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Court Rejects IRS Arguments Aimed at Limiting Taxpayers' Real Estate Losses.
(Parker Tax Publishing November 24, 2015)
A recent district court decision is good news for taxpayers with multiple real estate activities and ancillary businesses. In Stanley v. U.S., 2015 PTC 407 (W.D. Ark. 2015), the IRS tried various arguments, which the court struck down, to prevent a couple from deducting rental real estate losses against non-passive income. For example, the court rejected a novel attempt by the IRS to use Code Sec. 83 to deny that the taxpayer had ownership of 10 percent of a real property trade or business. The court rejected the IRS's argument that, in order for the taxpayer to substantiate his claim that he was a real estate professional, he needed to keep track of time spent using a minimum of two categories: activities in real property trades or businesses and activities not in real property trades or businesses.
With respect to the issue of grouping activities, the court dismissed IRS attempts to use Reg. Sec. 1.469-9(e)(3)(i) to categorically bar a real estate professional from grouping rental and non-rental activities for purposes other than material participation, including for purposes of determining passive activity loss and credit.
The case is useful as a roadmap for taxpayers with multiple rental properties and businesses as to what the IRS may attempt to argue to prevent taxpayers from taking losses against non-passive income and how taxpayers can rebut those arguments.
Background
Before February 1, 1994, Roy Stanley practiced law, primarily representing real-estate clients and financial institutions. On February 1, 1994, Roy began working full time as President of Lindsey Management Co., Inc., (LMC), a property-management company organized as an S corporation. Between February 1, 1994, and August 14, 2009, Roy also acted as general counsel for LMC. From 1996 through 2010, Roy also served as President of Lindsey Communications, Inc. (LCI), a company that provided telecommunications services to certain properties managed by LMC. By 2009 Roy worked only half time at LMC, and at the end of 2010 he retired from LMC.
From the beginning of Roy's employment with LMC, the Stanleys acquired minority ownership interests in business entities that owned or operated the rental properties and adjoining golf courses managed by LMC. By 2009 and 2010, the Stanleys had an ownership interest in more than 100 entities. They also directly owned two rental properties, 2 percent of a third rental property, and interests in more than 85 additional entities through the Roy E. Stanley Family Limited Partnership. For 2009 and 2010, the Stanleys elected to group their real estate activities and reported all income and losses resulting from these ownership interests as non-passive on their Schedules E. Upon his resignation from LMC, and pursuant to his employment agreement, Roy transferred his stock back to James Lindsey, a majority owner.
When the IRS audited the Stanleys' 2009 and 2010 returns, it reclassified all of the Schedule E income and losses (except for those related to Roy's income from LMC) as passive, increasing the Stanleys' liabilities for those years. The Stanleys paid the additional assessed tax over $120,000 and filed for a refund in a district court.
The Stanleys' Arguments
Before the district court, the Stanleys argued that the IRS had erroneously regrouped their Schedule E activities and reclassified non-passive activity as passive. Specifically, the Stanleys asserted that for 2009 and 2010: (1) Roy was a qualifying taxpayer or "real estate professional," as he met the requirements set out in Code Sec. 469(c)(7); (2) the Stanleys' rental real estate activities and business activities could be grouped pursuant to Reg. Sec. 1.469-4(d)(1); (3) the Stanleys appropriately aggregated their rental real estate activities pursuant to Reg. Sec. 1.469-9(g); and (4) the aggregated rental real estate activities together with the grouped business activities should be classified as non-passive because Roy materially participated in the grouped "activity" in accordance with the criteria set forth in Reg. Sec. 1.469-5T(a).
The IRS's Arguments
The IRS argued that the Stanleys were not entitled to a refund because the IRS appropriately re-characterized their Schedule E activities as passive for tax years 2009 and 2010. In support of their position, the IRS contended that: (1) Roy was not a 5 percent owner of LMC as would be required for his services performed as an employee of LMC to constitute material participation in a real property trade or business; (2) Roy did not qualify as a real estate professional; (3) the Stanleys' Schedule E activities were not appropriately grouped; (4) Roy did not materially participate in an appropriately grouped activity as required to show non-passive income or loss; and (5) Roy did not adequately substantiate that (a) he was a 5 percent owner in LMC, (b) he qualified as a real estate professional, (c) he appropriately grouped rental activities with non-rental activities, or (d) he materially participated in any appropriately grouped activity.
Rental Real Estate Losses in General
Generally, under Code Sec. 469(c), rental activities are considered passive activities, regardless of the level of participation by a taxpayer. Thus, losses from a rental activity are generally deductible only to the extent of passive income. However, under Code Sec. 469(c)(7)(B), a taxpayer in the real property business can deduct losses from that business for a tax year, and the rental activity of the taxpayer is not treated as per se passive, if the taxpayer is treated as a real estate professional because the taxpayer meets the following requirements:
(1) more than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses in which the taxpayer materially participates; and
(2) the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates (Code Sec. 469(c)(7)(B)).
In addition, personal services performed as an employee are not treated as performed in real property trades or businesses, but this rule does not apply if such employee is a 5-percent owner (as defined in Code Sec. 416(i)(1)(B)) in the employer.
Five Percent Ownership Analysis
The district court began its analysis by determining if Roy was at least a 5 percent owner of LMC such that his services performed as an employee of LMC could be treated as performed in a real property trade or business for purposes of determining if Roy was a "qualifying taxpayer" under Code Sec. 469(c)(7).
