TAXLITIGATOR – Tax Controversy (Civil & Criminal) Report

Determining a Taxpayer’s “Activity.” A taxpayer’s trade or business undertakings can be combined to form an “activity” for purposes of applying the material participation rules if the undertakings “form an appropriate economic unit for measuring gain or loss under the passive activity rules,” considering all relevant facts and circumstances.[i]  Taxpayers have the freedom to group their business undertakings (including those conducted through S corporations and partnerships) in accordance with the rules of Treasury Regulation § 1.469-4 using any reasonable method.  An example of this flexibility is provided in the regulations, which state:

“Example (1). Taxpayer C has a significant ownership interest in a bakery and a movie theater at a shopping mall in Baltimore and in a bakery and a movie theater in Philadelphia. In this case, after taking into account all the relevant facts and circumstances, there may be more than one reasonable method for grouping C’s activities. For instance, depending on the relevant facts and circumstances, the following groupings may or may not be permissible: a single activity; a movie theater activity and a bakery activity; a Baltimore activity and a Philadelphia activity; or four separate activities.”[ii]

As the above example demonstrates, a movie theater business and a bakery business can constitute an appropriate economic unit, simply on the basis that they are located in the same city. Similarity of businesses is also a reasonable method of grouping activities, even if the businesses are operated in different cities.  The following factors are given the greatest weight in determining whether activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of section 469: (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.[iii]

The material participation test is applied to work performed by the taxpayer in connection with the “activity,” so a broad grouping makes it easier to meet the material participation test because the taxpayer’s time is split between fewer activities. However, there are other considerations that should be taken into account when deciding whether to group multiple activities.  In particular, if the activity has losses being suspended into future tax  years, those losses cannot be deducted on the taxpayer’s return until all of the taxpayer’s interest in the activity has been disposed of.

Once a taxpayer determines which of his businesses are appropriately grouped, the taxpayer may not change how he has grouped these real property trades or businesses in subsequent taxable years unless the original determination was clearly inappropriate or there has been a material change in the facts and circumstances that makes the original determination clearly inappropriate.[iv]

Although taxpayers have freedom in grouping their undertakings however they wish as long as the method used in reasonable, for tax years after January 24 2010, certain disclosures are required for a taxpayer’s grouping. Taxpayers are required to report to the IRS: (1) changes to a taxpayer’s groupings during the tax year; (2) a new grouping; (3) or an addition to an existing grouping.[v]  Disclosures of new groups must be made on a written statement filed with the taxpayer’s written return, providing the names, addresses, and EINs, if applicable, for the activities being grouped as a single activity. The statement must also include a declaration that the grouped activities make up an appropriate economic unit for the measurement of gain or loss under the passive activity rules.[vi]

Material Participation Tests. There are seven tests for material participation, set forth in Treasury Regulation § 1.469-5T—if any one of these tests is satisfied, the activity will be considered to be active, allowing the taxpayer to avoid the loss limitation rules:[vii]

1)            Participated in the activity for more than 500 hours (a bright line test);

2)            The taxpayer’s participation was substantially all the participation in the activity of all individuals for the tax year (including employees);

3)            The taxpayer participated in the activity for more than 100 hours during the tax year, and the taxpayer participated at least as much as any other individual (including employees) for the year;

4)            The activity is a significant participation activity, and the taxpayer participated in all significant participation activities for more than 500 hours.  A significant participation activity is an activity in which the taxpayer performs more than 100 hours of services during the year and no other material participation test applies;[viii]

5)            Materially participated for any 5 of the 10 immediately preceding tax years;

6)            The activity is a personal service activity and the taxpayer materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year;[ix] or

7)            Based on all the facts and circumstances, the taxpayer participated in the activity on a regular, continuous, and substantial basis during the year (applicable only if the taxpayer worked at least 100 hours in connection with the activity).  This test is not frequently satisfied and there are limitations to when hours spent by an individual in managing an activity can be counted for purposes of satisfying the 100-hour minimum requirement.[x]

Proving Material Participation. The extent of an individual’s participation in an activity may be established by any reasonable means.  Contemporaneous daily time repots, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means.  Reasonable means include, but are not limited to, the identification of services performed over a period of time and of the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.[xi]  The regulations do not allow a post-event “ballpark guesstimate.”[xii]

LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is a senior tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere in complex civil tax litigation and criminal tax prosecutions (jury and non-jury). She represents U.S. taxpayers in litigation before both federal and state courts, including the federal district courts, the U.S. Tax Court, the U.S. Court of Federal Claims, and the Ninth Circuit Court of Appeals. Ms. Strachan has experience in a wide range of complex tax cases, including cases involving technical valuation issues. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue civil tax examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise, and in defending criminal tax fraud investigations and prosecutions. Additional information is available at http://www.taxlitigator.com

[i] Treas. Reg. ‘ 1.469-4(c)(1).  As previously noted in this series, there is an exception to the grouping rules for rental activities, which generally cannot be grouped with a non-rental trade or business.  The exception to this rule will be explored later in this series.

[ii] Treas. Reg. 1.469-4(c)(3)(Example 1).

[iii] Treas. Reg. ‘ 1.469-4(c)(2).

[iv] https://www.irs.gov/pub/irs-pdf/p925.pdf at p. 9.

[v] Id.

[vi] Id.

[vii] Treas. Reg. § 1.469-5T(a).  Section 1.469-5T(f) sets forth certain limitations on what services by an owner can be considered for purposes of the material participation rules, including certain management activities.  However, taxpayers may count as participation hours worked by their spouse.

[viii] This rule means that to qualify as a significant participation activity, the taxpayer must perform more than 100 hours but fewer than 500 hours.  This can create some peculiar results.  For example, if a Taxpayer has an interest in Activity A, Activity B, and Activity C, and spends 150 hours in Activity A, 250 hours in Activity B, and 499 hours in Activity C, then the taxpayer will be treated as having materially participated in all three activities.  However, if the taxpayer instead worked 501 hours in Activity C, then the taxpayer will be treated as materially participating in only Activity C, because Activity C is no longer a significant participation activity because it now satisfies one of the other material participation tests, and Activities B and C combined do not exceed the necessary 500 hour threshold.

[ix] See Treas. Reg. § 1.469-T(d).

[x] Treas. Reg. § 1.469-5T(b)(1)(ii).

[xi] Treas. Reg. § 1.469-5T(f)(4).

[xii] Bailey v. Comm’r, T.C. Memo 2001-296.