How Much Would A Worker Have To Work Before The IRS Believes They Were Really Working?

Can you own and work at a company but have the IRS consider it to be a “passive activity” for tax purposes?

The question seems odd to me, as I have never worked somewhere where I wasn’t unquestionably “materially participating.” There isn’t much choice, given what I do. I would like to someday, though. It’s on my bucket list.

What do these terms mean?

The terms entered the tax Code in 1986, and they were a (mostly successful) effort to battle tax shelters. To trigger the issue one had to have invested in a business activity, and one’s share (whether large or small) wound up on one’s personal tax return. This means – generally – that one is invested in a partnership, LLC or S corporation. One receives a Schedule K-1 for his/her ownership interest, and those numbers are included with one’s other income (a W-2, for example) on the personal return.

Make those numbers negative and you understand the mechanics of a tax shelter.

Congress said that one had to separate those activities into two buckets. The first was a “material participation” bucket, for activities where you actually worked. Those numbers went on your tax return whether they were positive or negative. Congress saw little risk of a tax shelter if one actually worked at the place.

The second was the “passive activity” bucket. Congress put stringent limits on the ability to use negative numbers from this bucket to offset other income. Congress wasn’t going to allow negative numbers from the passive activity bucket to offset positive numbers from one’s actual job.

You can anticipate that the definition of “material participation” was critical.

There are seven tests to qualify as material participation. They are found in Reg. 1.469-5T and are as follows:

·  The taxpayer works 500 hours or more during the year in the activity.

·  The taxpayer does substantially all the work in the activity.

·  The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.

·  The activity is a significant participation activity (SPA), and the sum of SPAs in which the taxpayer works 100-500 hours exceeds 500 hours for the year.

·  The taxpayer materially participated in the activity in any 5 of the prior 10 years.

·  The activity is a personal service activity and the taxpayer materially participated in that activity in any 3 prior years.

·  Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year.  However, this test only applies if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.

The key one is the first – the 500 hour test. That is the workhorse, and the one practitioners prefer to use. The 5-out-of-10 years test allows one to retire, as does the any-3-prior- years test. The SPA test is goofy, and should it be a one-person business, then the substantially-all-the-work test bypasses any reference to hours worked.

Then there is the last one – “facts and circumstances.” This is a fallback, in case one cannot shoehorn into one of the other tests. Tax practice being unpredictable, one would have expected a substantial body of precedence on what comprises “facts and circumstances.” We have had more than 25 years, after all. One would have been wrong, as the IRS prefers to proceed as though this test did not exist.

Now we have the Wade case.

Charles Wade owned stock in two corporations: Thermoplastic Services, Inc. (TSI) and Paragon Plastic Sheeting, Inc. (Paragon). He started these companies in 1980 to address the environmental impact of plastic waste materials. TSI acquired waste from chemical companies and converted it into useable products. Paragon bought raw materials from TSI and used them to make building and construction materials. Sounds green.

In 1994 his son (Ashley) came on board, and eventually wound up managing the companies.

This freed up his dad. Wade could be more involved with the customer relationships and less with the day-to-day stuff. This gave dad (and mom) a chance to move to Florida. He could still call and schmooze customers from Florida. I too would like the opportunity to work from Florida, especially as we get closer to winter.

Fast forward another fourteen years, and in 2008 the companies were struggling for their financial lives. Dad decided to step it up. He did the following:

·        Made 273 phone calls to the plant in 2008

·        Travelled to the plant three times to motivate and reassure employees that the companies would continue

·        Intensified his R&D efforts, resulting in

o   A new technique for fireproofing polyethylene partitions

o   A new method for treating plastics to destroy common viruses and bacteria on contact

·        Guaranteed a new line of credit

Wow! This man did everything short of stepping into a phone booth and coming out as Superman.

But 2008 was a tough year. His losses from the companies (including one other, which need not concern us here) was $3.8 million.

This created a net operating loss (NOL) on his personal return. Truthfully, a negative $3.8 million would create an NOL for pretty much all of us. He did what we would do: he carried back the NOL as allowed, which is to the prior two years. Any amount not used there can be carried forward 20 years. Why would he do that?

To obtain a refund of the taxes he paid in 2006 and 2007, that’s why.

