I love going to work every day.  Our tax controversy practice gives us, as tax lawyers, a taste of a myriad of issues that most tax lawyers do not get to sample.  A tax controversy lawyer’s practice often reflects the government’s current, most popular areas to attack.  Most recently, that has included conservation easements.

But a new area that seems to be raising its head relates to the application of the passive activity loss rules.  Not only have several audits in that area recently bubbled up, of late the Tax Court has been pushing out opinions regarding the passive activity loss rules on a more regular basis.

A key issue in the application of the passive activity rules under Section 469 (whether for purposes of analyzing the passive activity loss rules under Section 469 or the net investment income tax under Section 1411) is the rule that a taxpayer’s income or loss from an “activity” will be considered “passive” if the taxpayer’s participation in such “activity” does not rise to the level of “material participation.”  The regulations include seven different tests for determining material participation.

The issue of whether an activity is “passive” is relevant because losses from a passive activity can only be deducted by a taxpayer to the extent of the taxpayer’s income from passive activities.  Additionally, if a taxpayer’s share of income from an activity is “passive” under the 469 rules, such income could be subject to the tax on net investment income under Section 1411.

So a key issue in both Section 469 and Section 1411 cases is determining whether a taxpayer’s participation in an activity rises to the level of “material participation.”  While a taxpayer may establish his material participation in a given activity through “any reasonable means,” a key issue is how a taxpayer can best corroborate or prove that he is materially participating in such activity.

Of interest is the recent case Tolin v. Commissioner, TC Memo 2014-65, which illustrates how the Tax Court addresses the types of corroborating information that can be used to prove material participation.  The following highlights from Tolin provide guidance on the items taxpayers should consider and focus on in determining whether they materially participated in an activity.

  1. The Court found that the taxpayer’s estimates of his participation in the activity (breeding race horses) were reliable based on key corroborating evidence, specifically including testimony of third parties and telephone records.  The phone records corroborated the taxpayer’s account of how much time he spent working on his horse breeding and racing activity while the taxpayer was visiting horse farms in Louisiana (not his home state).
  2. The taxpayer, a lawyer, was able to show that he worked less than 1200 each year in his primary career as a lawyer.  (That is not a lot of hours for someone who is only practicing law.  The fact was helpful in demonstrating that he had time to and did participate in other activities, such as horse breeding.)
  3. The IRS focused on reducing the number of hours attributable to each of the taxpayer’s activities and the court did, in fact, reduce some of those hours.  In establishing that a taxpayer meets the 500 hour minimum, one might be concerned that an IRS attack that reduces some of those hours could bring a taxpayer below the 500 hour threshold.
  4. The Tax Court rejected the IRS’s argument that the activities of the taxpayer were investor-type activities.  Instead, the court observed that the activities (calling on breeders and visiting breeders to promote his horses for breeding) was part of “the day to day management of operations of the thoroughbred activity.”  In such cases, it may be important to develop how a taxpayer’s meetings and activities are or should be considered part of day-to-day management of operations and not simply activities of investors in the business.

Tolin should be compared with another recent Tax Court decision, Bartlett v. Commissioner, TC Memo 2013-182, where a taxpayer was not successful in substantiating material participation in the taxpayer’s bull breeding ranch.  The court in Bartlett found that the taxpayer’s testimony regarding his material participation did not sufficiently corroborate that he worked on the cattle ranch for more than 500 hours.  Instead, the court found that the taxpayer only offered non-contemporaneous schedules that were mere “guesstimates” constructed from credit card statements that showed he had made purchases on certain dates that did not support the number of hours claimed.  The court was also troubled by the taxpayer’s significant work in a landscaping business in which he participated, which was located over 200 miles away from the ranch.  The court just did not buy that the taxpayer materially participated in both the ranch and the landscaping businesses that were located far from one another.

These cases and others illustrate how the Tax Court will be analyzing IRS attacks on passive activity loss fact patterns.  Each case is different and how best to substantiate a taxpayer’s material participation should be considered up front inasmuch as contemporaneous substantiation is given much greater weight than “after the fact” substantiation.

Given the growth in the number of passive activity loss cases and audits, we may be seeing the IRS’s newest favorite area to attack.