Is A Zero-Return Partnership A Valid Tax Filing?

 

I remember when they were called Chief Counsel Advices. IRS employees – think revenue agents or officers in the field – would reach out to their employer – the IRS – for guidance on an issue.

I am looking at something called a Chief Counsel Email.

Everything changes.

It caught my eye because I was talking with a CPA last week on the very same issue.

And the IRS position is initially disturbing.

Let’s go over this.

A revenue agent (commonly called an auditor) wanted to know if an initial partnership return showing partner information but zeros for activity would constitute a valid tax return.

COMMENT: I have seen this situation many times, including last week. Someone obtains a federal EIN, putting the entity on the IRS radar. The entity then goes on to do … nothing. It never starts or starts a year or two later. Meanwhile the entity is on the IRS Christmas card list. Fail to file a return and the IRS may send a letter asking why you did not file. In response, practitioners usually file an initial return but show zeros as activity because… well because there has been no activity.

Here is the Email:

We agree with the RA’s memo that the initial return showing ownership information, but containing all 0s would most likely be considered invalid under application of the Beard test.

Not good.

To be fair, however, I do not think that it is difficult to work with this Email.

Let’s first talk about Beard.

Beard was a tax protestor.

He found himself in Tax Court over his 1981 return. He received a Form W-2, which he reported on the form 1040. He then inserted a line he described as “Non-taxable receipts” and subtracted his W-2. The result was that he owed – according to him – no taxes and was entitled to a full refund of his withholding.

The IRS wanted tax, of course, and also wanted penalties for failure to file a return. He filed something, but tampering with the forms voided the filing.

Beard responded that he obviously filed a return. The IRS was out of line saying that he had not.

The issue before the Court was: what is a tax return?

The Court presented a four-part test:

1. Does it purport to be a tax return?
2. Is it signed under penalties of perjury?
3. Does it include enough information to calculate a tax?
4. Does it represent an honest effort to satisfy the tax laws?

Beard – a protestor – missed the third test by altering the form.

Here was the Court on the fourth test:

The tampered form here is a conspicuous protest against the payment of tax, intended to deceive respondent’s return-processing personnel into refunding the withheld tax. Since such intentional tampering could go undetected in computer processing, respondent was forced to develop and institute special procedures for handling such submissions. The critical requirement that there must be an honest and reasonable attempt to satisfy the requirements of the Federal income tax law is clearly not met."

Back to our Email.

Numerous tax court decisions have found that a return (typically a 1040) containing all zeros, even if filed on an official IRS form, does not constitute a valid tax return.”

True, but …

However, these are all in the tax protestor context and other cases have held that a zero return may be valid if there is reason to believe that it is an accurate reflection of the taxpayer’s activity.”

Got it.

I will start including a schedule or attachment to the partnership tax return stating the following:

XXX Partnership/LLLC was formed on XX/XX/XX and no business operations occurred during its initial tax year ending XX/XX/20XX.”

Easy.

But it is a trap for a non-tax specialist.

This time we discussed CCA 2026030612260600 a/k/a Chief Counsel Email 202634014.

 

Whose Job Is It Anyway?

One of our accountants asked me recently:

R:      Do you think [so and so] qualifies as a real estate professional?

CTG: I do not know [so and so]. Tell me a little.

R:      Husband pulls a W-2.

CTG: How much and how many hours?

R:      Blah blah dollars.

CTG: Works in real estate?

R:      Nah.

CTG: Hours?

R:      Maybe 2,000.

CTG: Is the wife in real estate?

R:      No.

I have told you (almost) everything you need to answer the question.

Let’s look at the Warren case.

James Warren organized Warren Assisted Living, LLC in 2015.

He purchased a group home in 2016.

He started repairing the home almost immediately.

In 2017 he worked at Lockheed Martin for 1,913 hours as an engineer.

On his 2017 tax return he claimed a $41 thousand-plus loss from the group home. He claimed he was a real estate professional.

Warren did not keep time logs.

What sets this up are the passive activity rules under Section 469. As initially passed, that Section considered rental activities (with minimal exceptions) to be “per se” passive.

The passive activity rules would then stifle your ability to claim losses. You – for the most part – had to wait until you had income from the activity. You could then use the losses against the income. 

Well, that caught real estate landlords and others around the country by surprise. When you do one thing, it is difficult to have a Congressional staffer decide that your thing is not a regular thing like the next thing across the street.

Congress made a change.

(c)(7)  Special rules for taxpayers in real property business.

 

(A)  In general. If this paragraph applies to any taxpayer for a taxable year-

 

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

(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.

