Passive Loss Rules and M&A

Mergers and acquisitions (M&A) can offer powerful strategic benefits-but they also come with significant tax implications. One often-overlooked aspect of tax planning during an M&A transaction is how the passive activity loss (PAL) rules under the Internal Revenue Code can affect both buyers and sellers. These rules can substantially influence deal structure, asset valuation, and post-closing tax outcomes.

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What Are Passive Activity Loss Rules?

The passive activity loss rules were enacted under the Tax Reform Act of 1986 to prevent high-income taxpayers from using passive losses to offset active or portfolio income. These rules apply to individuals, estates, trusts, personal service corporations, and closely held C corporations.

A passive activity is any trade or business in which the taxpayer does not materially participate. Rental real estate is also generally considered passive, even if the taxpayer is active in other parts of their business.

Under the PAL rules:

Passive losses can only be deducted against passive income.
Unused passive losses are carried forward indefinitely.
Passive losses are freed up when the taxpayer disposes of their entire interest in the activity in a fully taxable transaction.

This last point becomes a crucial consideration in M&A transactions.

How Passive Loss Rules Affect Sellers in M&A

For sellers, the treatment of passive losses can have a meaningful impact on the after-tax proceeds of a transaction.

Disposition of a Passive Activity

If a taxpayer sells their entire interest in a passive activity in a fully taxable sale, then all suspended passive losses associated with that activity may be used to offset:

Gain on the sale, and
Other income, including active income and portfolio income.

Key Conditions for Release of Passive Losses:

Full disposition of the interest.
Fully taxable-installment sales or nonrecognition transactions (like 1031 exchanges) typically don't qualify.
Transfer to an unrelated party (sales to a spouse or controlled entity generally don't qualify).

This makes deal structuring essential: sellers with significant suspended passive losses may prefer an asset sale or a stock sale that is fully taxable to trigger those losses.

How Buyers Should View Passive Activity Losses

Buyers need to be aware of how PAL rules can affect their basis step-up, future deductions, and cash flow post-acquisition.

Basis Step-Up and Purchase Price Allocation

In an asset acquisition, the purchase price is allocated among the assets for tax purposes. This allocation affects:

Depreciation deductions, and
The buyer's ability to generate or limit passive income in the future.

A buyer acquiring a business with rental real estate or limited partnerships may inherit activities that are subject to passive loss limitations unless they materially participate in those activities.

Material Participation After the Acquisition

Buyers can reclassify a formerly passive activity as non-passive if they materially participate in the business post-acquisition. This is important because it changes how future income and losses are treated.

To materially participate, the buyer (or taxpayer) must meet one of the IRS's seven material participation tests, which include:

Working more than 500 hours in the activity during the year,
Doing substantially all the work in the activity, or
Participating in multiple activities for a combined 500+ hours under the aggregation rules.

Without material participation, losses from the business may still be subject to the passive loss limitation rules.

Passive Losses in Entity Structures: S Corps vs. Partnerships

Entity structure plays a critical role in how passive losses are allocated and used.

S Corporations

Shareholders report their pro-rata share of income and loss.
Losses are limited to the shareholder's basis in the stock plus debt directly owed to them.
Passive loss rules still apply at the shareholder level.

Partnerships (and LLCs taxed as partnerships)

Partners report their share of income/loss on their personal returns.
Material participation is determined at the partner level.
Partners with passive status must carry forward unused losses unless they dispose of their entire interest.

These structural differences should be evaluated during M&A planning to determine the most tax-efficient ownership post-transaction.

Structuring the Deal: Asset vs. Stock Sales

Whether the deal is structured as an asset sale or stock sale significantly impacts the tax treatment of passive losses.

Asset Sale

Each asset is transferred individually.
Triggers recognition of gain or loss on individual assets.
May qualify as a fully taxable disposition, releasing passive losses if the seller fully exits the activity.

Stock Sale

The corporation remains intact; only ownership changes.
Does not usually trigger the release of passive losses unless the seller completely disposes of the passive activity.
Buyer generally gets no step-up in asset basis, unless a Section 338(h)(10) election is made (available in certain circumstances with S corps or consolidated groups).

Section 338(h)(10) Elections and Passive Loss Implications

One powerful tool that can bridge the benefits of both asset and stock sales is the Section 338(h)(10) election. When properly applied in qualifying transactions, this election allows a stock sale to be treated as an asset sale for tax purposes-potentially unlocking significant advantages.

When Can 338(h)(10) Be Used?

This election is available in situations where:

The target is an S corporation, or
The target is part of a consolidated group (typically C corporations).

If the buyer and seller jointly elect under Section 338(h)(10):

The transaction is a stock sale legally, but
The IRS treats it as if the target sold all of its assets and then liquidated.

Benefits Related to Passive Losses

For the seller, if the target entity is a passive activity, a properly structured Section 338(h)(10) election can:

Qualify as a fully taxable disposition of the activity,
Trigger the release of suspended passive losses under §469(g)(1).

