The Tax Court recently held that a taxpayer that stepped in during the 2008 financial crisis to rescue several related family businesses in which he held interests did so as a material participant, not as an investor. On the facts, the passive activity loss rules of Internal Revenue Code (IRC) Section 469 didn't apply, and he could carry back a large loss to 2006 and generate a refund of over $5 million.
Under IRC Section 469, taxpayers cannot use passive activity losses to offset non-passive income. A passive activity is any trade or business in which the taxpayer does not materially participate. Generally, taxpayers materially participate if they are involved in the operations of the trade or business on a regular, continuous, and substantial basis. The regulations provide seven tests to determine whether a taxpayer materially participated, only one of those tests must be satisfied.
Under one of the tests, taxpayers can satisfy the material participation requirement if they participate in the trade or business activity for over 500 hours during the tax year. Under another test, taxpayers can satisfy the requirement if the activity is a "significant participation activity" for the tax year, and the individual's total participation in all significant participation activities that year exceeds 500 hours. A "significant participation activity" is a trade or business in which the individual significantly participates (for over 100 hours), but in which he doesn't otherwise materially participate.
A taxpayer generally may treat one or more trade or business activities or rental activities as a single activity if they are an appropriate economic unit for measuring gain or loss for IRC Section 469 purposes based on all the relevant facts and circumstances. Five factors are given the greatest weight:
(1) similarities and differences in types of trades or businesses;
(2) the extent of common control;
(3) the extent of common ownership;
(4) geographical location; and
(5) interdependencies between or among the activities.
A successful businessman helped fund three businesses for his children, structuring each business with one child as the majority owner, holding 60% of the shares, and the other two children each holding 20%. One of these three businesses, Shoma Development Corporation (“Shoma”), an S corporation, was owned 60% by the businessman's daughter and her husband, and by Jose Lamas and his sister, who each owned 20%. Shoma and the other two businesses were all related to the business of real estate and tangentially to each other.
In 2004 Shoma formed Greens at Doral, LLC (“Greens”), a condominium conversion project. Shoma and Greens were closely intertwined. Greens had the same ownership structure as Shoma and consolidated its financial information with Shomas. Greens operated out of Shoma's offices using Shoma's employees, and the shareholders planned to liquidate Greens after the conversion project was completed. Greens was treated as a partnership for tax purposes.
Jose Lamas owned 20% of Shoma and Greens and served on Shoma's board of directors. Throughout 2008, a bad year for real estate, he labored to raise capital for Shoma and find additional investors for Shoma's projects to fill its capital needs. He spent considerable time trying to line up outside investors and purchasers for Shoma's projects in an attempt to cure Shoma's capital deficit. Much of this time was spent speaking on the phone with potential backers and meeting with them while sharing a meal.
Lamas incurred substantial losses in 2008 from Shoma and Greens. He claimed these losses as a tentative carryback adjustment to 2006, resulting in a tentative refund of $5,260,964.
The IRS audited Lamas's 2006 and 2008 returns, determining that Lamas's 2008 NOL from Shoma and Greens was passive instead of non-passive, and ultimately issued a notice of deficiency of $4,911,669 for 2006.
Tax Court Conclusion
After weighing all the evidence, the Tax Court held that Lamas was a material participant in Shoma and Greens for 2008. It approved his claimed carryback to 2006. The Court cited the following factors in arriving at its decision.
- Single economic activity under the grouping rules: The Tax Court determined that Shoma and Greens met all the five criteria in Regulation Section 1.469-4(c)(2): both activities were similar businesses engaged in commercial and residential real estate; they shared common control and ownership for the years at issue; they shared geographic locations; and they were interdependent.
- More than 500 hours of material participation: The Tax Court found that Lamas worked at least 691 hours for Shoma and Greens during 2008. Credible testimony and phone records supported this conclusion.
- Participation wasn't as an investor: The Court found that Mr. Lamas worked in the day-to-day management and operations of Shoma because he was working to meet its need for capital for its projects, an essential part of Shoma's business during 2008. Accordingly, all of Mr. Lamas' work for Shoma, including investor activity, qualified as participation.
- Exception for work not customarily done by owners didn't apply: On the facts, the Tax Court concluded that Lamas participated in work customarily done by owners, and he did not do this work with a purpose of avoiding the IRC Section 469 loss limitations.
- Significant participation activity test met: Even if Lamas worked fewer than 691 hours for Shoma and Greens during 2008, he would still qualify as materially participating by having significant participation activities that exceed 500 hours in the aggregate for 2008.
As this case illustrates, the allowance of rental real estate losses is highly factual and requires a deep understanding of the passive activity and material participation rules. The Tax Warriors® at Drucker & Scaccetti have extensive experience in representing taxpayers in these types of situations and can help you sift through the rules and regulations related to your investments. Our view of Tax As A Business Strategy® allows us to help our clients plan appropriately to achieve the most advantageous tax treatment for their investments. For 25 years, we have always been prepared to help with this or any tax-related matter. Call on us to learn more and see how we can assist you.