Of course, the IRS did not like this at all. They argued that TSI and Paragon were passive activities to Wade, and there is no NOL from passive losses. In fact, there is no “loss” from passive losses, as the best passive activities can do (generally) is get to zero.

And both parties are bound for Tax Court.

The Court looks and notes that Wade has a couple of arguments. The first is that he spent more than 500 hours working at TSI and Paragon.

Now, this can be messy to prove, unless one is actually in the building every day. Time sheets or records would be great. This is an area where keeping good records is key.

The Court continued. Wade also argued that he worked on a “regular, continuous and substantial basis” in 2008. This is the last test from Reg. 1.469-5T, and is the one the IRS likes to ignore.

The Court decided it liked that one. Maybe it did not want to go through time records, which is understandable. 

It looked at the facts and said “duh!” to the IRS. Wade easily spent more than 100 hours just calling the plant (100 hours is the minimum under the facts-and-circumstances test). He developed new technology, called every day, visited the facilities several times, secured financing. Good grief IRS, what more did you want the guy to do?

The Court decided for Wade, noting:

TSI and Paragon are complex businesses that Mr. Wade built from the ground up and in which he continued to play a vital role. He was not merely a detached investor, as has often been the case when we have found that a taxpayer did not materially participate.”

So Wade won. The IRS would have to issue him refunds from his NOL carryback.

But the IRS made their point: they remained skeptical of anyone who wants to prove material participation by means of facts and circumstances.

Of course, a $3.8 million dollar NOL carryback undoubtedly did a lot to spotlight that facts-and-circumstances claim.

The IRS Updates a Real Estate Professional Tax Rule

I am glad to see that the IRS has reversed course on an issue concerning real estate professionals.

You may remember that “passive losses” entered the tax Code in 1986 as retaliation against tax shelters. The IRS had previously battled tax shelters using challenges such as “at-risk,” but 1986 brought a new and updated weapon to the IRS armory.

The idea is simple: separate business activities into two buckets: one bucket for material participation and a second for passive. The classic material participation is an activity where one works more than 500 hours. Activities in the material participation bucket can offset each other; that is, losses can offset income.

Move on to the second bucket. Losses can offset income – but not beyond zero. The best one can do (with exceptions, of course) is get to zero. One cannot create a net loss to offset against net income from bucket one.

Consider that tax shelters were placed into bucket two and you understand how Congress changed the tax Code to pull the rug out from under the classic tax shelter.

It was quickly realized that the basic passive activity rules were unfair to people who made their living in real estate. For example, take a real estate developer who keeps a few self-constructed office condominiums as rentals. If one went granular separating the activities, then the real estate development would be a material participation activity but the condominium rentals would be a passive activity. This result does not make sense, as all the income in our example originated from the same “activity.”

So Congress came in with Section 469(c)(7):

   469(c)(7) SPECIAL RULES FOR TAXPAYERS IN REAL PROPERTY BUSINESS.—

469(c)(7)(A) IN GENERAL.— If this paragraph applies to any taxpayer for a taxable year—

469(c)(7)(A)(i)   paragraph (2) shall not apply to any rental real estate activity of such taxpayer for such taxable year, and

469(c)(7)(A)(ii)   this section shall be applied as if each interest of the taxpayer in rental real estate were a separate activity.

Notwithstanding clause (ii), a taxpayer may elect to treat all interests in rental real estate as one activity. Nothing in the preceding provisions of this subparagraph shall be construed as affecting the determination of whether the taxpayer materially participates with respect to any interest in a limited partnership as a limited partner.

469(c)(7)(B) TAXPAYERS TO WHOM PARAGRAPH APPLIES.— This paragraph shall apply to a taxpayer for a taxable year if—

469(c)(7)(B)(i)   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, and

469(c)(7)(B)(ii)   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.

Look at Section 469(c)(7)(B)(ii) and the reference to 750 hours. There was confusion on what happened to the plain-vanilla 500-hour rule. Was a real estate pro to be held to a higher standard?

