Have you ever thought of working remotely?
Whether it is possible of course depends on what one
does. It is unlikely a nurse could pull it off, but could an experienced tax
CPA…? I admit there have been moments over
the years when I would have appreciated the flexibility, especially with out-of-state family.
I am looking at a case where someone pulled it off.
Fred lived in Chicago. He sold his company for tens of
millions of dollars.
COMMENT: I probably would pull the (at least semi-) retirement trigger right there.
He used some of the proceeds to start a money-lending
business. He was capitalizing on all the contacts he had made during the years
he owned the previous company. He kept an office downtown at Archer Avenue and
Canal Street, and he kept two employees on payroll.
Fred called all the shots: when to make loans, how to
handle defaulted loans. He kept over 40 loans outstanding for the years under
discussion.
Chicago has winters. Fred and his wife spent 60% of
the year in Florida. Fred was no one’s fool.
But Fred racked up some big losses. The IRS came a-looking,
and they wanted the following:
Year Tax
2009 $336,666
2011 $ 90,699
2012 $109,355
The
IRS said that Fred was not materially participating in the business.
What
sets this up are the passive activity rules that entered the Code in 1986. The
IRS had been chasing tax-shelter and related activities for years. The effort introduced
levels of incoherence into the tax Code (Section 465 at risk rules, Section
704(b) economic substance rules), but in 1986 Congress changed the playing field. One was to analyze an owner’s involvement in the business. If
involvement was substantial, then one set of rules would apply. If involvement
was not substantial, the another set of rules would.
The
term for substantial was “material participation.”
And
the key to the dichotomy was the handling of losses. After all, if the business
was profitable, then the IRS was getting its vig whether there was material
participation or not.
But
if there were losses….
And
the overall concept is that non-material participation losses would only be
allowed to the extent one had non-material participation income. If one went
net negative, then the net negative would be suspended and carryover to next
year, to again await non-material participation income.
In
truth, it has worked relatively well in addressing tax-shelter and related activities.
It might in fact one argued that it has worked too well, sometimes pulling non-shelter
activities into its wake.
The
IRS argued that Fred was not materially participating in 2009, 2011 and 2012. I
presume he made money in 2010.
Well,
that would keep Fred from using the net losses in those respective years. The
losses would suspend and carryover to the next year, and then the next.
Problem: Sounds to me like Fred is a one-man gang. He
kept two employees in Chicago, but one was an accountant and the other the
secretary.
The Tax Court observed that Fred worked at the office a
little less than 6 hours per day while in Chicago. When in Florida he would
call, fax, e-mail or whatever was required. The Court estimated he worked 460
hours in Chicago and 240 hours in Florida. I tally 700 hours between the two.
The IRS said that wasn’t enough.
Initially I presumed that Barney Fife was working this
case for the IRS, as the answer seemed self-evident to me. Then I noticed that
the IRS was using a relatively-unused Regulation in its challenge:
Reg § 1.469-5T. Material participation (temporary).
(a) (7) Based on all of the facts and circumstances (taking
into account the rules in paragraph (b) of this section), the individual
participates in the activity on a regular, continuous, and substantial basis
during such year.
The common rules under this Regulation are the 500
hours test of (a)(1), the substantially-all-the-activity test of (a)(2) and
100-hours-and-not-less-than-anyone-else test of (a)(3). There are only so
many cases under (a)(7).
Still, it was a bad call, IRS. There was never any
question that Fred was the business, and the business was Fred. If Fred was not
materially participating, then no one was. The business ran itself without human
intervention. When looked at in such light, the absurdity of the IRS position
becomes evident.
Our case this time was Barbara, TC Memo 2019-50.