This makes the election a valuable planning tool for sellers with significant PAL carryforwards-especially when compared to a standard stock sale where the PALs might remain locked indefinitely.

Integration with Net Investment Income Tax (NIIT)

Another layer of complexity arises from the Net Investment Income Tax (NIIT), a 3.8% surtax on certain net investment income for high-income taxpayers.

Passive income is generally subject to the NIIT, while income from material participation activities is not.

Why This Matters in M&A:

A taxpayer who doesn't materially participate in a business sold may owe NIIT on gains.
If they qualify for material participation, they may avoid NIIT on gain from the sale of an interest in a pass-through business.

This distinction becomes critical in pre-sale planning, especially for sellers nearing or exceeding the NIIT thresholds.

Strategic Planning: Unlocking Suspended Passive Losses Before or During Sale

Business owners with significant suspended passive activity losses often overlook them as hidden tax assets. However, with the right planning, those losses can become highly valuable during an M&A transaction.

Techniques to Leverage Suspended PALs:

Disposition Timing
- Ensure full disposition in a single tax year to trigger suspended losses.
Avoid Nonrecognition Transactions
- Avoid installment sales or like-kind exchanges if the goal is to free up passive losses.
Separate Activities
- Analyze whether multiple businesses or rental properties can be grouped or separated to maximize PAL utility under IRS grouping rules.
Gain Matching
- If PALs are unlocked in a sale, match them against ordinary income or capital gains to reduce tax liability.

Risks and Mistakes to Avoid

Passive loss rules are not intuitive, and applying them incorrectly can create costly errors during or after a business sale. Here are some common pitfalls to avoid:

Misclassifying an Activity: Treating a materially participated activity as passive-or vice versa-can distort allowable deductions.
Improper Aggregation: Combining or splitting activities without properly applying IRS rules can invalidate loss deductions.
Failing to Elect Out of Groupings: Some taxpayers forget to make formal elections, which can limit flexibility in loss treatment.
Overlooking Related Party Transactions: Selling to a related party will not trigger suspended losses.
Missing Basis Limitations: Passive losses are also subject to basis limitations-if the taxpayer doesn't have sufficient basis, the loss remains suspended.

Tax Due Diligence in M&A: What Attorneys Should Review

Tax due diligence should include a thorough review of all passive activities, suspended losses, and their treatment under proposed deal terms. As attorneys assisting clients in mergers or acquisitions, consider the following checklist:

Review Form 8582 to identify suspended passive losses.
Analyze basis in partnership interests or S corp stock.
Examine material participation logs, if any.
Confirm whether the transaction qualifies as a fully taxable disposition.
Assess opportunities for Section 338 elections or entity restructuring.
Coordinate with CPAs or tax advisors to structure the most efficient solution.

Contact an Attorney for Passive Loss Planning in M&A Transactions

The intersection of passive loss rules and M&A tax planning is complex but full of opportunity. With proper structuring and proactive analysis, sellers can unlock tax savings, and buyers can avoid post-closing surprises.

If you're considering selling your business, acquiring a company, or planning to exit a passive investment, working with an experienced M&A attorney familiar with passive loss treatment is essential.

Contact Heritage Law Office by using our online form or calling 414-253-8500. We help clients navigate these transactions with clarity and confidence.

Frequently Asked Questions (FAQs)

1. What triggers the release of suspended passive activity losses?

Suspended passive losses are released when a taxpayer fully disposes of their entire interest in a passive activity through a fully taxable transaction to an unrelated party. This includes the sale or exchange of a business or rental property where the taxpayer no longer has any ownership or control and recognizes the entire gain or loss in the same tax year.

2. Can passive losses be used to offset capital gains from the sale of a business?

Yes. If the passive activity is sold in a fully taxable transaction and all conditions are met under IRC §469(g), suspended passive losses can be applied against the capital gains realized from that same activity. Additionally, remaining passive losses can also be used to offset other types of income, including wages and interest.

3. Do passive losses expire if not used?

No. Suspended passive losses do not expire; they are carried forward indefinitely until the taxpayer either generates sufficient passive income to offset them or disposes of the passive activity in a fully taxable manner that qualifies under the tax rules.

4. How do I determine if I materially participate in a business?

Material participation is determined using one of seven IRS tests, the most common being: participating in the activity for more than 500 hours during the tax year, or doing substantially all the work in the activity. Documentation of time spent, roles performed, and decisions made is crucial to support material participation claims, especially during an IRS audit.

5. Is a stock sale enough to release suspended passive losses?

Not always. A stock sale alone generally does not qualify as a disposition of a passive activity for the purpose of releasing PALs unless it meets specific criteria-such as a Section 338(h)(10) election or complete exit from the passive investment. Sellers should consult a tax attorney to confirm whether their transaction qualifies.