Here for example is the Court in Bahas:

Mrs. Bahas misconstrues section 469. Because petitioners did not elect to aggregate their real estate rental activities, pursuant to Section 469(c)(7)(A) petitioners must treat each of these interests in the real estate as if it were a  separate activity. Thus, Mrs. Bahas is required to establish that she worked for more than 750 hours each year with respect to each of the three rental properties.”

How in the world did we get from 500 hours to 750 hours for each of Mrs. Bahas’ activities?  This is not what Section 469(c)(7) appears to say. There was a torrent of professional and academic criticism on Bahas and related decisions, but in the interim practitioners (me included) elected to aggregate all the real estate activities into one activity. Why? To make sure that one got to the 750 hours, that is why.

Academicians could argue the sequence of phrases and the intent of the law. Practitioners had to prepare annual tax returns, protect their clients and wait their time.

And now it is time.

The IRS released ILM 201427016 to discuss how the “750-hour test” works when one has multiple real estate activities. It includes the following obscuration:

However, some court opinions, while reaching the correct result, contain language which may be read to suggest that the election under Treas. Reg. 1.469-9(g) affects the determination of whether a taxpayer is a qualified taxpayer.”

The IRS finally acknowledged that the 750-hour rule is not a substitute or override for the generic 500-hours-to-materially-participate rule. A real estate taxpayer goes activity-by-activity to determine if he/she is materially participating in each activity. If it is advantageous, the taxpayer can also make an election to aggregate all real estate activities before determining material participation status.

Then, once all that is done, the IRS will look at whether the taxpayer meets the more-than-half and more-than-750-hours tests to determine whether the taxpayer is a real estate pro.

There are two separate tests. One is to determine material participation and a second to determine real estate pro status. 

A bit late for Mrs. Bahas, though.

On Warren Buffett, Berkshire Hathaway and PFICs

We have spoken before about passive foreign investment companies, or PFICs (pronounced pea-fick). There was a time when I saw these on a regular basis, and I remember wondering why the IRS made the rules so complicated.

I am thinking about PFICs because yesterday I read a release for IRS Notice 2014-28. The IRS is amending Regulations concerning the tax consequences of U.S. persons owning a passive foreign investment company through an account or organization which is tax-exempt. Think a hospital, pension plan or IRA, for example. 

Granted, this is not as interesting as Game of Thrones or Sons of Anarchy.

Could you walk unknowingly into a PFIC? It is not likely for the average person, but it is not as difficult as you might think.

PFICs came into the tax Code in 1986. They were intended to address what Congress saw as a loophole. I agree that there was a loophole, but whether the tax fly required the sledgehammer response it received is debatable.

There were a couple of ways to get to the loophole. One way would be to form a foreign corporation and have the corporation invest in stocks and bonds. This means you are forming a foreign mutual fund. There are a couple of issues with this, the key one being that it would require a large number of investors in order to avoid the rules for a controlled foreign corporation. To the extent that 10%-or-more U.S. shareholders owned more than 50% of the foreign corporation, for example, one would have a controlled foreign corporation (CFC) and would be back into the orbit of U.S. taxation.

The second way is to invest in an existing foreign mutual fund. Say that you invested in a German fund sponsored by Deutsche Bank, for example.

And the average person would say: so what? You invested in mutual fund.

Here s what the IRS did not like: the mutual fund could skirt the taxman by not paying dividends or distributions.  The value of the fund would increase, as it would accumulate its earnings.  When you sold that foreign mutual fund, you would have capital gains and you would pay U.S. tax.

Well, the IRS was unhappy with that, as you did not pay tax on dividends every year and, when you did pay, you paid capital gains rather than ordinary income tax. How dare you?

Why the sarcasm? Because you can get the same tax result from owning Berkshire Hathaway. Warren Buffet does not pay a dividend, and never has. You hold onto your shares for a few years and pay capital gains tax when you sell. The IRS never receives its tax on annual dividends, and you pay capital gains rather than ordinary tax on the sale.

Why the difference between the Berkshire Hathaway and Deutsche Bank? Exactly my point. Why is there a difference?

So we have PFIC taxation. Its sole purpose is to deny the deferral of tax to Americans investing in foreign mutual funds.

There are three ways to tax a PFIC.

