Restricted Stock Interest Still Found to Constitute Ownership Interest for Qualifying as Real Estate Professional

A recent Arkansas U.S. District Court case involved the court resolving a number of not often raised in court questions regarding the interaction of the passive activity rules, the real estate professional classification, S corporations and stock provided to an employee that was subject to restrictions triggering treatment under IRC §83(b).  The case in question is the case of Stanley v. United States, 116 AFTR2d ¶2015-5419, Case No. 5:14-CV-05236, U.S.D.C. Western District of Arkansas.

The issues arose regarding Mr. and Mrs. Stanley's claimed deductions for losses on Schedule E that arose from real estate related activities.  Mr. Stanley took the position that he qualified as a real estate professional and that all of the various items reported on Schedule E were properly classified as a single activity under the passive activity rules.

One key issue that the court had to deal with initially involved the interaction of restricted stock and an S corporation.  Mr. Stanley worked for Lindsey Management Co., Inc. (LMC), initially full time as its President, later going to half-time after 15 years and finally retiring from the company.  He was also President of Lindsay Communications, Inc., a company that provided telecommunications services to the property management company.

Mr. Stanley began to acquire activities related to his work with Lindsey.  The Court noted:

From the beginning of Roy's employment with LMC, the Stanleys acquired minority ownership interests in business entities that owned or operated the rental properties and adjoining golf courses managed by LMC. By 2009 and 2010, the Stanleys had an ownership interest in more than 100 entities. The Stanleys also directly owned two rental properties, two percent of a third rental property, and interests in 88 (in 2010) and 90 (in 2009) additional entities through the Roy E. Stanley Family Limited Partnership.

Mr. Stanley claimed he qualified as real estate professional under §469(c)(7) and, having grouped all of these activities together, could claim losses available to him from the operations he had acquired ownership interests in.

Generally to be a real estate professional a taxpayer must meet two criteria.  They are:

  • The taxpayers spent more than 750 hours performing services in real estate activities and
  • More time was spent by the taxpayer in participation in those activities than in other activities in which the taxpayer materially participated.

The taxpayer cannot count as real estate activities time spent in an enterprise in which the taxpayer did not have at least a 5% ownership interest. 

The initial issue the IRS raised was their claim that Mr. Stanley was not a more than five percent owner of LMC, Inc.  Should the IRS carry this point Mr. Stanley could not be a real estate professional since his hours for LMC, Inc. would no longer count as real estate hours—and they would be greater than his other hours.

His ownership of the stock was, via his employment agreement, subject to certain restrictions.  The court summarized the situation as follows:

Roy testified that, from the time he began working at LMC in 1994, he owned ten percent of the company. Roy admitted into evidence a stock certificate evidencing his ownership of 10 shares out of 100 shares of LMC stock issued. (Pl. Hearing Exh. 6). Scott Rogerson, Chief Financial Officer and President of Corporate Operations for LMC, testified that the certificate was in fact a stock certificate from LMC to Roy for ten shares of stock in LMC. (Doc. 59, p. 9). Mr. Rogerson testified that the stock certificate issued to Roy was restricted only by the terms of the Roy's employment agreement with LMC. (Doc. 59, p. 9). Roy testified under oath that his stock in LMC was voting stock, but that meetings of the 2 or 3 shareholders at LMC were informal and that, with only ten percent of the stock, his role was to give advice as opposed to making decisions. Id. at 27, 55. Roy's ownership of the stock was acknowledged in his February 1, 2004 employment agreement and a subsequent employment agreement, which memorialized the understanding between the parties to those agreements that Roy would relinquish his stock upon full retirement from LMC. (Doc. 57, pp. 7 and 10). Roy's salary from LMC was reported as W-2 income from wages or salaries on line 7 of the Stanleys' tax returns for 2009 and 2010. (Doc. 50-4, p. 3 and Doc. 50-5, p. 3). Income received as a result of Roy's 10-percent ownership interest in LMC was reported on a Form K-1 from LMC each year and reported on Schedule E of the returns as distributions from an S corporation. (Doc. 50-4, p. 59 and Doc. 50-5, p. 61). Upon his resignation from LMC, and pursuant to his employment agreement with LMC, Roy transferred the stock certificate back to James Edgar Lindsey. (Pl. Hearing Exh. 7). [Emphasis added]

The IRS argued that despite the fact that he held shares that purported to be 10% of the company’s stock, his ownership should not count for purposes of the passive activity rules.

