From The Boston Tax Institute

Lucien Gauthier has given me permission to reprint his e-mails to his customers.  Here is the latest.

In Larry Williams v. Comm., TCM 2015-76 (04/16/15), the Tax Court applied Reg. 1.469-2(f)(6) to recharacterize the net rental income from rental real estate, which was rented by an S corporation which was wholly-owned by the taxpayer to a wholly-owned C corporation in which the taxpayer materially participated, as NONPASSIVE income.  If the taxpayer had owned the rental real estate individually or perhaps though a single member LLC, there would have been no question that -2(f)(6) applied, and the Tax Court concluded that owning the rental real estate through a wholly-owned S corporation should not change this result.  Sections 469 and 1411 may be the two hottest areas of tax practice today.  If you would like to learn more about section 469 from a Tax Attorney/CPA with two masters degrees in taxation and 28 years of experience with section 469, please attend our full day seminar on May 27 entitled Passive Activity Losses at the Hyatt house in Waltham!!!           

 2015 SPRING 8 PAGE BROCHURE  

I'm behind on my reading thanks to tax season.  There is a good chance that I will find the Williams case to be forbes worthy. 

To Keep Your Story Straight You Need to Know What it Needs to Be

Originally published on Passive Activities and Other Oxymorons on May 27th, 2011.
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Yusufu Y. Anyika, et ux. v. Commissioner, TC Memo 2011-69

After the introduction of the at-risk rules, real estate was the last real tax shelter.  Then came the passive activity loss rules.  The passive activity loss rules (Code Section 469) require us to put our trade our business activities (including interest in flow through entities) into buckets.  Losses in the passive bucket can only be used to the extent of gains in the passive bucket (It is not an "offset".  Passive capital gains release passive ordinary losses.  So sometimes a gain can reduce your liability.)  Losses that are not used are carried forward and are attached to the activity that generated them.  They are released when the activity is fully disposed of even if there is no passive income in that year.

Activities are classed as passive based on how much you participate in them.  Their are a number of ways to meet the "material participation" standard.  The simplest is 500 hours per year.  "Rental activities" are special.  They are deemed to be passive regardless of how much time you spend on them.  There is an exception to that rule.  Rental losses are not "per se" passive to people engaged in real estate trade or businesses.  The magic number here is 750 hours:

such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

Sometimes people miss that "materially participates" part of the requirement.  In order for the exception to work for many people, they need to make an election to aggregate all their real estate activities for purposes of measuring material participation. Otherwise somebody with five properties might not be considered to be materially participating in any of them.

Now the 750 hours is not the whole story as Mr. Anyika discovered a bit late in the game.  Here is his situation:

Petitioners, Yusufu Yerodin Anyika (Mr. Anyika) and Cecelia Francis-Anyika (Mrs. Francis-Anyika), are married and filed joint returns for tax years 2005 and 2006. Mr. Anyika is employed as an engineer, and he works 37.5 hours per week, 48 weeks per year. Mrs. Francis-Anyika is employed as a nurse, and she works 24 hours per week.

Mr. Anyika has been purchasing, renovating, managing, and selling rental properties since the 1990s. He views his rental real estate activity as a second job and as an investment. During 2005 and 2006, Mr. Anyika owned two rental properties.

Mr. Anyika spent a good bit of time on the properties and thought he should qualify for the real estate trade or business exception.  He explained this in his petition and at trial:

 In their petition and at trial, petitioners contended that Mr. Anyika qualified as a real estate professional because he had spent at least 750 hours actively managing the rental properties. On Form 4564, Information Document Request, submitted by petitioners during their audit, petitioners declared, under penalty of perjury, that Mr. Anyika devoted 800 hours per year to working on the rental properties during 2005 and 2006.

With that nice fifty hour cushion he thought he was all set. Unfortunately 750 hours is not the only requirement.  Here is the other requirement:

more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates

Mr. Anyika also worked full time as an engineer which took up substantially more than 800 hours per year.  He tried to salvage the situation:

It was only after the Court had explained the law that Mr. Anyika understood, for the first time, that he would have to have spent at least 1,800 hours engaged in the real estate business in order to qualify as a real estate professional under section 469(c)(7)(B). After understanding that, to qualify, he had to spend more hours engaged in managing the rental properties than he did working as an engineer, Mr. Anyika began to contend that he had spent the equivalent of 8 hours per day, 5 days per week, 48 weeks per year (1,920 hours per year) working on the rental properties. After being confronted during trial by the evidence of his prior signed statement that he worked 800 hours per year on the rental properties, Mr. Anyika stated that he was “speaking from memory with the exact numbers”, and that to be sure, he would need to look over the numbers more closely.

