Practitioner’s incorrect change to passive status costly

Editor: Valrie Chambers, CPA, Ph.D.

A recent Tax Court case highlights the importance to practitioners of the proper way to correct an activity’s classification as either passive or active. Particularly when meeting with a new client, tax preparers might learn that an activity has been treated as active with respect to the client on a previously filed return when it should have been treated as passive. The resulting reclassification can result in tax savings if the taxpayer has suspended passive losses and the incorrectly classified activity is generating taxable income. Failing to do so correctly, however, can prove expensive, as that case showed.

Hardy, T.C. Memo. 2017-16, has been widely discussed for its holdings on self-employment tax and the IRS’s ability to group activities that it deems appropriate economic units. However, little focus has been placed on the Tax Court’s conclusion that the taxpayer couple’s CPA tax preparer failed to properly change the status of the taxpayer’s limited liability company (LLC) income from active to passive for prior years as well as currently. As a result, the taxpayers’ deduction of certain suspended passive activity losses was disallowed, and a significant portion of their refund claim was denied.

The facts in Hardy are similar to situations a tax preparer may face with many clients and their varied business activities. Stephen Hardy was a surgeon who operated his medical practice as a sole practitioner and held a minority interest in an LLC that ran a surgical center at which he sometimes performed surgery. The CPA testified that in the first two years he prepared the Hardys’ return, 2006 and 2007, relying on the characterization of the income in the Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., from the LLC, he treated the income as nonpassive income from self-employment in a trade or business. The Hardys’ joint return accordingly reported the income as nonpassive. In both those years, besides the losses from the LLC, the Hardys reported losses from other passive activities that were suspended due to the passive income limitations of Sec. 469(a).

While preparing the couple’s tax return for 2008, the CPA, learning that Hardy was not involved in the management of the LLC and was not liable for its debts, reassessed the characterization of the income from the LLC. The CPA used a checklist of passive activity criteria and gathered corroborating information from the taxpayer. Based on this review, he determined that Hardy’s relationship to the LLC was passive.

However, the CPA did not correctly report this change in characterization by amending the Hardys’ 2006 and 2007 returns, believing that the change would not be material. The practitioner simply changed the reporting of the 2008 income to passive on that year’s timely filed return and netted it against the Hardys’ current- and prior-year passive activity losses.

The Tax Court held that Hardy did qualify as a passive investor in the surgery center LLC, that he did not have to pay self-employment tax on the income, and that he could offset the income from the LLC against passive losses from other activities. Unfortunately for the Hardys, however, the court also held that if income from the LLC had been correctly reported as passive income in 2006 and 2007, the income would have fully absorbed their passive losses in those years, and there would have been no passive loss to carry forward to 2008. Accordingly, they were not entitled in 2008 to deduct any passive losses carried forward from years before 2008, and tax and interest were payable due to the disallowed deduction in 2008, as well as a possible penalty for a substantial understatement of tax due. By the time the Tax Court heard the case, the 2006 and 2007 tax years were closed, and no refunds were available to the taxpayers.

The taxpayers alternatively argued that they were entitled to relief under the equitable recoupment doctrine, which allows a taxpayer to offset a tax assessment with a tax overpayment from a closed year to avoid an inequitable result. The court rejected this claim, holding that since the taxpayers did not raise this argument in their initial court petition or amend the petition during trial, they failed to timely raise it as a defense.

Fortunately for the taxpayers, the court disallowed the imposition of a Sec. 6662 negligence penalty, due to reasonable cause. The court held that Hardy reasonably relied on the advice of the CPA and that the CPA “did not take into account the proper characterization of Dr. Hardy’s income . . . when considering the amount of the passive activity loss carryover.”

To correctly report a change in classification, a tax practitioner should amend the earliest open tax year and adjust any suspended passive loss carryovers accordingly. This will ensure the proper utilization of passive losses in the correct tax years and avoid penalties and the potential loss of tax benefits. Practitioners should also take care in reviewing the effect of any prior grouping elections under Regs. Sec. 1.469-4(c) that erroneously grouped a passive activity with an active activity and might make reclassification more difficult.

Although not common with existing clients, the potential for this situation to occur with new clients is quite high. When preparing returns for the first time, practitioners should review each activity and correctly determine whether it is active or passive. Relying solely on the prior year’s treatment or Schedule K-1 reporting of income is not appropriate and can expose CPAs to malpractice claims. Gathering appropriate evidence from the client each year is the best way to avoid incorrect reporting positions.