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.

Silicon Valley Cafeterias And Tax-Free Meals

I have a friend who lives and works on the north side of Cincinnati (or as we south-of-the-river-residents call it: “Ohio”). He works for significant company, and one of the perks is a company cafeteria. The cafeteria provides breakfast, should one choose, and of course it provides lunch. Free.

I admit I am a bit envious.

In this day and age when just about everything is taxed – at least once – you may wonder how this can happen. It has to do with Code Section 119:

(a) Meals and lodging furnished to employee, his spouse, and his dependents, pursuant to employment

There shall be excluded from gross income of an employee the value of any meals or lodging furnished to him, his spouse, or any of his dependents by or on behalf of his employer for the convenience of the employer, but only if—

(1)     in the case of meals, the meals are furnished on the business premises of the employer

                                                                     

How did this provision come to be?

It officially entered the Code in 1954, although employers were already taking the deduction (and employees excluding the income) under administrative and judicial decisions.  Prior to 1954 there was some inconsistency on what was required for the employee to omit the income. Sometimes the courts focused exclusively on the convenience of the employer. Other times the courts would look at whether there was a compensatory reason for the meal. Depending on the focus, they could arrive at different answers, of course.

So Congress stepped-in in 1954 and gave us Section 119. There were differences between the House and Senate bills (The House did not want a convenience-of-the-employer test, but the Senate did). Both House and Senate booted out the issue of “compensatory reason.” If it were primarily for the convenience of the employer, then the meals were free. Whether the employee considered it compensatory was beside the point.

Let’s use an extreme example to understand what Congress was after. In Olkjer, for example, the taxpayer was employed at a remote location in Greenland. The employer provided meals (and, in this case, lodging also) because there was nowhere else to go.

And there any number of examples like that. Think of emergency room personnel. Could they hypothetically get in a car and go to a restaurant for lunch? Of course they could. It would not serve the hospital’s needs, however, and hence they are required to stay on premises. The same can be said for casino workers.

Fast forward a few decades and we now have Silicon Valley. Take Google, for example. If you work at the Googleplex you can eat breakfast, lunch and dinner for free. I recall that the personal chef for the Grateful Dead was one of the early chefs at Google. These companies prey on each other’s chefs, too. Facebook hired a chef away from Google, for example. Facebook now serves Thai-spiced cilantro chicken and salmon with red curry sauce. Their chef will also prepare a special meal as an employee award or recognition. These meals can be quite upscale, featuring seven courses on white tablecloth.

No doubt Section 119 has come a long way from what Congress was thinking back in 1954.

And there is the rub.

In 2013 the Wall Street Journal published an article on these cafeterias, including the question whether the provision of gourmet-level meals were intended to be tax-free. Spring forward a year or so and the IRS has included the issue in their 2014-2015 Priority Guidance Plan. It appears the IRS is shifting resources to develop tax lines-of-reasoning requiring such benefits be reported as taxable compensation to employees.

How? Actually, the direction is fairly straightforward. The IRS will challenge the perk as not being “primarily” for the convenience of the employer. They cannot challenge whether there is a “compensatory” reason, as the reports to the 1954 tax Code makes it clear that Congress was not concerned with that issue.

The companies of course argue that such perks are “primarily” for their convenience. How?

           

·        Encourage employees to arrive early

·        Encourage employees to stay late

·        Employees do not waste time going out to eat

·        Maximize collaboration opportunities, as employees eat together rather than taking individual cars and dining alone elsewhere

·        Help retain people and foster employee trust

·        Help attract prospective employees

You must admit, the companies have a point. My hunch is that the IRS will restrict the definition of “convenience” to require a closer connection between the cafeteria perk and the alleged convenience.

What do I think? I have been in tax practice long enough to see provisions come into the tax Code, and then see practitioners take said provisions into places and distances that Congress or the IRS never intended. There is uproar, and Congress or the IRS then cracks-down. The practitioners regroup, study tape, develop new game plans and all parties eventually take the field again for the next game. It is just the wheel and rhythm of tax law and practice.

I suspect the same will happen here.

I have over the years worked unreasonable hours, and many (not all, mind you) CPA firms will make some provision for their staff during busy season. These meals have been tax-free, as the impetus for the meal was exclusively for the convenience of the CPA firm (as far as I was concerned). There was nothing there that approached this level, however.

But then, Google and Twitter and companies like them have taken this provision into places and distances that Congress likely never intended.

I admit I am a bit envious.