The Court did not find him credible:

We do not find Mr. Anyika's testimony that he worked approximately 1,920 hours per year on the rental properties credible. Not only does it contradict his earlier signed statement, but it also changed during trial once Mr. Anyika realized that he would need to have devoted more hours to his real estate properties than to his job as an engineer (i.e., he would need to have spent more than 1,800 hours working on the rental properties), instead of the 750 hours he had originally believed would be sufficient for him to qualify as a real estate professional under section 469(c)(7).

When it came to the penalties taxpayers tried the classic "Turbo Tax made me do it" defense.  The Court, using more measured if less colorful language, gave the old data processing answer to the Turbo Tax defense - Garbage in, Garbage Out.  Their has been much talk, of late, of what the qualifications of people who prepare tax returns should be.  Their will be special exams with members of some professions such as CPA's exempt from taking then.  Based mainly on reading tax court decisions, I think members of some professions should be required to take a special exam before they are allowed to prepare their own returns specifically engineers and attorneys.  Nobody ever listens to me, though.

They Also Serve

James F. Moss, et ux. v. Commissioner, 135 T.C. No. 18, Code Sec(s) 469; 6662.

This was originally published on October 8th, 2010.

God doth not need
Either man's work or his own gifts. Who best
Bear his mild yoke, they serve him best. His state
Is kingly: thousands at his bidding speed,
And post o'er land and ocean without rest;
They also serve who only stand and wait

So this is another post about a development in the passive activity loss rules.  The rules require us to group our trade or business activities into different buckets depending on our level of participation.  Losses in the passive activity bucket can be used against gains from passive activities, but a net loss is suspended until the related activity is fully disposed of.  A special feature of the rules is that rental activities are "per se" passive.  Persons who are in real estate trades or businesses can be exempted from this "per se" passive rule.  They may need to make a special election to take advantage of this benefit.

I've discussed the election in a previous post.  I've also discussed the biggest problem, people have, which is proving how they spend their time. James Moss has introduced a new angle.  Mr. Moss worked full time at a nuclear power plant.  The total hours worked at this job for 2007 came to 1900.  Included in his work hours were 200 to 300 hours of "call out" or "standby time".  Apparently, this was time where he had to be ready to go in, if they needed him.  Maybe it was the days when Homer Simpson was working alone, but I'm pretty sure that's a different power plant.

Mr. Moss also rented out some property that he owned.  There was a four unit apartment building and three single family homes.  He apparently kept meticulous track of his time. (His "day job" involved planning the maintenance activities of a nuclear power plant, so the habits there may have carried over).  He spent 507.75 hours working on his properties and 137.75 hours travelling two and fro for a grand total of 645.50 hours.  The court noted that the IRS did not say that Mr. Moss failed to make the election to group his properties, so they figured he must have.

You guys who know all the answers, I need you to slow down here.  Mr. Moss has done better than most real estate exception wannabees in tax court.  The court isn't calling his time records a ballpark guesstimate and they are giving him credit for the election.  It doesn't make him win, but he deserves a cheer.  Sadly, one of the necessary, though not sufficient, conditions is that you have 750 hours in a real estate trade or business.  So by his own meticulous records Mr. Moss loses.  He has another argument, though.  All the time that he wasn't working at the power plant, he was "on-call" for his tenants.  That should easily put him over the 750 hours.  OK wise guys.  He actually has to beat 1900 hours, because another condition is that you spend more time in real estate than anything else.  Well by my reckoning the "on-call" theory could be another 6,000 hours.

Sadly the tax court wouldn't buy it.  So he has to pay the tax.  He also got hit with an accuracy related penalty.  He proffered two arguments.  The first was that the penalty should be waived, because the IRS mistreated him.  Sadly we don't get the details.  The other was reliance on his CPA, but it is indicated that he did not tell his CPA how many hours he worked. 