 

(B)   Taxpayers to whom paragraph applies. This paragraph shall apply to a taxpayer for a taxable year if-

 

(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

(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.

 

In the case of a joint return, the requirements of the preceding sentence are satisfied if and only if either spouse separately satisfies such requirements. For purposes of the preceding sentence, activities in which a spouse materially participates shall be determined under subsection (h) .

The above is called the real estate professional exception. It is a mercy release from the per se rule that would otherwise inaccurately (and unfairly) consider people who work in real estate all day to not be working at all.

It has two main parts:

(1) You have to spend at least 750 hours working in real estate, and

(2)  You have to spend more than 50% of your “working at something” total hours actually “working in real estate.”

If you are a real estate professional, you avoid the “per se” label. You have not yet escaped the passive activity rules – you still have to show that you worked - but at least you have the opportunity to present your case.

The Court looked at Warren’s 1,913 hours at Lockheed. That means he would need 3,827 total hours for real estate to be more than ½ of his total work hours. (1,913 times 2 plus 1).

First of all, 3,827 total hours means he was working at least 74 hours a week, every week, without fail, for the entire year.

Maybe. Doubt it.

Warren is going to need really good records to prove it.

Here is the Court:

Mr Warren did not keep contemporaneous logs of his time renovating the group home.”

Not good, but not necessarily fatal. I represented a client who kept Outlook and other records. She created her log after the fact but from records which themselves were contemporaneous. Mind you, we had to go to Appeals, but she won.

In preparation for trial, Mr Warren created – and presented – two time logs.”

Good grief.

The first log maintained that he worked 1,421 hours at the group home; it was created one week before trial.”

End it. That is less than his 1,913 hours at Lockheed.

The second log maintained that Mr. Warren worked 1,628 at the group home; it was created the night before trial.”

Why bother?

This was a slam dunk for the Court. They did not have to dwell on contemporaneous or competing logs or believability or whether the Bengals will turn their season around. Whether 1,421 or 1,628, he could not get to more-than-50%.

Warren lost.

As a rule of thumb, if you have a full-time W-2, it will be almost impossible to qualify as a real estate professional. The exception is when your full-time W-2 is in real estate, maybe with an employer such as CBRE or Cushman & Wakefield.  At 1,900-plus Lockheed hours, I have no idea what Warren was thinking, although I see that it was a per se case. That means he represented himself, and it shows.

I suppose one could have a W-2 and work crazy hours and meet the more-than-50% requirement, but your records should be much tighter. And skip the night before thing.

BTW another way to meet this test is by being married.

Look at (B)(ii) again:

In the case of a joint return, the requirements of the preceding sentence are satisfied if and only if either spouse separately satisfies such requirements. For purposes of the preceding sentence, activities in which a spouse materially participates shall be determined under subsection (h) .

If your spouse can meet the test (both parts), then you will qualify by riding on the shoulders of your spouse.

Our case this time was Warren v Commissioner, T.C. Summary Opinion 2024-20.

A Real Estate Course – And Dave

 

The case made me think of Dave, a friend from long ago – one of those relationships that sometimes surrenders to time, moving and distance.

Dave was going to become a real investor.

That was not his day job, of course. By day he was a sales rep for a medical technology company. And he was good at sales. He almost persuaded me to join his incipient real estate empire.

He had come across one of those real estate gurus – I cannot remember which one – who lectured about making money with other people’s money.

There was even a  3-ring binder or two which Dave gave me to read.

I was looking over a recent case decided by the Tax Court.

The case involved an engineer (Eason) and a nurse (Leisner).

At the start of 2016 they owned two residential properties. One was held for rent; the other was sold during 2016.

COMMENT: Seems to me they were already in the real estate business. It was not a primary gig, but it was a gig.

Eason lost his job during 2016.

A real estate course came to his attention, and he signed up – for the tidy amount of $41,934.

COMMENT: Say what?

In July 2016 the two formed Ashley & Makai Homes (Homes), an S corporation. Homes was formed to provide advice and guidance to real estate owners and investors.  They had business cards and stationary made and started attending some of those $40 grand-plus courses. Not too many, though, as the outfit that sponsored the courses went out of business.

COMMENT: This is my shocked face.

By 2018 Eason and Leisner abandoned whatever hopes they had for Homes. They never made a dime of income.

You know that $40 grand-plus showed up on the S corporation tax return.

The IRS disallowed the deduction.

And tacked on penalties for the affront.

This is the way, said the IRS.

And so we have a pro se case in the Tax Court.

Respondent advances various reasons why petitioners are not entitled to any deductions …”

The respondent will almost always be the IRS in these cases, as the it is the taxpayer who petitions the Court.