The IRS first argued that, due to the terms of the arrangement, Roy did bear any risk of loss during the period in question.  The Court did not accept this view, noting:

The parties dispute whether Roy bore any risk of loss were LMC to experience a loss during Roy's tenure. This argument, however, does not factor into the Court's analysis, as it is rooted in speculation. LMC never experienced a loss during Roy's tenure. Rather, the issue here is whether Roy has adequately and reasonably substantiated his ownership for purposes of the tax code. The Court finds that he has. Furthermore, the fact that Roy did not make a capital contribution for his shares is not determinative of whether he nevertheless owned 10 percent of the stock of LMC. A capital contribution is merely one avenue of acquiring ownership of stock or other property.

The IRS’s next argument was more interesting—the IRS, pointing out that Mr. Stanley’s stock was restricted, argued that, pursuant to §83, the stock was not outstanding for tax purposes.  Thus, the IRS claimed, he failed to hold at least 5% of the “tax stock” in this case.

Although the opinion does not reference it, it seems likely the IRS was arguing by reference to Reg. 1.1361-1(b)(3) which provides:

(3) Treatment of restricted stock. For purposes of subchapter S, stock that is issued in connection with the performance of services (within the meaning of §1.83-3(f)) and that is substantially nonvested (within the meaning of § 1.83-3(b)) is not treated as outstanding stock of the corporation, and the holder of that stock is not treated as a shareholder solely by reason of holding the stock, unless the holder makes an election with respect to the stock under section 83(b). In the event of such an election, the stock is treated as outstanding stock of the corporation, and the holder of the stock is treated as a shareholder for purposes of subchapter S. See paragraphs (l)(1) and (3) of this section for rules for determining whether substantially nonvested stock with respect to which an election under section 83(b) has been made is treated as a second class of stock.

That provision is important in the S context because is such stock is treated as “outstanding” in most cases the corporation would have two classes of stock outstanding, a fact that would put the S election at risk under the second class of stock rules.

However, the Court rejected any use of Section 83 to determine if stock was outstanding in the context of the passive income rules for a real estate professional, noting:

Section 83 does not explicitly reference any provisions of the code or regulations at issue in this case. The Government has not cited to any authority that would require or allow application of Section 83 to 26 U.S.C. § 416(i)(1)(B)(i)(I), and the Court has not otherwise found any such authority. At the hearing, counsel for the Government argues that Section 83 was relevant to the issues in this case simply because it is entitled "Property Received in Connection with the Provision of Services." (Doc. 59, p. 95). The mere title of a section of the tax code does not act as a net that might ensnare any other provision falling within its broad subject-matter reach. The purpose of Section 83 appears to be to provide guidance on when a taxpayer should report certain property received in exchange for services (i.e. stock options) as gross income on a tax return, and further provides taxpayers with the option to elect to include such property in gross income in the year of transfer notwithstanding any restriction on its transferability or any substantial risk of forfeiture. 26 U.S.C. § 83(b). The Court finds that the section provides no authoritative, or even persuasive, guidance on the issue of whether Roy was a 5-percent owner of LMC.

Thus the Court found, being the owner of 10% of LMC, Mr. Stanley could count the hours he worked for LMC as real estate hours and, due to that, he was a real estate professional.

Another issue in this case arose because Mr. Stanley grouped rental real estate activities with other activities, a grouping the IRS argued was not allowed.

As the Court summarized:

Subsection 1.469-9(e)(3)(i) is entitled "Grouping rental real estate activities with other activities—In general" and provides as follows:

For purposes of this section, a qualifying taxpayer may not group a rental real estate activity with any other activity of the taxpayer. For example, if a qualifying taxpayer develops real property, constructs buildings, and owns an interest in rental real estate, the taxpayer's interest in rental real estate may not be grouped with the taxpayer's development activity or construction activity. Thus, only the participation of the taxpayer with respect to the rental real estate may be used to determine if the taxpayer materially participates in the rental real estate activity under § 1.469-5T. (emphasis added by the court in the opinion)

However the Court read that provision in a very limited fashion.  The Court held:

The Court cannot agree with the Government's interpretation that this section categorically prohibits real estate professionals from grouping rental activity with other activity for all purposes. While this particular argument was not raised in the parties' original briefs, the Court requested briefing on the issue of whether subsection 1.469-9(e)(3)(i) "prohibit[s] grouping of rental real estate activities (whether singular or aggregated) with non-rental real estate activities for purposes of determining material participation in the rental real estate activity." (Doc. 56, p. 2). Implicit in that question was the Court's initial understanding that 1.469-9(e)(3)(i) likely limited grouping but only for purposes of determining material participation in a rental activity. The Government's arguments in its supplemental brief and at the hearing did not convince the Court that its initial understanding was wrong. Read in context, subsection 1.469-9(e)(3)(i) bars grouping only for purposes of determining material participation and does not categorically bar a real estate professional from grouping rental and non-rental activities for other purposes, including for purposes of determining passive activity loss and credit.