First reader to identify the poem above can chose the topic of a future post.

Real estate election relief

This was originally published on PAOO on September 6th, 2010.

When I titled this blog Passive Activities and Other Oxymorons, it was by no means, because I intended to write only on the passive activity loss rules.  If I was going to totally devote myself to one tax topic it would be the capital account maintenance rules of 704(b) (That blog would be titled "Minimum Gain - Maximum Pain").  Fortunately, I once saw the slides of a presentation of someone else who is passionate about those rules.  I think they also had a thing for 704(c).  One of the slides practically screamed "There is no such thing as negative basis".  I feel a certain bond with that person, but I'm really not anxious to meet with them.

At any rate the passive activity loss rules do seem to be cropping up quite a bit.  In a recent case which I'm thinking doesn't merit its own post (Gregory J. Bahas, et ux. v. Commissioner, TC Summary Opinion 2010-115) Linda Bahas tried to use the real estate professional exception.  She hadn't made the aggregation election and the services she provided were as an employee not as a business owner.  Other than that Mrs. Lincoln how did your enjoy the play ?  At least she didn't have to put up with the court telling her she was ballpark guestimating her time.

There is some good news, though.  A quick review of the context might be in order first.  The passive activity loss rules were created more or less out of whole cloth by the Tax Reform Act of 1986.  They require us to sort trade or business activities into those in which we materially participate and those in which we don't.  One of the concepts in the rules is that rental activities are per se passive.  This may have been an example of someone getting their notions about reality from watching TV infomercials about making a fortune in real estate with no capital and very little work.  Regardless, my philosophy about tax rules is that they are what they are.  In the early 1990's relief from the per se passive rule was granted to real estate professionals.

In order for this relief to be effective, though, it is frequently necessary for them to elect to aggregate all their real estate activities.  Without the election they would have to establish material participation in each property. Donald Trask (TCM 2010-78) was able to establish that he spent enough time to be considered a real estate professional, but he had not made the election and his time was spread over 33 properties. 

PLR 201033015 was addressed to taxpayers who were qualified, but had failed to make the election.  Since they had relied on a tax preparer who had failed to advise them of the necessity of making the election, the service granted them an extension of time to make it.

If you have been posting negative numbers from real estate investments to your return on the theory that you or your spouse is a real estate professional, you should make sure that you have made the election.  If not you may want to consider requesting relief.  Furthermore, I generally believe in keeping tax returns indeefinitely, but if you must dispose of some of them, be sure to keep the return for the year that you made the election.  It is relevant for all future returns in which you are claiming its effect and I know from experience that you cannot rely on the IRS to preserve it for you.

LLC Member Not Presumed to be Passive

This was originally published on PAOO on August 30th, 2010.

In Action On Decision 2010-002 the IRS acquiesced in a Court of Claims decision (Thompson v. US 104 AFTR 2d 2009-5381) holding that a membership interest in a LLC was not presumptively passive.  Since the LLC is really the entity of choice, if you want a flow through this can be of significance. The passive activity loss rules were probably the most novel element of the Tax Reform Act of 1986.  They created a new taxonomy of business undertakings based on each individual taxpayers participation in the business.

The income or loss created by passive activities are aggregated and, in general, the losses are only allowed to the extent of the income.  It is erroneous to think of the process as an offset, because the various types of income and losses retain their character.  So if you have a capital gain from one passive activity and an ordinary loss from another activity, the ordinary loss will be allowed, while the capital gain will retain its character as a capital gain.  Losses without accompanying gains languish suspended from year to year until they are released by the total disposition of the activity giving rise to them.  It all gets tracked by Form 8582.  If you have been involved in passive activities it could be a worthwhile exercise to review your 8582's from year to year.  You will have two sets, one for the regular tax and another for the alternative minimum tax.  If you have switched tax preparers, there is a decent chance something got lost in transition.  It can happen even from preparers switching software.

The cleanest way out of the morass of passive activity concerns is "material participation".  The regulations give an individual seven ways to establish material participation :

(1) The individual participates in the activity for more than 500 hours during such year.


