U.S. Return of Partnership Income

Grouping Activities

Generally, one or more trade or business activities or rental activities may be treated as a single activity if the activities make up an appropriate economic unit for the measurement of gain or loss under the passive activity rules. Whether activities make up an appropriate economic unit depends on all the relevant facts and circumstances. The factors given the greatest weight in determining whether activities make up an appropriate economic unit are:

• Similarities and differences in types of trades or businesses.
• The extent of common control.
• The extent of common ownership.
• Geographical location.
• Reliance between or among the activities.

Example. The partnership has a significant ownership interest in a bakery and a movie theater in Baltimore and a bakery and a movie theater in Philadelphia. Depending on the relevant facts and circumstances, there may be more than one reasonable method for grouping the partnership's activities. For instance, the following groupings may or may not be permissible:

• A single activity,
• A movie theater activity and a bakery activity,
• A Baltimore activity and a Philadelphia activity, or
• Four separate activities.

Once the partnership chooses a grouping under these rules, it must continue using that grouping in later tax years unless a material change in the facts and circumstances makes it clearly inappropriate.

The IRS may regroup the partnership's activities if the partnership's grouping fails to reflect one or more appropriate economic units and one of the primary purposes of the grouping is to avoid the passive activity limitations.

Limitation on grouping certain activities. The following activities may not be grouped together:

1. A rental activity with a trade or business activity unless the activities being grouped together make up an appropriate economic unit and
   1. The rental activity is insubstantial relative to the trade or business activity or vice versa or
   2. Each owner of the trade or business activity has the same proportionate ownership interest in the rental activity. If so, the portion of the rental activity involving the rental of property to be used in the trade or business activity may be grouped with the trade or business activity.
2. An activity involving the rental of real property with an activity involving the rental of personal property (except personal property provided in connection with the real property or vice versa).
3. Any activity with another activity in a different type of business and in which the partnership holds an interest as a limited partner or as a limited entrepreneur (as defined in section 464(e)(2)) if that other activity engages in holding, producing, or distributing motion picture films or videotapes; farming; leasing section 1245 property; or exploring for or exploiting oil and gas resources or geothermal deposits.

Activities conducted through other partnerships. Once a partnership determines its activities under these rules, the partnership as a partner may use these rules to group those activities with:

• Each other,
• Activities conducted directly by the partnership, or
• Activities conducted through other partnerships.

A partner may not treat as separate activities those activities grouped together by a partnership.

Recharacterization of Passive Income

Under Temporary Regulations section 1.469-2T(f) and Regulations section 1.469-2(f), net passive income from certain passive activities must be treated as nonpassive income. Net passive income is the excess of an activity's passive activity gross income over its passive activity deductions (current year deductions and prior year unallowed losses).

Income from the following six sources is subject to recharacterization. Note that any net passive income recharacterized as nonpassive income is treated as investment income for purposes of figuring investment interest expense limitations if it is from (a) an activity of renting substantially nondepreciable property from an equity-financed lending activity or (b) an activity related to an interest in a pass-through entity that licenses intangible property.

1. Significant participation passive activities. A significant participation passive activity is any trade or business activity in which the partner both participates for more than 100 hours during the tax year and does not materially participate. Because each partner must determine the partner's level of participation, the partnership will not be able to identify significant participation passive activities.
2. Certain nondepreciable rental property activities. Net passive income from a rental activity is nonpassive income if less than 30% of the unadjusted basis of the property used or held for use by customers in the activity is subject to depreciation under section 167.
3. Passive equity-financed lending activities. If the partnership has net income from a passive equity-financed lending activity, the smaller of the net passive income or the equity-financed interest income from the activity is nonpassive income.

   Note: The amount of income from the activities in paragraphs 1 through 3 that any partner will be required to recharacterize as nonpassive income may be limited under Temporary Regulations section 1.469-2T(f)(8). Because the partnership will not have information regarding all of a partner's activities, it must identify all partnership activities meeting the definitions in paragraphs 2 and 3 as activities that may be subject to recharacterization.