The IRS first argued that any income Roy received as a portion of LMC's profits was more properly characterized as direct salary income and was not indicative of ownership in the company. Roy testified that, from the time he began working at LMC in 1994, he owned 10 percent of the company. He admitted into evidence a stock certificate evidencing his ownership of 10 shares out of 100 shares of LMC stock issued and testified under oath that his stock in LMC was voting stock.
The court concluded that Roy adequately and reasonably substantiated his ownership in LMC for purposes of the Code. Furthermore, the court added, the fact that Roy did not make a capital contribution for his shares, as the IRS had argued, was not determinative of whether he nevertheless owned 10 percent of the stock of LMC since a capital contribution is merely one avenue of acquiring ownership of stock or other property.
Because LMC is an S corporation, the IRS alternatively argued that it was a corporate employer and Roy was required, pursuant to Code Sec. 416(i)(1)(B)(i)(I), to have owned 5 percent of the outstanding stock of LMC for 2009 and 2010 for him to count his work as an employee of LMC towards the participation required to be a real estate professional. The IRS argued that Roy's stock was restricted in that he was required to surrender it, pursuant to his employment agreement with LMC, either at the end of his employment or five years after his disability or death. Because of this restriction, the IRS said, Roy could not transfer his stock to anyone other than back to LMC or to James Lindsey. In advancing its argument that Roy did not own outstanding stock, the IRS relied on Code Sec. 83, which provides guidance for when a taxpayer should report gross income for property received in connection with the performance of services.
The district court rejected the IRS's reliance on Code Sec. 83, saying that the provision provided no authoritative, or even persuasive, guidance on the issue of whether Roy was a 5-percent owner of LMC. The court concluded that, in the ordinary understanding of the term "outstanding stock," Roy owned 10 percent of outstanding LMC stock.
Whether Roy Qualified as a Real Estate Professional
The court then addressed whether Roy satisfied the requirements to be considered a real estate professional who is, thus, not subject to the per se passive activity rule for rental real estate activities. The court began by noting that it was undisputed that (1) Roy spent over half of his working time performing services for LMC, as Roy had no employment other than his employment at LMC; (2) Roy performed more than 750 hours of services as an employee of LMC in 2009 and 2010; and (3) LMC was a real property management business. The court also found that Roy materially participated in LMC for tax years 2009 and 2010, as he spent more than 500 hours participating in the activity during each year.
The court rejected the IRS's argument that, in order for Roy to substantiate his claim that he was a real estate professional, he needed to keep track of time spent using a minimum of two categories: activities in real property trades or businesses and activities not in real property trades or businesses, such as the provision of legal services. Code Sec. 469, the court noted, does not require that the services performed in a real property trade or business be of any specific character or that all such services must be directly related to real estate. Rather, the court said, the services must simply be performed in real property trades or business in which the taxpayer materially participates. Because LMC was a real property business in which Roy materially participated, the court concluded that Roy satisfied the requirements of Code Sec. 469(c)(7) and was thus a real estate professional for 2009 and 2010.
Grouping Activities
With respect to the issue of grouping activities, the court noted that Reg. Sec. 1.469-9(e)(3)(i) bars grouping only for purposes of determining material participation and does not categorically bar a real estate professional from grouping rental and non-rental activities for other purposes, including for purposes of determining passive activity loss and credit.
After rejecting the IRS's interpretation that Reg. Sec. 1.469-9 prevented the Stanleys from grouping their aggregated rental activity with any other non-rental activity, the court analyzed whether the Stanleys' grouping of their Schedule E activities was appropriate under Reg. Sec. 1.469-4. Under Reg. Sec. 1.469-4(c)(1), the court noted, one or more trade or business activities or rental activities may be treated as a single activity if the activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of Code Sec. 469. The Stanleys grouped their aggregated rental activity with other trade or business activities, including LMC, LCI, and the activity of golf courses adjoining LMC-managed properties.
After considering the relevant facts and circumstances, the court first found that the Stanleys' rental activity, LMC, LCI, and the golf courses formed an appropriate economic unit. According to the court, while there were certainly significant differences in the types of services offered by the rental properties, LMC, LCI, and the golf courses, all four services worked in concert in connection with the same trade or business category: rental real estate. The court also found that LMC, LCI, and the golf activities were insubstantial in relation to the rental activity. However, the court did exclude from the grouping several non-operational activities.
Material Participation
With respect to the IRS argument that Roy did not materially participate in an appropriately grouped activity as required to show non-passive income or loss, the court concluded that Reg. Sec. 1.469-9(e)(3)(ii) should be read to allow all work engaged in by Roy for the benefit of LMC to be counted as work performed in managing Roy's own rental real estate interests such that Roy's time at LMC should be counted towards determining whether he materially participated in his rental real estate activity. According to the court, it would be unreasonable, in the limited scenario presented by this case of a real estate professional who works at a real estate management company and also has ownership interests in the vast majority of properties managed by the company, to delineate the time he spent on an individual property, especially where much of the work performed by Roy was done for the benefit of multiple properties or LMC generally. Thus, the court concluded that Roy materially participated in the grouped activities.
For a discussion of the passive activity loss rules, including real estate professional requirements and grouping activities, see Parker Tax ¶ 247,100. (Staff Editor Parker Tax Publishing)
Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.
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