And we have discussed “pro se” many times. It generally means that a taxpayer is representing himself/herself, but that is not fully accurate. A taxpayer can be advised by a professional, but if that professional has not taken and passed the exam to practice before the Tax Court the matter is still considered pro se.

Back to the Court:

          … we need to focus on only one [reason].”

That reason is whether a business had started.

Neither Homes nor petitioners reported any income from a business activity related to the disputed deductions, presumably because none was earned.”

This is not necessarily fatal, though.

The absence of income, in and of itself, does not compel a finding that a business has not yet started if other activities show that it has.”

This seems a reasonably low bar to me: take steps to market the business, whatever those words mean in context. If the context is to acquire clients, then perhaps a website or targeted advertising in the local real estate association newsletter.

Here, however, the absence of income coupled with the absence of any activity that shows that services were offered or provided to clients or customers […] supports respondent’s position that the business had not yet started by the close of the year.”

Yeah, no. The Court noted that a business deduction requires a business. Since a business had not started, no business deduction was available.

The Court disagreed with any penalties, though. There was enough there that a reasonable person could have decided either way.

I agree with the Court, but I also think that just a slight change could have changed the outcome in the taxpayers’ favor.

How?

Here’s one:  remember that Eason and Leisner owned a rental property together?

What if they had broadened Homes’ principal activity to include real estate rental and transferred the property to the S corporation? Homes would have been in business at that point. The tax issue then would have been expansion of the business, not the start of one.

Our case this time was Eason and Leisner v Commissioner, T.C. Summary Opinion 2024-17.

Navigating The Tax Code On Your Own

 

I received a phone call recently from the married daughter of a client. I spoke with the couple – mostly the son-in-law – about needing an accountant. They had bought property, converted property to rental status and were selling property the following (that is, this) year.

It sounds like a lot. It really isn’t. It was clear during our conversation that they were well-versed in the tax issues.

I told them: “you don’t need me.”

They were surprised to hear this.

Why would I say that?

They knew more than they gave themselves credit for. Why pay me? Let them put the money to better use.

Let’s take an aside before continuing our story.

We - like many firms - are facing staffing pressure. The profession has brought much of this upon itself – public accounting has a blemished past – and today’s graduates appear to be aware of the sweatshop mentality that has preceded them. Lose a talented accountant. Experience futility in hiring new talent. Ask those who remain to work even harder to make up the shortfall. Be surprised when they eventually leave because of overwork. Unchecked, this problem can be a death spiral for a firm.

Firms are addressing this in different ways. Many firms are dismissing clients or not accepting new ones. Many (if not most) have increased minimum fees for new clients. Some have released entire lines of business. There is a firm nearby, for example, which has released all or nearly all of its fiduciary tax practice.

We too are taking steps, one of which is to increase our minimum fee for new individual tax clients.

Back to the young couple.

I explained that I did not want to charge them that minimum fee, especially since it appeared they could prepare their return as well as I could. 

They explained they wanted certainty that it was done right.

Yeah, I want that for them too. We will work something out.

But I think there is a larger issue here.

The tax Code keeps becoming increasingly complex. That is fine if we are talking about Apple or Microsoft, as they can afford to hire teams of accountants and attorneys. It is not fine for ordinary people, hopefully experiencing some success in life, but unable – or fearful - to prepare their own returns. Couple this with an overburdened accounting profession, a sclerotic IRS, and a Congress that may be brewing a toxic stew with its never-ending disfigurement of the tax Code to solve all perceived ills since the days of Hammurabi.

How are people supposed to know that they do not know?

Let’s look at the Lucas case.

Robert Lucas was a software engineer who lost his job in 2017. He was assisting his son and daughter, and he withdrew approximately $20 grand from his 401(k) toward that end.

Problem: Lucas was not age 59 ½.

Generally speaking, that means one has taxable income.

One may also have a penalty for early distribution. While that may seem like double jeopardy, such is the law.

Sure enough, the plan administrator issued a Form 1099 showing the distribution as taxable to Lucas with no known penalty exception.

Lucas should have paid the tax and penalty. He did not, which is why we are talking about this.

The IRS computers caught the omission, of course, and off to Tax Court they went.

Lucas argued that he had been diagnosed with diabetes a couple of years earlier. He had read on a website that diabetes would make the distribution nontaxable.

Sigh. He had misread – or someone had written something wildly inaccurate about – being “unable to engage in any substantial gainful activity.”

That is a no.

Since he thought the distribution nontaxable, he also thought the early distribution penalty would not apply.

No … again.

Lucas tried.

He thought he knew, but he did not know.

He could have used a competent tax preparer.

But how was he to know that?