(2) The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;


(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;


(4) The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;


(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;


(6) The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or


(7) Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

The regulations go on to state that if the taxpayers interest in the activity is as a limited partner qualification for material participation can only come from items 1, 5, and 6 above. Thus a limited partner who does more than any other individual in the activity will not be considered to be materially participating if that amounts to less than 500 hours.  In the Thompson case the service had argued that an LLC membership interest was the same as a limited partnership interest for purposes of this regulation.  The Court of Claims did not agree and the service has thrown in the towel on this issue.

This decision should further bolster the LLC as the entity of choice where a flow though is desired.  Taxpayers should bear in mind though that if they are posting negative numbers from an activity, the IRS will likely attack any reconstruction of their time as a ballpark guesstimate (This has become a term of art apparently).

Guess me Out of the Ballpark

This was originally published on PAOO on August 6th, 2010.

The case of Marcel Ajah (TC Summary Opinion 2010-90) is about the ultimate oxymoron - "passive activities". The concept of passive activities embodied in Section 469 is a creature of the Tax Reform Act of 1986's attempt to drive a stake through the heart of the tax shelter vampires after the silver bullet of the at-risk rules under 465 had failed to eliminate them. Oddly enough while the at-risk rules specifically excluded real estate, the passive activity rules specifically target it, by indicating that rental activities are per se passive. This was a source of real aggravation to people who actively manage their own real estate. In the 1990's there was a relaxation for people who spent most of their time in trades or businesses related to real estate.

In order to take advantage of the relief many taxpayers needed to make a special election to treat all their rental real estate activities as one activity. Otherwise, the exception to the "per se" passive rule would do them no good unless they were "materially participating" in each of their properties. Since the basic standard of material participation is 500 hours per year (there is a separate 750 hour requirement to be recognized as being in a real estate trade or business), even very hard working people can't materially participate in more than a couple. There are wonderful regulations that explain to you how to go about grouping your activities to keep track of whether you are meeting the material participation standard.

Marcel Ajah illustrates the Achilles heel of the whole system, though. Most people don't keep very good track of how they spend their time. The regulations do not specify a particular method, but the cases beginning with William Goshorn in 1993 (TCM 1993-578) seem to characterize any method that taxpayers use to reconstruct their time as being a "post-event ballpark guesstimate". "Ballpark guesstimate" which seems to me to be a fairly robust concept is apparently limited to estimates of time spent to satisfy material participation requirements.

Marcel Ajah and his wife owned two rental properties, the commercial building out of which he operated his medical practice in Jamaica, NY and a single family residence in Baltimore MD. They claimed that Mrs. Ajah qualified as a real estate professional. They lost the case on two grounds.

Mrs. Ajah argues that she qualifies as a real estate professional for the year in issue. She relies upon certificates from the Long Island Board of Realtors, Inc., the Multiple Listing Service of Long Island, Inc., and the State of New York Department of State Division of Licensing Services. These certificates reflect, respectively, that for 2005 she pledged to adhere to the realtor code of ethics, had completed required courses on broker rules and regulations, and was licensed as a real estate broker. Mrs. Ajah testified that she worked at least 20 hours a week for the 52 weeks of 2005 on the two rental properties. Mrs. Ajah did not offer any evidence as to the number of hours she worked as an attorney in 2005. No contemporaneous record, calendar, appointment book, or any other method of recording time spent between rental real estate activities and activities as an attorney was provided. Thus, the Court is unable to conclude that more than one-half of Mrs. Ajah's personal services were devoted to the rental properties.


We conclude that Mrs. Ajah's method of calculating her time spent participating in the rental activities constitutes an impermissible “ballpark guesstimate”.

The other problem was that the Ajahs had not filed the election to aggregate meaning that she would have to meet the 750 hour requirement on each of the properties which wasn't even in her ballpark.

Earlier in the year Donald Trask (TCM 2010-78) who owned 33 rental properties managed to convince the tax court that he spent more than 750 hours working on them, but he was hung by the failure to make the election to aggregate. The fact that he had aggregated the properties in reporting his income and loss was not sufficient.

It is not always advantageous for the real estate professionals to make the election, but it is definitely something that should be looked at. There is no question that if you are posting negative numbers from real estate or side businesses on your returns you should be doing something to keep a current record of your time. My own experience working with appeals on this issue is that the Service will characterize almost any reconstruction of time spent as being a "ballpark guesstimate". And they aren't handing out any peanuts or cracker jacks,