Small Business Taxes & ManagementTM--Copyright 2014, A/N Group, Inc.
There are several ways you can be denied a deduction for losses from a partnership, LLC, or S corporation (even a sole proprietorship). Insufficient basis is one, the at-risk limitation is another. Failing to materially participate in the activity is another. If you're running the business virtually full-time, meeting the last test is generally easy. But if you've got a manager and only show up occasionally, you could have a problem. Performing the tasks normally performed by an investor doesn't count. We won't go into the definition and requirements to materially participate in a business. You can find it in our article Material Participation. Keep in mind that if the losses are considered passive and disallowed they aren't lost, but suspended until you have offsetting passive income or dispose of the activity. But that could be small comfort.
The taxpayer in Charles E. Wade et ux. (T.C. Memo. 2014-169) and a colleague founded a company in 1980 that later became TSI. TSI's business involved acquiring plastic waste from chemical companies and converting it into usable products. A second company, Paragon, received raw materials from TSI and used them to make building and construction materials. The taxpayer developed the manufacturing processes TSI and Paragon used and established and managed their industrial facilities.
In 1984 the taxpayer's son moved back to Louisana and began helping the taxpayer manage TSI and Paragon and in 2008 owned 30% of TSI and 70% of Paragon. The taxpayer and his wife owned all the remaining stock of both entities. The taxpayer relinquished day-to-day operations to his son and focused on product and customer development. Since he did not have to been near the plant to perform these duties he moved to Florida. The taxpayer regularly spoke on the phone with plant personnel and made periodic visits to the plant.
In 2008 TSI and Paragon began struggling financially as prices for their products plummeted. The taxpayer became more involved in the business, visiting the plant on three occasions and redoubled his research and development efforts. The efforts proved fruitful and the taxpayer invented a new technique for fireproofing polyethylene partitions and developed a method for treating plastics that would allow them to destroy common viruses and bacteria on contact. In addition, he secured a new line of credit for the companies. The Court felt he was critical to the survival of the companies.
The IRS disallowed the taxpayers' deduction for the substantial losses of the S corporation, claiming the taxpayers did not materially participate in the business, making it a passive activity. The taxpayers claimed they satisfied two of the tests (only one was necessary) for material participation. First they claimed that the taxpayer spent more than 500 hours during the year at issue (2008) working on the companies' activities. (The Court treated TSI and Paragon as a single economic unit because the companies were interdependent and share common control and ownership.) Second, they contended that he participated in the companies' activities on a regular, continuous, and substantial basis during 2008. The Tax Court accepted the second argument and, for that reason, didn't address the first.
The Court noted that a taxpayer materially participates in an activity for a given year if, based on all the facts and circumstances the individual participates in the activity on a regular, continuous, and substantial basis during the year. There are two other requirements to meet this test. First, the individual must participate in the activity for more than 100 hours during the taxable year. Second, when determining the number of hours of participation for this test, services performed in the management of the activity aren't taken into account. (This second requirement doesn't apply to the other material participation tests such as more than 500 hours of participation.)
The Court noted that the taxpayer spent over 100 hours participating in TSI and Paragon during the year and his participation consisted primarily of nonmanagement and noninvestment activities. He focused on product development and customer retention. The Court also cited the fact that he secured financing for the companies that allowed them to continue their operations and visited the industrial facilities to meet with employees about their future throughout the year.
The IRS argued that the taxpayers did not demonstrate that the spouse actively participated in TSI and Paragon. The Court noted that for passive loss limitation purposes married taxpayers who file a joint return are treated as a single taxpayer. That is participation by a taxpayer is considered participation by a spouse.
The Court found the taxpayer's contribution to the companies was critical. It felt the companies could not continue to operate without his contacts and expertise. The Court held the taxpayer materially participated in TSI and Paragon and allowed a deduction for the losses.
This case isn't heavy on details. Except for the fact that the record showed the taxpayer participated in 273 phone calls with the plant during the year, there is no mention of a logbook, diary, etc. documenting the taxpayers participation. On the other hand, it could be the Court could see from the testimony and evidence that he clearly meet the 100-hour test. You may not be so lucky. Here the taxpayer had a record of phone calls. Do you have your phone bill from five years ago? If you get your bills electronically, do you download and save them?
That brings up a second point here. The fact the IRS challenged the taxpayer's participation was somewhat surprising. It many have been a gamble based on the size of the losses. The government stood to collect a substantial amount of tax if it won the case. Unless you're sure you will clearly meet one of the participation standards during the year, keeping a log or diary is strongly suggested. Other forms of proof may also be available such as minutes of meetings, testimony of vendors, customers, or employees, etc.
In one footnote the Court indicated that Congress enacted this section to reduce the opportunity for taxpayers to offset income from one source with tax shelter deductions and credits from another. Congress' concern was over taxpayers who invested in businesses simply to benefit from losses. The tests and standards in the law were not meant to apply to taxpayers such as those in the case. That seems to indicate the Court might have required more documentation as to the hours and amount of work if the taxpayer had simply say, purchased an interest in a business shortly before or while it was incurring substantial losses.
There was a second issue here related to the passive activity rules. It was dealt with only in the footnotes. That's unfortunate because it's the first time the issue seems to have been addressed by the courts, and it's a complex one. The Court decided to treat the two companies (both had losses) as a single economic unit for purposes of applying Sec. 469 rules. The Court found the companies to be interdependent and share common ownership and control. Clearly Paragon and TSI had common management and ownership, but in addition Paragon was dependent on TSI for raw material. You may not have it so easy. And you don't have to have multiple entities to have multiple activities where material participation is determined separately for each one. Consider Madison Inc., an S corporation, the principal operation of which is construction and maintenance of bridges and roads. Madison is wholly owned by Fred Flood. Madison loaned money to Chatham Painting (an unrelated supplier) to insure its survival. Chatham couldn't repay the loan and Madison acquired Chatham's jet in settlement. Madison hired two pilots and put the jet out for charter. The IRS would most likely deem the charter operation a separate activity and Fred may not be able to deduct the associated losses if he can't show he materially participates in the charter operation.
This issue shouldn't be treated lightly. Small business losses can be substantial and can be important factors in a shareholder's cash flow. For example, the losses may offset other income and reduce taxes to free up the shareholder's cash. Talk to your tax advisor regularly if you have losses from an activity to make sure you have sufficient basis and amount at risk and can show material participation. The time will be well worth it.
Copyright 2014 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 08/30/14