Auto Dealerships - Audit Technique Guide - Uncle Fed's Tax*Board

Chapter 17
Passive / Non-Passive Considerations
Introduction
In the attempt to be good tax planners, it is possible that a taxpayer involved with auto dealerships
will overlook the complexities of passive loss rules and regulations of IRC section 469. Please
recall that due to the rules of that section, generally only passive income can offset passive losses.
This means that the taxpayers will have losses from passive activities that are not deductible in a
particular year unless income from other sources is properly characterized as passive income.
Should this issue be considered?
It is paramount that the agent look at the individual and related entity returns and see the "big
picture" to determine if the taxpayer may be manipulating passive characterization rules. Please
also see the chapter on Financial Status in this Guide. Simply see if any of the individuals are
securing a benefit by using flow through entities.
The Typical Scenario
The taxpayer, who is also a shareholder in a large C-Corporation auto dealership, is somewhat
wealthy and owns several rental properties (passive by definition, with some exceptions, under
IRC section 469(c)(2)). Making over $150,000 per year, taxpayer is not entitled to the $25,000
passive loss offset for rental real estate. The taxpayers rental losses for the year are about
$100,000. The taxpayer creates a partnership which purchases assets from the C-Corporation and
then rents the dealership the land and building at a rent that produces partnership net income of
$100,000. Taxpayer flows this $100,000 partnership net income through to his 1040 as passive
income. The taxpayer is attempting to offset his passive loss of $100,000 against this income.
Under Treas. Reg. section 1.469-2(f)(6), the rental income is recharacterized as non-passive. This
means that the taxpayer cannot offset passive losses from other activities against the rental profit.
Any rental income generated from the rental of property by the taxpayer to a trade or business in
which the taxpayer materially participates is treated as non-passive income.
In this situation, the $100,000 profit would be recognized as non-passive and the $100,000
passive loss would be carried forward.
Audit Techniques
1. Secure all lease agreements.
2. Inspect Shareholder’s Forms 1040 to determine if the issue is viable.
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