Can the material participation tests of Section 469 be met remotely? The Tax Court says yes.
In a recent Memorandum Opinion, the Tax Court (the “Court”) held that Fred Barbara (“Barbara”) satisfied the requirements for materially participating in his Chicago based business despite living in Florida approximately 60% of the year.1 The Internal Revenue Service (the “IRS”) took the position that Barbara failed to meet any of the material participation tests discussed below and thus the losses from his Chicago based business were passive losses only deductible to offset passive income pursuant to Section 469 of the Internal Revenue Code (All references to a Section are references to a Section of the Internal Revenue Code unless otherwise stated).
Barbara operated a lending business based in Chicago. Barbara maintained an office in Chicago for his lending business. He also employed a full-time accountant and secretary in his business, and Barbara performed all the executive and management functions of the business himself. Barbara made all of the decisions related to granting loans, handling defaults, and managing and servicing outstanding loans, including managing approximately 40 outstanding loans during the years at issue. During the years at issue, the lending business lost money. Outside of the lending business, Barbara had no other significant work-related activities.
Barbara split his time between Chicago and Florida, spending approximately 40% of this time in Chicago and 60% of his time in Florida. When in Chicago, he kept a regular work schedule and was in the office approximately 5.75 hours each work day. The Court concluded that this amounted to 460 hours per year while in Chicago (200 days x 5.75 hours x 40%).
While in Florida, Barbara called the Chicago office every day when it opened at 9AM. He also was in communication with the office by telephone, fax, and email at other times. On average, Barbara spent 2 hours per work day on the business while in Florida, amounting to 240 hours per year (200 days x 2 hours x 60%). In total, Barbara devoted approximately 700 hours to his lending business between his time in Chicago and his time in Florida.
The IRS issued a Notice of Deficiency to Barbara and his wife for the tax years 2009, 2010, 2011, and 2012 which asserted deficiencies and the accuracy related penalty under Section 6662(a). Most of the issues were resolved prior to trial leaving the Court to decide (1) whether Barbara materially participated in the lending business in 2010 (which would also affect 2011 and 2012 due to net operating loss carry-forwards); and (2) whether Barbara and his wife were liable for the Section 6662(a) accuracy related penalties assessed?
Deduction of Losses: Section 469 and Material Participation
Sections 162 and 212 allow taxpayers to deduct certain business and investment expenses respectively.2 However, such deductions and losses generated by a “passive activity” are limited to income from passive activities by Section 469.3 A passive activity is one which involves a trade or business and in which the taxpayer does not materially participate.4 Material participation is defined as an activity in which the taxpayer’s participation is regular, continuous, and substantial.5 The Treasury Regulations have promulgated the following seven alternative tests to determine whether a taxpayer’s activities meet the threshold for material participation:6
- The individual participates in the activity for more than 500 hours during such year;7
- The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;8
- The individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;9
- The activity is a significant participation activity (within the meaning of Treas. Reg. §1.469-5T(c)) for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours;10
- The individual materially participated in the activity for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;11
- The activity is a personal service activity (within the meaning of Treas. Reg. §1.469-5T(d)), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or12
- Based on all of the facts and circumstances (taking into account the rules in Treas. Reg. §1.469-5T(b)), the individual participates in the activity on a regular, continuous, and substantial basis during such year.13
With regard to Treas. Reg. §1.469-5T(a)(4), Treas. Reg. §1.469-5T(c) states that an activity is a significant participation activity of an individual if the individual dedicates more than 100 hours per year to the activity and only if such activity:
- Is a trade or business activity (within the meaning of Treas. Reg. §1.469-1T(e)(2)) in which the individual significantly participates for the taxable year; and
- Would be an activity in which the individual does not materially participate for the taxable year if material participation for such year were determined without regard to Treas. Reg. §1.469-5T(a)(4).
