Rules for Grouping Activities Under Section 469

Section 469 of the Internal Revenue Code establishes the passive activity loss rules, which prevent taxpayers from using losses from passive activities, such as certain rental operations or businesses in which they do not materially participate, to offset income from non-passive sources like wages. This framework is designed to curb tax shelters that generate artificial losses. Within these regulations, taxpayers can group multiple trade or business or rental activities into a single, larger activity.

This grouping decision can directly impact whether an activity is considered passive or non-passive. For instance, combining several ventures may allow a taxpayer to meet material participation tests that they would otherwise fail on a standalone basis. The income or loss from all operations within a properly constructed group is combined, potentially allowing passive losses from one venture to be deducted against passive income from another within the same group. The decision of how to group activities is based on a flexible facts-and-circumstances analysis governed by specific Treasury Regulations.

Defining an Appropriate Economic Unit

The foundation for grouping activities rests on the principle that the combined activities must constitute an “appropriate economic unit.” This determination is based on a review of all relevant facts and circumstances. Treasury Regulation § 1.469-4 provides that taxpayers can use any reasonable method to apply these facts, but it gives the greatest weight to five specific factors. These factors help determine if the operations are economically intertwined in a way that justifies treating them as a single enterprise.

The first factor considers similarities and differences in the types of businesses. Activities in the same general line of business, such as two separate restaurants, are more likely to form an appropriate economic unit. The second and third factors are the extent of common control and common ownership. When the same individuals have significant control and ownership over multiple activities, it suggests they are managed as a cohesive whole.

Geographical location examines the physical proximity of the operations. Two retail stores in the same shopping mall are better candidates for grouping than stores in different states. The final factor is the degree of interdependence between the activities. This looks at the extent to which businesses rely on each other by sharing employees, having the same customers, using a single set of books, or selling products that are typically offered together.

Not all five factors must be present to justify a grouping. A taxpayer might reasonably group two businesses in different geographical locations if they share common ownership, management, and a centralized accounting system. The goal is to form a grouping that accurately reflects the economic reality of how the businesses are run for a proper measurement of gain or loss.

Making the Initial Grouping Election

A taxpayer makes a grouping election by filing their tax return in a manner consistent with the chosen group for the first year the decision is made. According to IRS guidance, this initial grouping is disclosed by attaching a statement to the tax return for that year. This statement must identify the names, addresses, and employer identification numbers for the activities being grouped together.

The statement must also include a declaration that the grouped activities constitute an appropriate economic unit. The election is made with the original tax return, including extensions, for the first taxable year in which the activities are grouped. For example, if a taxpayer starts a new business in 2024 and decides to group it with an existing one, the statement must be attached to the 2024 income tax return.

Once a taxpayer groups activities, they must continue to use that same grouping in all subsequent tax years. This consistency requirement is binding and prevents taxpayers from changing the grouping from year to year simply to gain a tax advantage.

If a taxpayer later adds a new activity to an existing group, a similar disclosure is required. A statement must be filed with the tax return for the year the new activity is added, identifying the new operation and the existing group. Failure to make the required disclosure can result in the IRS disregarding the grouping and treating each activity as separate.

Special Rules for Rental Activities

The rules for grouping become more restrictive when rental activities are involved. The regulations generally prohibit a taxpayer from grouping a rental activity with a trade or business activity. This rule is intended to prevent taxpayers from sheltering active business income with passive rental losses, such as grouping a profitable restaurant with an unprofitable rental property.

A narrow exception to this prohibition exists. A rental activity and a trade or business activity can be grouped if they form an appropriate economic unit and one of the activities is “insubstantial” in relation to the other. While the regulations do not provide a bright-line test for what qualifies as insubstantial, it implies a significant disparity in scale. For example, if a large manufacturing business owns a small office space and rents it out, generating minor gross income, the rental activity might be considered insubstantial.

Another exception allows for grouping when each owner of the trade or business has the exact same proportionate ownership interest in the rental activity. This rule is often relevant in self-rental situations, where business owners own a building in a separate legal entity and lease it to their operating company. If the ownership percentages in both entities are identical for all owners, the activities may be grouped.

An activity involving the rental of real property and an activity involving the rental of personal property generally cannot be treated as a single activity. The only exception is if the personal property is provided in connection with the real property, such as renting a furnished apartment.

Modifying a Grouping Election

Although the initial grouping election is binding, it can be modified in limited circumstances. A taxpayer is required to regroup their activities if the original grouping is determined to have been “clearly inappropriate.” Regrouping is also required if a “material change” in the facts and circumstances occurs that makes the original grouping no longer appropriate. A taxpayer cannot regroup activities for other reasons.

A material change refers to a significant event that alters the economic relationship between the activities. For example, if a taxpayer owns two grouped restaurants and sells one, this constitutes a material change. Another example is a change in operational structure, such as one of two previously integrated businesses ceasing to share management, employees, and accounting systems. A desire to achieve a better tax outcome is not a material change.

The Internal Revenue Service also has the authority to force a regrouping of a taxpayer’s activities. This can occur if the IRS determines that the taxpayer’s grouping is not an appropriate economic unit and a principal purpose of the grouping was to circumvent the passive activity loss rules. This provision acts as a safeguard against abusive arrangements. If the IRS imposes a regrouping, it will reconfigure the activities to reflect a more appropriate economic unit.