & Special Industries)