Did a taxpayer continue to materially participate in an S corporation when he turned the day-to-day operations over to his son and focused on product development and customer retention?
Taxpayer Says: He meets the “facts and circumstances” material participation test.
Internal Revenue Service Says: The taxpayers did not satisfy any of the material participation tests and accordingly did not materially participate in the activities.
From Internal Revenue Code Section 469: Individuals may not deduct passive activity losses for the year in which they are sustained.
From Internal Revenue Code Section469(c)(1): A passive activity is any activity that involves the conduct of any trade or business in which the taxpayer does not materially participate.
From Internal Revenue Code Section 469(d)(1): A “passive activity loss” is the amount by which the aggregate losses from all passive activities for a taxable year exceed the aggregate income from all passive activities for such year.
From Temporary Regulation 1.469-5T(a)(7): A taxpayer materially participates in an activity for a given year if, “[b]ased on all of the facts and circumstances * * * the individual participates in the activity on a regular, continuous, and substantial basis during such year.” (A taxpayer who participates in the activity for 100 hours or less during the year cannot satisfy this test, and more stringent requirements apply to those who participate in a management or investment capacity. See sec. 1.469-5T(b)(2)(ii) and (iii),(f)(2)(ii).)
THE CAUSE OF THE DISPUTE
In order to currently claim losses from trade or business activities you have to “materially participate” in the activities. In general, this means passing one of seven tests. For example, you can prove material participation when you participate in a trade or business on a regular, continuous and substantial basis for more than 100 hours during a year. (Note that additional requirements apply if you participate as a manager or investor.)
In this case, the taxpayers, a married couple, owned stock in two subchapter S corporations that recycled and manufactured plastic products. The husband had established the businesses in 1980, and eventually turned the day-to-day management operations over to his son.
Though the taxpayers moved to another state after turning over the businesses, the husband continued to participate, focusing his time on product development and customer retention, and spending more than 100 hours on those activities during 2008.
He made periodic visits to the business facilities in Louisiana and regularly spoke on the phone with plant personnel, making 278 phone calls to the plant during the year. He invented a new technique for fireproofing polyethylene partitions and he developed a method for treating plastics that would allow them to destroy common viruses and bacteria on contact. In addition to his research efforts, he secured a new line of credit for the companies.
He and his wife received Forms K-1 from the businesses and claimed a deduction for losses of $3,178,961 on their 2008 federal income tax return.
The IRS said the losses were not currently deductible because the taxpayers did not pass any of the seven material participation tests. In addition, the IRS says the wife did not actively participate in the businesses.
The taxpayers say they did meet the requirements of the facts and circumstances test because the husband’s participation during 2008 was regular, continuous and substantial.
WHAT WOULD YOU DECIDE?
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1. You participated in the activity for more than 500 hours during the tax year.
2. Your participation in the activity for the tax year was substantially all of the participation in the activity of all individuals (including individuals who did not own any interest in the activity) for the tax year.
3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other person for the tax year. This includes individuals who did not own any interest in the activity.
4. The activity is a significant participation activity for the tax year, and you participated in all significant participation activities for more than 500 hours during the year. An activity is a significant participation activity if it involves the conduct of a trade or business, you participated in the activity for more than 100 hours during the tax year, and you did not materially participate under any of the material participation tests (other than this test 4).
5. You materially participated in the activity for any 5 of the prior 10 tax years.
6. The activity is a personal service activity in which you materially participated for any 3 prior tax years. A personal service activity is an activity that involves performing personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.
7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis for more than 100 hours during the tax year. Your participation in managing the activity does not count in determining if you meet this test if any person (except you) (a) received compensation for performing management services in connection with the activity, or (b) spent more hours during the tax year than you spent performing management services in connection with the activity (regardless of whether the person was compensated for the services).
Note: You only have to meet one of the seven to qualify for material participation.
Although the taxpayer took a step back when his son became involved in the companies’ management, he still played a major role in their 2008 activities.
He researched and developed new technology that allowed TSI and Paragon to improve their products. He also secured financing for the companies that allowed them to continue operations, and he visited the industrial facilities throughout the year to meet with employees about their futures. These efforts were continuous, regular, and substantial during 2008, and we accordingly hold that the taxpayer materially participated in the businesses.
In addition, the IRS’s argument that the taxpayers have not proved that the wife actively participated in the companies is irrelevant because for purposes of the passive loss limitation, we treat married taxpayers who file a joint return as a single taxpayer, and because we treat participation by a married taxpayer as participation of his or her spouse. The husband’s material participation in the companies is sufficient to establish material participation for both taxpayers.
The companies are complex businesses that the taxpayer built from the ground up and in which he continued to play a vital role. He was not merely a detached investor. He brought something to the companies that no one else could have, and they could not have continued to operate without his contacts and expertise.
Accordingly, we hold that the IRS erred in classifying as passive the losses from the companies.