4. Rental of property incidental to a development activity. Net rental activity income is the excess of passive activity gross income from renting or disposing of property over passive activity deductions (current year deductions and prior year unallowed losses) that are reasonably allocable to the rented property. Net rental activity income is nonpassive income for a partner if all of the following apply:
   • The partnership recognizes gain from the sale, exchange, or other disposition of the rental property during the tax year.
   • The use of the item of property in the rental activity started less than 12 months before the date of disposition. The use of an item of rental property begins on the first day that (a) the partnership owns an interest in the property; (b) substantially all of the property is either rented or held out for rent and ready to be rented; and (c) no significant value-enhancing services remain to be performed.
   • The partner materially or significantly participated for any tax year in an activity that involved performing services to enhance the value of the property (or any other item of property, if the basis of the property disposed of is determined in whole or in part by reference to the basis of that item of property).

   Because the partnership cannot determine a partner's level of participation, the partnership must identify net income from property described above (without regard to the partner's level of participation) as income that may be subject to recharacterization.

5. Rental of property to a nonpassive activity. If a taxpayer rents property to a trade or business activity in which the taxpayer materially participates, the taxpayer's net rental activity income from the property is nonpassive income.
6. Acquisition of an interest in a pass-through entity that licenses intangible property. Generally, net royalty income from intangible property is nonpassive income if the taxpayer acquired an interest in the pass-through entity after the pass-through entity created the intangible property or performed substantial services, or incurred substantial costs in developing or marketing the intangible property. Net royalty income means the excess of passive activity gross income from licensing or transferring any right in intangible property over passive activity deductions (current year deductions and prior year unallowed losses) that are reasonably allocable to the intangible property.

See Temporary Regulations section 1.469-2T(f)(7)(iii) for exceptions to this rule.

Passive Activity Reporting Requirements

To allow partners to correctly apply the passive activity loss and credit rules, any partnership that carries on more than one activity must:

