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

3. Question the taxpayer directly where circumstances warrant such action.
If after inspecting Forms 1040, passive income is seen to be offsetting passive losses, it should be
scrutinized. Make sure the income is not subject to the recharacterization rules of Treas. Reg.
sections 1.469-2 and 1.469-2T as well as the material participation rules of Treas. Reg.
section 1.469-5T.
Treas. Reg. section 1.469-2T(f) sets forth specific criteria for recharacterizing income from
passive to non-passive. The most pertinent to auto dealerships follow:
Law
1. Treas. Reg. section 1.469-2T(f)(3)
Net income from the rental of property in which less than 30 percent of the unadjusted basis
of the property is subject to depreciation is considered NON-PASSIVE.
2. Treas. Reg. section 1.469-2(f)(6)
For tax years ending after May 10, 1992, the net income from the rental of any property to a
closely held C-Corporation, a S-Corporation, a partnership, is considered NON-PASSIVE if
the taxpayer to whom this income flows to materially participates in the activities of the
lessee.
Note: It is unclear where in the regulations that a trust is included in these rules. A trust is
included as a pass through entity in Treas. Reg. section 1.469-4T(b)(2)(i) which is applicable
only to that section. Treas. Reg. section 1.469-4T(b)(2)(ii)(B) is no longer included as a
temporary regulation.
Note: That for 1992 and before, this rule applied for all except a closely held C-Corporation
(Treas. Reg. section 1.469-4T(b)(2)(ii)(B)).
Note: There are material participation relief provisions under IRC section 465(c)(7)(C) for
closely held C-Corporations.
Treas. Reg. section 1.469-2T(f)(8) limits recharacterization if the taxpayer is required to
recharacterize gains from significant participation activities and also gains from the rental of
nondepreciable property, the maximum amount of gain to be recharacterized is the greater of
the two computations.
If the rental income producing entity is not clearly connected to the dealership, it may still be
necessary to pursue the issue.
If the taxpayer materially participated in an activity other than rental activity, then the income is
non-passive per IRC section 469. Treas. Reg. section 1.469-5T sets forth the criteria for
determining material participation.
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