Question

Congress put the passive activity loss rules in effect starting in 1987. They stop taxpayers from offsetting losses on passive activities against income from other sources.

Why did Congress impose these rules?

Answer 1

Congress could have accomplished that objective simply by eliminating the so-called tax expenditures inherent in tax shelter activities and taxing those activities in accordance with their economics. In that event, depreciation rates would closely reflect actual economic depreciation of assets used in the activity, and tax subsidies for those activities would be eliminated. The result of that course of action would be both simplicity and fairness. Congress did not choose that course, however. Instead it chose parts of two alternative systems.

Congress enacted the passive loss limitation rules,which, in essence, limit the use of losses from certain activities to offset income from other activities. In that way, Congress chose to penalize those activities that had generally yielded tax losses to investors, typically by reason of the tax subsidies inherent in those activities. In order to restrain taxpayers who are able to work around the passive loss limitations, Congress retained, and in some respects fortified, the alternative minimum tax structure. That structure, in substance, ensures that all taxpayers will pay at least some tax on their incomes, even if their taxable income, after taking into account tax subsidy provisions under the general sections of the Internal Revenue Code, is a small or zero amount. Under the minimum tax structure, tax preferences are added back to taxable income to compute an alternative taxable income, upon which a flat rate of tax of 21 percent is then imposed. If the tax under the alternative minimum tax structure is greater than the regular tax, the alternative minimum tax is the amount payable by the taxpayer. In spite of this very complex, multitiered structure, Congress has failed to achieve its objective. Instead, Congress should have gone back to basics and forced all taxpayers to compute their income for tax purposes in accordance with their economic income.