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Saturday, August 30, 2014
Be Prepared to Prove the Time You Spend on Losing Side Activities
Originally Published on forbes.com on February 5th,2012
If you have a lucrative day job and lose money on a different business activity, be warned. The IRS will not believe what you say about how you spend your time and the Tax Court will be skeptical. That is the main lesson in these two cases.
The passive activity loss rules require us to divide our trade or business activities into passive and non-passive buckets. Losses in the passive bucket can only be used to the extent of profits and gains in the passive bucket or when an activity is totally disposed of. Real estate rental activity is “per se” passive. There is an exception for people engaged in real estate trades or business, but the standard is very hard for anyone who has a significant non-real estate job to meet. The standard is 750 hours on real estate and more time on real estate than anything else. Despite being credible, Mr. Vandergrift just could not convince the Court he met the standard:
Petitioners maintain Mr. Vandegrift qualifies as such an individual. He testified that over one-half of the total time he spent in business activity was devoted to the real estate business. We found Mr. Vandegrift to be generally honest and forthright, but his time estimate is suspect given his employment as a salesman for an employer in a business unrelated to the real estate activity. His subjective estimate also suffers from a lack of contemporaneous verification by records or other evidence.
The term “ballpark guestimate” is always thrown around in these cases. If you have any sort of a full time job outside of real estate you will need to keep very detailed time records to qualify as being in a real estate trade or business. Here is an example of someone who managed it.
This one is another passive activities case. It involves a ranch, so it is not subject to the “per se” passive rule. That meant that Mr. Iverson just had to meet the material participation test. Although there are other ways to meet that test in some circumstances, the gold standard is 500 hours. Mr. Iverson had a pretty demanding day job:
In 1979 Mr. Iversen founded PMT Corp. (PMT), which over the years has become a large and successful manufacturer and worldwide seller of surgical and medical equipment. PMT sells its medical equipment throughout the United States and in more than 30 foreign countries. PMT is a Minnesota corporation. Petitioners own a controlling interest in the stock of PMT.
In both 2005 and 2006, as president of PMT Mr. Iversen worked more than 40 hours a week, and he received from PMT a total of approximately $6 million in salary and other income.
His 14,000 acre “Stirrup Ranch” is in Colorado, which, even though they are both in kind of that middle area of the country, is pretty far from Minnesota. You get pretty rough conditions being a cowboy:
The main ranch house on the Stirrup Ranch property is a 20,000-square-foot lodge with a log exterior and wraparound decks. The house has a large great room with vaulted ceilings, a floor to ceiling fireplace, andleather couches and chairs. The house also includes meeting rooms, office space, a conference room, a recreation room, and a number of bedroomsand bathrooms.
Mr. Iverson maintained that during the 23 days that he was at the ranch he worked dawn to dusk doing stuff like repairing fences and branding cattle and even castrating them (I now know more about ranching than I care to). While in Minnesota he was in constant touch with the on-site managers practically micro-managing them. What is puzzling about that is that while he was a good enough manager to make $6,000,000 on his day job in two years, the ranch just had large losses – $288,066 for 2005 and $197,077 for 2006.
Mr. Iverson lost the case because he could not come up with evidence of his meeting the 500 hour test. He had phone records showing a total of 3.75 hours and only four e-mails or faxes from the ranch managers for all of 2006. There was also evidence that maybe he did not spend dawn to dusk branding and whatever:
Occasionally in 2005 and 2006 Mr. Iversen hosted at the ranch PMT employees, sales representatives, clients, and potential clients. The PMT guests at the ranch would have meetings relating to PMT business, and they would hunt elk and other wildlife. The guests would stay overnight in the ranch lodge.
Here is what he should have had:
If, in spite of the fact that there was an onsite Stirrup Ranch ranch manager, Mr. Iversen was running, supervising, managing, and involved with all significant activities of Stirrup Ranch, as petitioners seem to claim, we would expect petitioners to have offered into evidence extensive files, to-do lists, home and mobile phone records, business plans, project descriptions, instructions to employees, etc., documenting and establishing Mr. Iversen’s active involvement in the regular, continuous, and substantial management and day-to-day activities of Stirrup Ranch. That documentary evidence is absent.
Mr. Iverson did not get hit with penalites, although the reason might be a little disturbing to tax practitioners:
Petitioners’ accountant should have known better, particularly if the accountant was shown no more evidence and documentation than was shown to us. Regardless of the incorrectness of their accountant’s advice, we conclude that petitioners reasonably and in good faith relied on their accountant in claiming the losses disallowed. We reject respondent’s determination of the section 6662(a) accuracy- related penalties.
Tax preparers are not auditors. Mr. Iverson’s accountant should have warned him about the exposure that a large loss on a side activity creates for someone with a lucrative day job, but it would have been reasonable for him to accept Mr. Iverson’s representation that he spent significantly more than 500 hours on ranch business. He should also have advised him on being prepared to prove it, but he did not have an obligation to examine the evidence. If there was a failing here, it was not in preparation but in audit representation and litigation. Of course, you don’t know what Mr. Iverson gave them to work with. Still, I look at this as a possible challenge to preparers to be more assertive in questioning your clients in this area.
The accountant identified was Martin Negaard, a partner in the regional firmHansen, Jergenson, Nergaard & Co. For what it is worth HJN was recently merged into a a larger firm. Mr. Negaard, a CPA, was also a lawyer and a former IRS revenue agent. Based on the size of the firm, it would seem likely that Mr. Iverson was a significant client. If he said he spent 500 hours working on the ranch, I would certainly believe him and that is what you need to sign his return. What is mysterious is why a better file was not created for audit representation, never mind Tax Court litigation. I would not rule out a stubborn client, who thought that people should just believe him.
Actually it could have been worse. Losses suspended under the passive activity loss rules are ultimately allowed when there is passive income or the activity is disposed of. I would have also seen the ranch as being vulnerable to a hobby loss attack which would have denied the losses forever.