The default scheme is found in Code Section 1291. You are allowed to defer taxation on a PFIC until the PFIC makes an “excess” distribution. An excess distribution is defined as one of two events:

(1)   The PFIC distributes an amount in excess of 125% of the average distribution for its preceding three years; or

(2)   You sell the PFIC stock.

Let’s say that we use the default taxation on the PFIC. What does your preparer (say me) have to do next?

(1)   I have to calculate your additional tax per year had the distribution been equally paid over the period you owned it (this part is relatively easy: it is the highest tax rate for that year); and

(2)   I have to calculate interest on the above annual tax amounts.

You can imagine my thrill in anticipation of this magical, career-fulfilling tax opportunity. There are severe biases in this calculation, such as presuming that any income or gain was earned pro rata over your holding period. I have seen calculations where - using 15 to 20 year holding periods - the tax and interest charge can approach 100%. This is not taxation. This is theft.

The second option is to annually calculate a "mark to market" on the PFIC. This works if there is a published trading or exchange price. You subtract the beginning-of-year value from the end-of-year value and pay tax on it. I have never seen a tax professional use this option, and frankly it strikes me as tax madness. With extremely limited exceptions, the tax Code does not consider asset appreciation to be an adequate trigger to impose tax. There would be no 401(k) industry, for example, if the IRS taxed 401(k)s like they tax PFICs.

The third option is what almost everyone does, assuming they recognize they have a PFIC and make the necessary election to be taxed as a “qualified election fund,” or QEF for short.

   OBSERVATION: Tax practitioners like their acronyms, as you can see.

There are two very important factors to a QEF:

           

(1)   You have to elect.

a.     No election, no QEF.

(2)   The foreign fund has to agree to provide you numbers, made up special just for its American investors. The fund has to tell you what your interest and dividends and capital gains would have been had it actually distributed income rather than accumulate.

You can fast forward why: because you are going to pay tax on income you did not receive.

What happens in the future when you sell the fund? Remember, you have been paying tax while the fund was accumulating. Don’t you get credit for all those taxes when you finally sell?

Yes, you do, and I have to track whichever of three calculations we decide on in a permanent file. For every fund you own.

BTW there had better be a specific form attached to your tax return: Form 8621. If you were required to disclose a foreign financial account (which a PFIC would be) and did not do so, either on Form 8621 or on another form intended for that purpose, the IRS might be able to "toll" the statute of limitations. Tolling means "suspend" in tax talk. This means the IRS could assess taxes, penalties and interest many years after the tax year should normally have closed. 

This applies only to rich people, right? Not so much, folks. This tax pollution has a way of dissolving down to affect very ordinary Americans.

How? Here are a couple of common ways:

(1)   You live abroad.

You live abroad. You invest abroad.

I intend to retire abroad, so some day this may affect me. Me and all the other tax CPA billionaires high-stepping it out of Cincinnati. Yep, we are a gang of tax-avoiding desperados, all right.

(2)   You work/worked in Canada.

And you have a RSSP. The RRSP is invested in Canadian mutual funds. How likely is this to happen? How about “extremely likely.”

There you have two ordinary as rain ways that someone can walk into a PFIC.

Keep in mind that the IRS is convinced that anyone with a nickel overseas is hiding money. We have already gone through the FBAR and OVDI fiascos, and tax literature is thick with stories of ordinary people who were harassed if not near-bankrupted by obscure and never-before-enforced tax penalties. The IRS is unabashed and wonders why you – the average person – cannot possibly keep up with its increasingly frenetic schedule of publishing tax rules, required disclosures, Star Trek parodies, bonuses to deadbeat employees and Fifth Amendment-pleading crooks.

Beginning in 2014, FATCA legislation requires all “foreign financial institutions” to report to the IRS all assets held by U.S. citizens and permanent residents. The U.S. citizen and permanent resident in turn will disclose all this information on new forms the IRS has created for this purpose – assuming one can find a qualified U.S. tax practitioner in Thailand, Argentina or wherever else an American may work or retire. Shouldn’t be a problem for that overseas practitioner to spot your PFIC – and all the related tax baggage that it draws in its wake - right?

What happens if one doesn’t know to file the PFIC form, or files the form incorrectly? I think we have already seen the velvet fist of the IRS with FBARs and OVDI. Why is this going to be any different?