Is There A Tax Difference Between A Company And An Activity?

Some tax cases are just fun to read.

Our story takes place in south Florida.  

Dad started a business many years ago. It did well, and Dad in turn started three businesses for his children. He structured each business so that one sibling owned 60% and the remaining two siblings owned the balance. He gave each child (two daughters and a son) a controlling interest in their own business, with the remaining siblings owning a (non-controlling) interest.

All these businesses were somehow tied-in to real estate, whether by selling lumber, providing mortgages, payroll services or other activities.

Our protagonist (Jose Antonio Lamas) owned a company called Adrimar.

However the company we are interested is called Shoma, and it is (majority) owned by Jose’s sister and her husband (Masoud Shojaee).

Shoma formed an LLC (Greens at Doral) pursuant to a condominium development. The two companies were closely intertwined. Greens had the same ownership as Shoma, operated out of the same office, used the same employees and so on. Shoma intended to liquidate Greens once the project was done, which is the standard structure for these projects.

 

Shoma got itself into financial straits. Jose was called in to help turn Shoma around.

The soap opera is in the details of how Shoma got itself into difficulties. Turns out that Mr. Shojaee was using Shoma to guarantee loans for a non-family company he owned. He made a pledge to the University of Miami for $1.5 million, in return for which they were going to name a building after him. That is swell, except that he had no intention of using his own money. Instead he used Shoma money to fund the donation. He developed Shoma land – and we have a feel for his ethics at this point – but decided to run the development (and profits) through his own company.

Somewhere in here Jose and his sister had enough and in 2008 sued Mr. Shojaee.

Knock me over with a feather.

Shoma must have been losing crazy-level money, as Jose filed for a tax refund of over $5 million.

Here is an easy quiz: what happens when you file a tax refund of over $5 million with the IRS?

The IRS audits you, that’s what.

What is there to audit, you ask? The “real” audit would be on the business books, not Jose’s personal return, right?

Not so fast.

You see, if Jose did not “materially participate” in the business, then the business would be “passive” to him. He would not be able to offset his other income with that big “passive” loss. The loss would have to wait for passive income to someday soak it up.

Jose needed to provide time records to show that he worked over 500 hours, which is the gold-plated standard of showing “material participation” to the IRS.

Problem: he was not accustomed to working someplace where he kept time records. He didn’t have any. He had to go to plan B, which means evidencing his times through other means, such as by showing regular appointments and obtaining the testimony of other people.

He talked to Tania Martin, who was CFO for Shoma. She testified that she did not see Jose at the office, except maybe one time. There was a problem with her testimony, though. You see she worked remotely from North Carolina.

Francisco Silva was in-house counsel for Shoma. He testified that that Mr. Lamas would walk past his office in the morning and say “hi.” Other than that, he didn’t know “what, if anything, he was doing. I just don’t know.”

Then there was a stream of other people who worked regularly and extensively with Jose, including obtaining financing, soliciting investors, visiting jobsites and so on.

Alex Penelas, for example, was a former Miami-Date County mayor who testified that it was “more effective” to talk with Jose than Mr. Shojaee.

Jose had provided a letter to the IRS from his employer – Shoma - and signed by Mr. Shojaee, stating that he was a full-time employee. It appears that after brother and sister decided to sue, Mr. Shojaee sent a corrected letter to the IRS wherein he stated:

"Recently Shoma Development learned that the IRS requires active participation and 500 hours of work to qualify” and that “Jose Antonio Lamas had no direct nor indirect involvement with Shoma.”

Mr. Shojaee did request the IRS to keep this letter quiet, of course, lest it cause him family trouble. He is clearly all about the family.

The case finally gets to Court, which decides that Jose did work over 500 hours and that Mr. Shojaee was a creep.

But… there is one more thing.

You see, Jose worked for Shoma (an S corporation), not Greens (an LLC), and Greens was a substantial part of the loss.

Which brings us to the tax issue herein: can Shoma and Greens be combined, so that by showing material participation in Shoma, Jose also showed material participation in Greens?

The concept at play is whether the activities comprise an “appropriate economic unit,” a concept introduced to the tax Code as part of the passive loss rules in 1986. An example would be four related companies, each of which owns theaters: one east, one south, one north and one west. The common activity is owning theaters, and if there are enough other similarities then one could determine that the four companies comprise one economic activity. How is this important? If one shows a big loss while the other three show profits, for example. If they are one economic unit, the income and loss would automatically offset without having to employ a lot of tax planning.

So the Tax Court reviewed the rules in Regulation 1.469-4(c) for evaluating an appropriate economic unit:

(1)  similarities and differences in types of business

(2)  the extent of common control

(3)  the extent of common ownership

(4)  geographical location, and

(5)  other interdependencies

It found that there was sufficient overlap between Shoma and Greens that Jose was materially participating in both, and that he was entitled to his tax refund.

And I suspect that Mr. Shojaee is no longer invited to family functions.