Editor: Mark G. Cook, CPA, CGMA
In a recent case, the Tax Court held that a taxpayer had materially participated in his business located in Chicago, despite residing in Florida for the majority of 2009, 2010, 2011, and 2012, the tax years in question (Barbara, T.C. Memo. 2019-50). Generally, material participation is established if a taxpayer's involvement in a trade or business activity is regular, continuous, and substantial (Sec. 469(h)(1)). Further guidance for determining material participation can be found in IRS regulations.
Material participation tests
Temp. Regs. Sec. 1.469-5T(a) provides seven tests to determine whether a taxpayer is materially participating in a trade or business activity for purposes of Sec. 469:
- More than 500 hours: The individual participates in the activity for more than 500 hours during the year.
- Substantially all participation: The taxpayer's participation in the activity constitutes substantially all of the participation by all individuals (including nonowners) in the activity for the year.
- More than 100 hours: The taxpayer's participation is more than 100 hours during the year, and no other individual (including nonowners) participates more hours than the taxpayer.
- Significant-participation activity: The taxpayer participates in the activity for more than 100 hours during the year (but does not materially participate under any of the other tests), and the taxpayer's annual participation in all significant-participation activities in the aggregate exceeds 500 hours.
- Prior-year material participation: The taxpayer materially participated in the activity (under any of the other tests) for any five tax years (whether or not consecutive) during the 10 immediately preceding tax years.
- Personal service activity: For a personal service activity, the taxpayer materially participated in the activity for any three tax years (whether or not consecutive) preceding the current tax year. A personal service activity is one involving performing personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, or in any other trade or business in which capital is not a material income-producing factor.
- Facts and circumstances: The taxpayer participated in the activity for more than 100 hours during the tax year, and, based on all the facts and circumstances, the participation was regular, continuous, and substantial.
Material participation is determined annually.
In Barbara, the Tax Court focused on the catch-all, seventh test, the facts-and-circumstances test.
The taxpayers in Barbara owned a company in Chicago that was in the business of lending money. The couple sought to carry forward a net operating loss from the business to 2011 and 2012. While employing an accountant and a secretary, Fred Barbara performed all the business's executive functions himself. These included determining when the company would loan money and how to handle defaulted loans, plus generally managing the company's outstanding loans. During the tax years in question, he managed over 40 outstanding loans, and he had no other significant business activities outside the lending business.
From 2009 to 2012 Barbara split his time between Chicago and Florida. Each year, he spent about 40% of his time in Chicago and 60% of his time in Florida, while working about 200 days per year. Therefore, after allocating time spent in each state to working days, the Tax Court determined he worked about 80 days in Chicago and 120 days in Florida for each of the years in question.
While in Chicago, he maintained a regular work schedule, averaging about 5.75 hours each workday. The Tax Court therefore concluded that, while in Chicago, he had worked a total of 460 hours per year on his lending business (80 working days × 5.75 hours per workday). When Barbara was in Florida, he called the Chicago office daily at 9 a.m. when it opened. In addition, he communicated with the Chicago office at other times via email, telephone, and fax. This amounted to about two hours per workday. Therefore, the Tax Court concluded that, while in Florida, he worked a total of 240 hours per year on his lending business (120 working days × two hours per workday). Between his time working in Chicago and Florida, the court concluded, Barbara spent about 700 hours per year working on his lending business (460 hours in Chicago + 240 hours in Florida).
The IRS's position in this case was that the taxpayer was not a material participant in the lending business; thus, the lending business was a passive activity for him. As a result of this determination, the passive losses from the lending business could offset only the taxpayer's passive income pursuant to Sec. 469.
The Tax Court determined that Barbara's participation in the lending business met the requirements of the seventh test for material participation — the facts-and-circumstances test — because he had worked over 100 hours in the lending business in the years in question and his participation in the business was regular, continuous, and substantial. Therefore, he was a material participant in the lending business and it was not considered to be a passive activity.
Regulations provide that taxpayers can use any reasonable method to prove their level of involvement and participation in an activity. Further, the regulations provide examples of methods that may be helpful to taxpayers. Under Temp. Regs. Sec. 1.469-5T(f)(4), reasonable means may include, but are not limited to, identifying services performed during a period and calculating the approximate number of hours spent performing them, based on appointment books, calendars, or narrative summaries. Contemporaneous daily time reports, logs, or similar documents are not required but may be helpful. Taxpayers are well advised to keep records and other evidence contemporaneous to their involvement in a given activity instead of creating records after the fact. Written evidence of actual time spent is far more persuasive than estimates or verbal testimony.
As Barbara demonstrated, a taxpayer in a trade or business does not need to be physically present at a business location to be a material participant in the business activity. This is an important clarification, as more people are working remotely today than in the past. As technology continues to evolve, this trend may continue. As such, it is important for such taxpayers to keep adequate written records to substantiate their involvement in a given activity, especially when working remotely.
Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600 or firstname.lastname@example.org.
All contributors are members of SingerLewak LLP.