1. Provide an attachment for each activity conducted through the partnership that identifies the type of activity conducted (trade or business, rental real estate, rental activity other than rental real estate, or investment).
2. On the attachment for each activity, provide a schedule, using the same line numbers as shown on Schedule K-1, detailing the net income (loss), credits, and all items required to be separately stated under section 702(a) from each trade or business activity, from each rental real estate activity, from each rental activity other than a rental real estate activity, and from investments.
3. Identify the net income (loss) and credits from each oil or gas well drilled or operated under a working interest that any partner (other than a partner whose only interest in the partnership during the year is as a limited partner) holds through the partnership. Further, if any partner had an interest as a general partner in the partnership during less than the entire year, the partnership must identify both the disqualified deductions from each well that the partner must treat as passive activity deductions, and the ratable portion of the gross income from each well that the partner must treat as passive activity gross income.
4. Identify the net income (loss) and the partner's share of partnership interest expense from each activity of renting a dwelling unit that any partner uses for personal purposes during the year for more than the greater of 14 days or 10% of the number of days that the residence is rented at fair rental value.
5. Identify the net income (loss) and the partner's share of partnership interest expense from each activity of trading personal property conducted through the partnership.
6. For any gain (loss) from the disposition of an interest in an activity or of an interest in property used in an activity (including dispositions before 1987 from which gain is being recognized after 1986):
   1. Identify the activity in which the property was used at the time of disposition.
   2. If the property was used in more than one activity during the 12 months preceding the disposition, identify the activities in which the property was used and the adjusted basis allocated to each activity.
   3. For gains only, if the property was substantially appreciated at the time of the disposition and the applicable holding period specified in Regulations section 1.469-2(c)(2)(iii)(A) was not satisfied, identify the amount of the nonpassive gain and indicate whether the gain is investment income under the provisions of Regulations section 1.469-2(c)(2)(iii)(F).
7. Specify the amount of gross portfolio income, the interest expense properly allocable to portfolio income, and expenses other than interest expense that are clearly and directly allocable to portfolio income.
8. Identify separately any of the following types of payments to partners:
   1. Payments to a partner for services other than in the partner's capacity as a partner under section 707(a).
   2. Guaranteed payments to a partner for services under section 707(c).
   3. Guaranteed payments for use of capital.
   4. If section 736(a)(2) payments are made for unrealized receivables or for goodwill, the amount of the payments and the activities to which the payments are attributable.
   5. If section 736(b) payments are made, the amount of the payments and the activities to which the payments are attributable.
9. Identify the ratable portion of any section 481 adjustment (whether a net positive or a net negative adjustment) allocable to each partnership activity.
10. Identify the amount of gross income from each oil or gas property of the partnership.
11. Identify any gross income from sources that are specifically excluded from passive activity gross income, including:
    1. Income from intangible property if the partner is an individual and the partner's personal efforts significantly contributed to the creation of the property.
    2. Income from state, local, or foreign income tax refunds.
    3. Income from a covenant not to compete (in the case of a partner who is an individual and who contributed the covenant to the partnership).
12. Identify any deductions that are not passive activity deductions.
13. If the partnership makes a full or partial disposition of its interest in another entity, identify the gain (loss) allocable to each activity conducted through the entity, and the gain allocable to a passive activity that would have been recharacterized as nonpassive gain had the partnership disposed of its interest in property used in the activity (because the property was substantially appreciated at the time of the disposition, and the gain represented more than 10% of the partner's total gain from the disposition).
14. Identify the following items from activities that may be subject to the recharacterization rules under Temporary Regulations section 1.469-2T(f) and Regulations section 1.469-2(f):
    1. Net income from an activity of renting substantially nondepreciable property.
    2. The smaller of equity-financed interest income or net passive income from an equity-financed lending activity.
    3. Net rental activity income from property that was developed (by the partner or the partnership), rented, and sold within 12 months after the rental of the property commenced.
    4. Net rental activity income from the rental of property by the partnership to a trade or business activity in which the partner had an interest (either directly or indirectly).
    5. Net royalty income from intangible property if the partner acquired the partner's interest in the partnership after the partnership created the intangible property or performed substantial services, or incurred substantial costs in developing or marketing the intangible property.
15. Identify separately the credits from each activity conducted by or through the partnership.

Extraterritorial Income Exclusion

The partnership may exclude extraterritorial income to the extent of qualifying foreign trade income. For details and to figure the amount of the exclusion, see Form 8873, Extraterritorial Income Exclusion, and its separate instructions. The partnership must report the extraterritorial income exclusion on its return as follows:

1. If the partnership met the foreign economic process requirements explained in the Instructions for Form 8873, it may report the exclusion as a nonseparately stated item on whichever of the following lines apply to that activity:
   • Form 1065, page 1, line 20;
   • Form 8825, line 15; or
   • Form 1065, Schedule K, line 3b.

   In addition, the partnership must report as an item of information on Schedule K-1, line 25, the partner's distributive share of foreign trading gross receipts from Form 8873, line 15.

2. If the foreign trading gross receipts of the partnership for the tax year are $5 million or less and the partnership did not meet the foreign economic process requirements, it may not report the extraterritorial income exclusion as a nonseparately stated item on its return.

Instead, the partnership must report the following separately stated items to the partners on Schedule K-1, line 25:

• The partner's distributive share of foreign trading gross receipts from the partnership's Form 8873, line 15.
• The partner's distributive share of the extraterritorial income exclusion from the partnership's Form 8873, line 55, and identify the activity to which the exclusion relates.

Note: Upon request of a partner, the partnership should furnish a copy of the partnership's Form 8873 if that partner has a reduction for international boycott operations, illegal bribes, kickbacks, etc.

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