I am looking at a case that stacks a couple of
different tax rules atop another and then asks: are we there yet?
Let’s talk about it.
The first is something called the continuity of
business doctrine. Here we wade into the waters of corporate taxation and - more
specifically - corporate reorganizations. Let’s take an easy example:
Corporation A wants to
split into two corporations: corporation B and corporation C.
Why? It can be any number of things. Maybe management
has decided that one of the business activities is not keeping up with the
other, bringing down the stock price as a result. Maybe two families own
corporation A, and the two families now have very strong and differing feelings
about where to go and how to get there. Corporate reorganizations are
relatively common.
The IRS wants to see an active trade or business in
corporations A, B and C before allowing the reorganization. Why? Because
reorganizations can be (and generally are) tax-free, and the IRS wants to be
sure that there is a business reason for the reorganization – and avoiding tax
does not count as a business reason.
Let me give you an example.
Corporation A is an exterminating company. Years ago
it bought Tesla stock for pennies on the dollar, and those shares are now worth
big bucks. It wants to reorganize into corporation B – which will continue the
exterminating activity – and corporation C – which will hold Tesla stock.
Will this fly?
Probably not.
The continuity of business doctrine wants to see five
years of a trade or business in all parties involved. Corporation A and B will
not have a problem with this, but corporation C probably will. Why? Well, C is
going to have to argue that holding Tesla stock rises to the level of a trade
or business. But does it? I point out that Yahoo had a similar fact pattern when
it wanted to unload $32 billion of Alibaba stock a few years ago. The IRS
refused to go along, and the Yahoo attorneys had to redesign the deal.
Now let’s stack tax rules.
You have a business.
To make the stack work, the business will be a
passthrough: a partnership or an S corporation. The magic to the passthrough is
that the entity itself does not pay tax. Rather its tax numbers are sliced and
diced and allocated among its owners, each of whom includes his/her slice on
his/her individual return.
Let’s say that the passthrough has a loss.
Can you show that loss on your individual return?
We have shifted (smooth, eh?) to the tax issue of “materially
participating” and “passively nonparticipating” in a business.
Yep, we are talking passive loss rules.
The concept here is that one should not be allowed to
use “passively nonparticipating” losses to offset “materially participating”
income. Those passive losses instead accumulate until there is passive income
to sponge them up or until one finally disposes of the passive activity
altogether. Think tax shelters and you go a long way as to what Congress was
trying to do here.
Back to our continuity of business doctrine.
Corporation A has two activities. One is a winner and
the other is a loser. Historically A has netted the two, reporting the net
number as “materially participating” on the shareholder K-1 and carried on.
Corporation A reorganizes into B and C.
B takes the winner.
C takes the loser.
The shareholder has passive losses elsewhere on
his/her return. He/she REALLY wants to treat B as “passively nonparticipating.”
Why? Because it would give him/her passive income to offset those passive
losses loitering on his/her return.
But can you do this?
Enter another rule:
A taxpayer is considered to material participate in an activity if the taxpayer materially participated in the activity for any five years during the immediately preceding ten taxable years.
On first blush, the rule is confusing, but there is a reason
why it exists.
Say that someone has a profitable “materially
participating” activity. Meanwhile he/she is accumulating substantial “passively
nonparticipating” losses. He/she approaches me as a tax advisor and says: help.
Can I do anything?
Maybe.
What would that something be?
I would have him/her pull back (if possible) his/her
involvement in the profitable activity. In fact, I would have him/her pull back
so dramatically that the activity is no longer “materially participating.” We
have transmuted the activity to “passively nonparticipating.”
I just created passive income. Tax advisors gotta
advise.
Can’t do this, though. Congress thought of this loophole
and shut it down with that five-of-the-last-ten-years rule.
This gets us to the Rogerson case.
Rogerson owned and was very involved with an aerospace
company for 40 years. Somewhere in there he decided to reorganize the company
along product lines.
He now had three companies where he previously had
one.
He reported two as materially participating. The third
he treated as passively nonparticipating.
Nickels to dollars that third one was profitable. He
wanted the rush of passive income. He wanted that passive like one wants Hawaiian
ice on a scorching hot day.
And the IRS said: No.
Off to Tax Court they went.
Rogerson’s argument was straightforward: the winner was
a new activity. It was fresh-born, all a-gleaming under an ascendent morning
sun.
The Court pointed out the continuity of business
doctrine: five years before and five after. The activity might be a-gleaming,
but it was not fresh-born.
Rogerson tried a long shot: he had not materially participated
in that winner prior to the reorganization. The winner had just been caught up
in the tide by his tax preparers. How they shrouded their inscrutable dark arts
from prying eyes! Oh, if he could do it over again ….
The Court made short work of that argument: by your
hand, sir, not mine. If Rogerson wanted a different result, he should have done
- and reported - things differently.
Our case this time was Rogerson v Commissioner,
TC Memo 2022-49.
