If you own multiple businesses you know all too well that start-ups generally lose money the first or second year. But did you know you can deduct these losses against current earnings, lower taxes and increase cash flow all at the same time you phase into rapid growth and expansion? Before you get too excited about having such a great tax strategy, turn around and make sure your tax professional has your back, for lurking in the dark at an IRS office near you is a Government agent getting ready for battle using a new and exciting weapon against you, the “material participation” rules of engagement. Long time business owners and start ups alike are increasingly at risk of losing all losses in the battle to comply with IRS regulations requiring at least 500 hours of material participation. Stay with me on TaxView as we head to US Tax Court to find out how to protect and armor up your business losses from adverse IRS audit consequences if the Government finds that you are not “materially participating” in your business activities.
Let’s start out with Iversen vs IRS a rather simple introdution to Section 469. Iversen owned various business interests included 100% ownership in Stirrup Ranch LLC, a 14,000 acre cattle and horse ranch in Fremont County Colorado. Martin Nergaard, attorney and CPA and former IRS employee prepared and filed Iversen’s 2005 and 2006 tax returns. Nergaard concluded Iversen qualified for material participation in that he worked the Ranch at least 500 hours. As a result Nergaard deducted almost $500,000 in losses on Iversen’s tax returns. Sure enough the IRS audited and disallowed all the losses claiming that Iversen did not materially participate in the Ranch. Iversen appealed to US Tax Court. Judge Swift’s Opinion in Iversen vs IRS (2012) defines material participation as involvement on a “regular, continuous and substantial basis”. Sec.469(h)(1)(A-C) Judge Swift says you can use “any reasonable means” to prove you materially participated, including calendars, appointment books, and narrative summaries citing 1.469-5T. Iversen’s testimony and evidence he presented to the Court was not credited as adequate enough to convince Judge Swift to allow Iversen’s losses. IRS wins Iversen loses.
Our next case, Newell vs IRS, decided in US Tax Court in February of 2010, has somewhat of a different set of facts than Iversen. Newell owned 100% of a California Millworks business and owned a 33% interest in Pasaddra Country Club LLC. Newell deducted over $5 Million of losses on his 2001 2002 and 2003 income tax returns from these businesses. The IRS audited and disallowed all these losses citing 469(h)(2) claiming that Newell as a “limited partner” did not materially participate in the Country Club. The Court's Opinion written by Judge Marvel, sided with Newell, noting that only limited partners in a “partnership” not partners in an LLC are limited by 469(h)(2). Newell wins IRS loses.
We now come to our final case involving real estate businesses. Fasten your seat belts on this ride because real estate passive activity road map requires acceleration at dizzying speeds sometimes causing taxpayers to faint into disastrous head on collisions with the IRS into the walls of US Tax Court in Washington DC. Frank Aragona Trust vs IRSdecided in US Tax Court in March of 2014 Aragona is a trustee which manages rental real estate properties. Real estate activities, even with material participation, are considered passive under 469(c)(2). For those of you in real estate please take a look at these excellent articles on real estate passive losses. See Journal of Accountancy 469(c)(2). Also see theTax Advisor Section 469. Aragona deducted on the trust tax return from 2003-2006 millions of dollars of losses. When the IRS audited these years all losses were disallowed and almost $600,000 of tax was assessed. Aragona appealed to US Tax Court. The question presented before the Court: Whether 469(c)(7) applies to a trust as it does for all other business entities.
Before we find out the exciting conclusion of the Court, I suggest we rewind history to the Tax Reform Act of 1986 as championed by President Reagan. The 1986 Reform Act had generally disallowed all Real Estate losses from offsetting ordinary income in order to fight back against abusive tax shelters in that era. However after years of lobbying by the Real Estate industry, Section 469(c)(7) was enacted in the 1993 during the Clinton Administration to give “Real Estate Professionals” a chance to deduct their legitimate losses. For those of you with multiple businesses you need to jump through two high, but with proper structure planning and record keeping, not impossible hoops: 1)More than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses in which the taxpayer materially participates; and 2) The taxpayer performs more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates.
Fast forward please back to Aragon Trust. The IRS agreed that the trust had adequately documented its records to prove material participation. However, the IRS said a “trust” was not capable of performing personal service since the trust was not a person. The Court rejected this IRS argument and concluded that a trust is “capable of performing personal services and therefore can satisfy the section 469(c)(7) exception. The Court opined that indeed, if Congress had wanted to exclude trusts from the section 469(c)(7) exception, it could have done so explicitly by limiting the exception to “any natural person”. Aragon wins IRS Losses; a big victory for trusts and taxpayers nationally.
In conclusion if you do not all feel 100% protected from a possible IRS material participation attack on your business activities ask your tax professionals to document your time in each business in the actual tax returns they file for you. If you have multiple businesses, and you feel you need even more protection, please consult your tax advisors and make sure you are extemporaneously and contemporaneously keeping track of your participation in each business. Perhaps you wish to disclose summary participation data in attachments to your annual income tax returns before you file? Finally subscribe as I do to the “now or later” ancient philosophy of tax audits: Consult tax attorney now, protect you from IRS audit later.
Thanks for joining Chris Moss CPA on TaxView