Tax controversy lawyers are constantly thrown a myriad of issues that reflect the government’s current agenda. The latest segment that has grasped tax lawyers’ attention is the application of the passive activity loss rules. In addition to several audits in this area, the Tax Court has been issuing opinions about passive activity loss rules on a regular basis.
Passive activities are those in which the taxpayer does not materially participate and rental real estate activities (unless the taxpayer is a real estate professional).
Losses on a passive activity can only be deducted to the extent of the taxpayer’s passive income. Under Section 469 rules, if the taxpayer’s income from an activity is considered passive, then it can be subject to the tax on net investment income under Section 1411.
So, how do you know if your activities are passive? If you meet any of the following tests, you are a material participant and the activity is not passive (except rental activities):
1. You participated in the activity for more than 500 hours;
2. Your participation was substantially all of the participation in the activity of all individuals for the tax year;
3. You participated in the activity for more than 100 hours during the tax year and you participated at least as much as any other individual for the year;
4. The activity is a significant participation activity (one which you participated more than 100 hours) and you participated in all significant participation activities for more than 500 hours during the year;
5. You materially participated in the activity for any 5 of the past 10 preceding tax years;
6. The activity is a personal service activity and you materially participated in the activity for any 3 of the preceding tax years; or
7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
Recent court cases like Tolin v. Commissioner and Bartlett v. Commissioner illustrate how Tax Courts will be analyzing IRS attacks on passive activity loss fact patterns. The challenge faced in these cases was in proving that the taxpayer did, in fact, materially participate in the activity.
In Tolin, the taxpayer had corroborating evidence to prove the number of hours he claimed to have participated in horse breeding. This included third party testimony and phone records. The court additionally analyzed the difference between management activities and simple investment activities, to ensure that the evidence did actually point to business activity. Bartlett, on the other hand, was not able to prove that he materially participated in bull breeding based upon non-contemporaneous schedules and credit card purchases showing he made purchases on various dates throughout the year.
The growing number of passive activity loss cases and audits could be a sign that they will be the IRS’s newest target area and emphasizes the importance of accurate record keeping.