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The Tax Reform Act of 1986 substantially reduced the effectiveness of the tax shelter by classifying
taxable income and loss into three major categories: active, portfolio, and passive. Active income
consists mainly of wages, salaries, and bonuses; portfolio income is mainly interest and dividends;
while passive income and loss consist of distributions from the so-called “pass-through” entities, such
as LLCs, limited partnerships, and subchapter S corporations. In their most simple terms, the passive
activity loss rules add to the limits set by the above described basis limitations (and the similar socalled
“at-risk rules”), making it impossible to use passive losses to offset active or portfolio income.
Thus, tax shelter losses can no longer be used to shelter salaries or investment proceeds; they must
wait for the taxpayer‟s passive activities to generate the anticipated end-of-the-line gains, or be used
when the taxpayer disposes of a passive activity in a taxable transaction (see Exhibit 9.2).
Fortunately for Morris, the passive activity loss rules are unlikely to affect his thinking for at least
two reasons. First, the Internal Revenue Code defines a passive activity as the conduct of any trade or
business “in which the taxpayer does not materially participate.” Material participation is further
defined in a series of tax code sections and Regulations (which mock the concept of tax simplification,
but let Morris off the hook) to include any taxpayer who participates in the business for more than 500
hours per year. Morris is clearly materially participating in his business, despite his status as a
stockholder of a subchapter S corporation, and thus the passive loss rules do not apply to him. The
second reason Morris is not concerned is that he does not anticipate any losses from this business;
historically, it has been very profitable. Therefore, let us depart from this detour into unprofitability
and consider Morris‟s acquisition of the plastics plant.
Acquisition
Morris might well believe that the hard part of accomplishing a successful acquisition is locating an
appropriate target and integrating it into his existing operation. Yet, once again, he would be well
advised to pay some attention to the various tax strategies and results available to him when
structuring the acquisition transaction.
To begin with, Morris has a number of ways to acquire the target business. Simply put, these
choices boil down to either acquiring the stock of the owners of the business, merging the target
corporation into Plant Supply, or purchasing the assets and liabilities of the target (see Exhibit 9.3).
The choice of method will depend on a number of factors, many of which are not tax-related. For
example, acquisition by merger will force Plant Supply to acquire all the liabilities of the target, even
those that neither it nor the target knows about. Acquisition of the stock of the target by Plant Supply