Grouping: Tax Strategy for Owners of Multiple BusinessesTax Planning
When you own more than one business, you need to consider the grouping rules that apply for passive-loss purposes.
Should one of your businesses lose money, you may not deduct the losses from that business during the current tax year unless you
- materially participate in the business or, if grouped, materially participate in the group; or
- do not materially participate but have passive income from other sources against which to deduct your passive business losses.
Example. Sam Warren, MD, operates a medical practice and starts a new physical therapy business (his second business) in which he will not materially participate. The physical therapy business is going to lose money during its first years of operation. If Dr. Warren wants to deduct the losses from his physical therapy business, he has one choice: group that business with his medical practice.
Overview of Passive-Loss Rules
Dr. Warren knows that he will have tax losses in his physical therapy business during its start-up years. Because he will not materially participate in the physical therapy business, the tax code deems his losses passive. He may deduct his passive losses
- against his passive income from other sources (excess passive losses are carried forward); and
- in total, when he sells or otherwise disposes of his entire interest in the passive activity.
This is ugly.
First, Dr. Warren has no other passive income. The medical practice, his only other business or activity, is an active business that produces active income.
Second, he does not plan on selling the physical therapy business anytime soon, so he would not realize any benefit from the accumulation of his carried-forward passive losses.
His solution: the group.
Grouping to Achieve Material Participation
For purposes of meeting the standards for material participation, you may group your business activities into appropriate economic units.
Whether activities constitute an appropriate economic unit, and therefore may be treated as a single activity, depends on the relevant facts and circumstances. You may use any reasonable method of applying the relevant facts and circumstances in grouping activities.
The five factors listed below (not all of which are necessary for you to treat more than one activity as a single activity) are given the greatest weight in determining whether activities constitute an appropriate economic unit for the measurement of gain or loss:
- Similarities/differences in types of activities
- Extent of common control
- Extent of common ownership
- Geographic location of the activities
- Interdependence between activities
Entities do not limit activities. You can have more than one activity inside an entity.
Related businesses and activities can be conducted by Schedule C proprietorships, partnerships, C or S corporations, or limited liability companies, all of which may be grouped if they are appropriate economic units into one activity.
Example. Your solely owned S corporation owns a bakery and a movie theater at a shopping mall in Baltimore and a bakery and a movie theater in Philadelphia. The S corporation’s common ownership indicates that you may group all four activities into one activity to prove your material participation so that you can deduct any losses.
Making the Election to Group
Revenue Procedure 2010-13 requires grouping disclosures in your tax returns for taxable years beginning on or after January 25, 2010. The procedure requires a disclosure statement with your tax return in the taxable year you
- make a grouping,
- add an activity to an existing grouping, or
- regroup a clearly inappropriate grouping.
In addition, the revenue procedure sets forth special rules for disclosures of partnership and S corporation groupings.
Key point. In general, should you fail to follow the requirements of Revenue Procedure 2010-13, your activities will be treated as separate activities for the passive-loss rules. In other words, the IRS will deny your grouping benefits when you fail to follow the procedure.
Planning note. You are not required to file the grouping disclosure for your preexisting groupings (those groupings that were in effect for taxable years beginning before January 25, 2010).
Say you are on a calendar-year basis for your taxes and you have a grouping already in place before 2011 that is unchanged as of April 1, 2022; you didn’t need to make any disclosures on your prior-year returns, and you don’t need to make a grouping disclosure in your 2021 tax return.
Dr. Warren’s Action
Dr. Warren automatically qualifies for grouping under the common ownership rule because he owns both the medical practice and the physical therapy business and the two businesses create an appropriate economic unit.
Dr. Warren attaches a written statement to his 2022 tax return that meets the requirements of Revenue Procedure 2010-13, declaring that the medical practice and physical therapy businesses are grouped as a single appropriate economic unit for measuring gain or loss under IRC Section 469. His statement identifies the names, addresses, and employer identification numbers of the medical practice and the physical therapy business that he grouped into
this single activity.
Here’s a sample format for a statement attached to the Form 1040 creating a group:
Close to Perfect
Reporting solidifies the claim of this single entity and does not require other corroborative evidence of intent to group. (This election in Dr. Warren’s tax return is audit-proof evidence of grouping. In fact, there is no easier way to prove the grouping.)
If Dr. Warren’s physical therapy business loses $175,000 as he projects, he can write off that $175,000 because the grouping makes him a material participant.
Without the grouping, he does not materially participate in the physical therapy business. Without material participation, his $175,000 loss is a passive-loss deductible against only passive income, of which he has none.
The medical practice income is active income, not passive income.
When he makes the grouping election, the law combines the two businesses for material participation purposes.
Let’s say he works 2,000 hours a year in his medical practice. With grouping, he now works 2,000 hours a year in the combined activity, and that makes the loss from the physical therapy business deductible.
You Need to Pay Attention
Think like Dr. Warren. Don’t let the passive-loss rules unfairly trap your deductions.
Grouping is one consideration.
Another consideration: Why enter a business for which you cannot deduct the losses?
The timing of tax deductions plays a part in your annual rate of profit. Make sure you have a handle on this cost before you invest.
Your One-Owner Advantage
If you or you and your spouse are entrepreneurs who own multiple businesses, you have excellent control of your grouping elections.
The next question: Do you have taxable income that you want to offset with losses? If so, you need to consider grouping.
In summary, when you have multiple businesses, make sure you have a plan that helps you realize your business losses.
If you have more than one business or are considering whether to start a second business, make sure to consider the grouping rules. The grouping can make sense if you have losses and no other way to deduct the losses currently.
This article examined the grouping of businesses. You face similar rules if you want to group rentals. Also, as we reported last month, you can use a grouping election with a self-rental (see Avoid the Self-Rental Trap).
If you have a group in place that requires the election, make sure that you have made the election in your tax return. If you have not made it, make it now. As long as you make the election before the IRS discovers the oversight, the IRS will respect your grouping (assuming it is an appropriate grouping).