With regard to Treas. Reg. §1.469-5T(a)(6), Treas. Reg. §1.469-5T(d) defines a personal service activity as an activity that involves the performance of personal services in:
- The fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting; or
- Any other trade or business in which capital is not a material income-producing factor.
With regard to the catch all facts and circumstances test of Treas. Reg. §1.469-5T(a)(7), Treas. Reg. §1.469-5T(b) does not contain hard and fast rules for satisfying the facts and circumstances test but does contain some prohibitions, one of which relates to management activities and provides an individual’s services performed in the management of an activity shall not be taken into account in determining whether such individual is treated as materially participating unless:
- No person (other than such individual) who performs services in connection with the management of the activity receives compensation described in Section 911(d)(2)(A) in consideration for such services; and
- No individual performs services in connection with the management of the activity that exceed (by hours) the amount of such services performed by such individual.
Further, Treas. Reg. §1.469-5T requires the individual dedicate at least 100 hours to such activity in order to meet the facts and circumstances test for material participation under Treas. Reg. §1.469-5T(a)(7). It should be noted that there are different tests applicable to real estate activities that were not applicable to this case and not discussed in this article.
It is clear that Barbara met the requirements of the 500-hour test of Treas. Reg. §1.469-5T(a)(1) since he dedicated 700 hours to the lending business during the year. The 500-hour test of Treas. Reg. §1.469-5T(a)(1) strictly looks at how many hours were dedicated to the activity, and there are no other requirements to satisfy the test. However, the Court made no mention of the 500-hour test and instead analyzed B’s activities under the catch all facts and circumstances test of Treas. Reg. §1.469-5T(a)(7). It is unclear why the Court did this. Nevertheless, the Court quickly concluded that the Barbara had met the 100-hour threshold and the facts and circumstances test of Treas. Reg. §1.469-5T(a)(7) was satisfied.
Since there were other adjustments in the Notice of Deficiency that were unrelated to whether Barbara materially participated in the lending business, the accuracy related penalty under Section 6662(a) was still an issue to be resolved by the Court. The Court concluded that there was no reasonable cause exception available to avoid Section 6662(a) penalties even though the Court did find that Barbara had materially participated in the lending business. Accordingly, Barbara and his wife were liable for such penalties to the extent the Rule 155 computation (a Tax Court Rule governing agreed computations) showed any underpayments or substantial underpayments.
The Court’s conclusion in this case was pretty straightforward, although I am a bit perplexed as to why the issue was not settled by the 500-hour test discussed above. Barbara clearly materially participated in the lending business and the Court was right to count his activities while in Florida towards his material participation. It is likely the IRS felt that Barbara’s time spent in Florida would be a negative factor against him in this case, but the evidence and testimony presented showed otherwise. There is no requirement that I am aware of that the individual be physically present in a certain location in order for his or her time to count towards the material participation requirements. We live in a digital world, and this case confirms what was already known, working remotely should not be treated any differently than working in a physical office when it comes to determining time spent towards an activity for purposes of material participation.
- Barbara v. Commissioner, T.C. Memo. 2019-50.
- It should be noted that Section 212 expenses are deductible as miscellaneous itemized deductions pursuant to Section 67, and as such, Section 212 expenses are not deductible for tax years 2018-2025 due to the enactment of Section 67(g) as part of the Tax Cut and Jobs Act of 2017.
- Section 469(a).
- Section 469(c).
- Section 469(h).
- It is worth noting that under Treas. Reg. §1.469-5T(e)(2), the tests for material participation are limited to those under paragraph (a)(1), (5), and (6) with respect to activities of a limited partnership.
- Treas. Reg. §1.469-5T(a)(1).
- Treas. Reg. §1.469-5T(a)(2).
- Treas. Reg. §1.469-5T(a)(3).
- Treas. Reg. §1.469-5T(a)(4).
- Treas. Reg. §1.469-5T(a)(5).
- Treas. Reg. §1.469-5T(a)(6).
- Treas. Reg. §1.469-5T(a)(7).