Our case this time was Robert B. Lucas v Commissioner T.C.M. 2023-009.

A Brief History of Limited Partner Self-Employment Tax

 

There is a case going through the courts that caught my eye.

It has to do with limited liability companies (LLCs). More specifically, it has to do with LLC members.

LLCs started coming into their own in the 1990s. That gives us about 35 years of tax law to work with, and in many (if not most) cases practitioners have a good idea what the answers are.

There is one question, however, that still lingers.

Let’s set it up.

Before there were LLCs there were limited partnerships (LPs). The LPs will forever be associated with the tax shelters, and much of the gnarliness of partnership taxation is the result of Congress playing whack-a-mole with the shelters.

The LPs tended to have a similar structure.

(1)  Someone set up a partnership.

(2)  There were two tiers of partners.

a.    The general partner(s) who ran the show.

b.    The limited partner(s) who provided the cash but were not otherwise involved in the show. It is very possible that the limited was a well-to-do investor placed there by a financial advisor. The limited partner was basically investing while hoping for a mild/moderate/lavish side dish of tax deduction goodness.

The liability of the limited partners in the event of disaster was capped, generally to the amount invested. They truly were limited.

A tax question at this point was:

Is a limited partner subject to self-employment tax on his/her share of the earnings?

This question was not as simple as it may sound.

Why?

Did you know there was a time when people WANTED to pay into social security?

Let’s do WAYBAC machine.

When first implemented, social security only applied to certain W-2 workers.

This was an issue. There was a significant tranche of workers, such as government employees and self-employeds, who did not qualify. Enough of these excluded workers wanted (eventual) social security benefits that Congress changed the rules in 1950, when it introduced self-employment (SE) taxes. FICA applies to a W-2 worker. SE taxes apply to a self-employed worker. Both FICA and SE are social security taxes.

Congress also made all partners subject to SE tax: general, limited, vegan, soccer fan, whatever.

This in turn prompted promoters to peddle partnerships for the primary purpose of paying self-employment tax.

It sounds crazy in 2023, but it was not crazy at the time. During the 1950s the SE rate varied between 2.25% and 3.375% and the wage base from $3,600 to $4,200. Take someone who had never paid into social security. Getting an annual partnership K-1 and paying a little bit of SE tax in return for a government-backed lifetime annuity sounded appealing. The value of those benefits likely far exceeded the cost of any SE taxes.

It was appealing enough to catch Congress’ attention.

In 1977 Section 1402(a)(13) entered the tax Code:

There shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments … to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of renumeration for those services.”

You see what Congress did: they were addressing the partnerships gaming the social security system. One could earn social security benefits if one was involved in business activities, but not if one were just an investor – that is, a “limited” partner.

But things change.

Social security tax rates kept going up. The social security wage base kept climbing. Social security was becoming expensive. Rather than opt-in to social security, people were trying to opt out.

And businesses themselves kept changing.

Enter the LLCs.

Every member in an LLC could have “limited” liability for the entity’s debts. How would that play with a tax Code built on the existence of general and limited partners? LLCs introduced a hybrid.

Taxwise, it was problematic.

In 1994 the IRS took its first shot. It proposed Regulations that would respect an LLC member as a limited partner if:

(1) The member was not a manager of the LLC, and

(2) The LLC could have been formed as a limited partnership, and, if so, the member would have been classified as a limited partner.

It was a decent try, but the tax side was relying very heavily on the state law side. Throw in 50 states with 50 laws and this approach was unwieldy.

The IRS revisited in 1997. It had a new proposal:

         An individual was a limited partner unless

(1) He/she was personally liable for partnership debt, or

(2)  He/she could sign contracts for the partnership, or

(3) He/she participated in partnership activities for more than 500 hours during the year.

Got it. The IRS was focusing more on functional tests and less on state law.

I was in practice in 1997. I remember the reaction to the IRS proposal.

It was intense enough that the politicians got involved. Congress slapped a moratorium on further IRS action in this area. This was also in 1997.

The moratorium is still there, BTW, 26 years later.

And now there is a case (Soroban Capital Partners LP v Commissioner) coming through and returning attention to this issue.

Why?

Sure, there have been cases testing the SE tax waters, but most times the numbers have been modest. There has been no need to call out the National Guard or foam the runways.

Soroban upped the ante.

Soroban is challenging whether approximately $140 million (over several years) is subject to SE tax.

Soroban also brings a twist to the issue:

Can a partner/member wear both hats? That is, can the same person be a general partner/member (and subject to SE tax) and a limited partner/member (and not subject to SE tax)?

It is not a new issue, but it is a neglected issue.

We’ll return to Soroban in the future.