In Lamas v. Comm’r, T.C. Memo 2015-59, the Tax Court, in a detailed analytical discussion of the passive activity loss rules under § 469, found that the taxpayers, a married couple, satisfied the material participation exception to the passive activity loss rules. As result, the Lamases were entitled to a refund of income taxes of approximately $5.2 million dollars. Lamas serves as a guidepost for circumventing the maze of issues and sub-issues involved in the passive activity loss rules.
In Lamas, the issue facing the Tax Court was whether or not losses from Shoma Development Corp. (“Shoma”) and Greens at Doral, LLC (“Greens”) were passive with respect to the taxpayers. Section 469 prohibits taxpayers from deducting losses generated by passive activities from nonpassive income. If a taxpayer does not “materially participate” in a trade or business, then losses from the trade or business will be considered passive. In other words, if the losses from Shoma and Greens were passive, then the taxpayers’ income tax liability would effectively increase by approximately $5,000,000.
Material participation is defined as participation in a given activity on a regular, continuous, and substantial basis. The Regulations under § 469 provide several different quantitative tests for determining material participation based on the number of hours spent in a given activity. For instance, if a taxpayer’s participation exceeds 500 hours in a single activity, then he or she has materially participated. However, activities performed by a taxpayer that are not customarily performed by owners or work performed as an investor do not count towards material participation. If two or more activities constitute an appropriate economic unit, the Regulations permit the grouping of the activities as a single activity for purposes of determining material participation.
First, the Tax Court concluded that Shoma and Greens is an appropriate economic unit and should be grouped as one activity. The Tax Court found that both Shoma and Greens are similar businesses that were both engaged in real estate development, there was common control and ownership among the two businesses, and both business had the same geographic location. Therefore, the activities performed by Mr. Lamas in each of Shoma and Greens would be aggregated for measuring the quantitative tests.
The court in Lamas then analyzed Mr. Lamas’ participation in the context of the quantitative 500 hour test—whether Mr. Lamas participated for more than 500 hours in the activities of Shoma and Greens. In analyzing the 500 hour test, the Tax Court found that Mr. Lamas collectively spent 691 hours in the Shoma and Greens activity. The nature of Mr. Lamas’ work consisted primarily of restoring assets and raising capital, which is work customarily performed by an owner of a business. Moreover, Mr. Lamas worked in the day-to-day operations of Shoma and thus the work performed was not merely as an investor. Therefore, the court concluded that Mr. Lamas materially participated in Shoma and Greens and the losses were not passive.
The crux of satisfying the quantitative tests was the credible evidence presented to establish the time Mr. Lamas spent working at Shoma and Greens. The court found that phone records and believable testimony from witnesses clearly established that Mr. Lamas spent 691 hours on the Shoma and Greens activity. The lesson on this point is clear. Presenting credible, consistent, and truthful facts is important. Thus, honestly presenting evidence—whether for the IRS or for the taxpayer—is vital to success.
Of interest in this case is the court’s review of the testimony of several indivduals who testified about Mr. Lamas’ significant (and material) participation in Shoma and Greens. But the testimony was not unanimous as one individual, Mr. Shojaee, Mr. Lamas’ brother-in-law, testified that Mr. Lamas did not provide significant services to Shoma and Greens. The Tax Court ignored Mr. Shojaee’s testimony and found it not credible, noting that an obvious rift existed between Mr. Lamas and Mr. Shojaee. Accordingly, the Tax Court, using common sense, determined that Mr. Shojaee’s testimony was inaccurate and not truthful, finding that Mr. Lamas materially participated in Shoma and Greens.
The Tax Court opinion in Lamas provides an excellent roadmap for successfully navigating the material participation rules. In the case of the taxpayers in Lamas, this resulted in a $5,000,000 benefit.