The opinion first holds that the language “for purposes of this section” limits the restriction only to the specific regulation (Reg. §1.469-9) and not for the general grouping regulation at Reg. §1.469-4. 

The Court continues:

26 C.F.R. § 1.469-4(c)(1) explicitly allows for grouping of rental and non-rental activities in certain circumstances. This regulation on grouping does not include any provision indicating that real estate professionals are prohibited from availing themselves of the benefits of grouping their rental real estate activities with any other activity if they otherwise meet the requirements of the grouping regulation.

The Court then considered whether, in this case, it was appropriate to group the rental properties with other activities—and found that it was.  The Court noted:

The Stanleys grouped their aggregated Rental Activity with other trade or business activities, including LMC, LCI, and the activity of golf courses adjoining LMC-managed properties. Having considered the relevant facts and circumstances, the Court first finds that the Rental Activity, LMC, LCI, and the golf courses formed an appropriate economic unit. With few exceptions, the rental properties aggregated in the Stanleys' Rental Activity were all managed by LMC, with telecommunications services provided by LCI. LMC is a property-management company that manages rental apartment complexes, golf courses, and commercial properties in Arkansas and surrounding states. The parties stipulated that "[t]he vast majority of LMC's revenues came from property management fees." (Doc. 26-4, ¶ 31). LCI "provided telecommunications services . . . to some apartment complexes and golf courses managed by [LMC] or negotiated with third-party providers to provide telecommunications services to certain LMC-managed apartment complexes and golf courses." (Doc. 26-4, ¶ 25(a)). As for the golf courses, "[e]very LMC-managed golf course [is] located next to an LMC-managed apartment complex." (Doc. 26-4, ¶ 39). Some LMC apartment complexes have no adjoining golf course; some have 9-hole courses that are free for tenants to use; and some have 18-hole courses that tenants may be able to use at a reduced rate. All courses are also open to the public for a fee.

While there are certainly significant differences in the types of services offered by the rental properties, LMC, LCI, and the golf courses, all four services worked in concert in connection with the same trade or business category—rental real estate. While the precise ownership of the various rental properties was technically diverse, it appears from the record that James E. Lindsey and/or his family exerted common control over the rental properties, LMC, LCI, and the golf courses. All the rental real estate properties as well as the golf courses were also under common control to the extent that they were all managed by LMC, which was an S corporation with a majority shareholder—Mr. Lindsey. As to the geographic location of the various activities, LMC is headquartered in Northwest Arkansas and the rental properties and golf courses it manages (and for which LCI provides services) are all concentrated in Arkansas and nearby states. Finally, the interdependencies of the rental properties with LMC and LCI and with the golf courses is apparent. As already stated, LMC and LCI were entities whose function was to perform services on behalf of LMC-managed rental properties. Those rental properties included certain complexes whose business model was to provide tenants with access—for free or at a reduced rate—to an adjoining golf course. While golf and apartment rentals are not inherently related, LMC created an apparently successful business model that linked the two, and the regulations allow for consideration of all relevant facts and circumstances—not just those factors that are specifically enumerated. Much as a fast food restaurant might attract customers via a playground area or a savings club might have an adjoining gas station or restaurant, LMC's model sought to attract tenants through golf. Roy testified that developing golf courses in conjunction with apartment rentals generally decreased neighborhood opposition that would otherwise be encountered in response to a proposed apartment rental development on its own. Grouping these two activities in this context represents a "reasonable method of applying the relevant facts and circumstances in grouping activities." 26 C.F.R. § 1.469-4(c)(2).

The Court also finds that LMC, LCI, and the golf activities were insubstantial in relation to the Rental Activity. In making this determination, the Court has endeavored to consider all the "pertinent factors." TD 8565, 1994-43 I.R.B. 4 (rejecting a bright-line rule for determining insubstantiality "to avoid complex and mechanical rules," stating that "the regulations already adopt a facts-and-circumstances test that looks at all the pertinent factors"); Candelaria v. United States, 518 F. Supp. 2d 852, 859-60 (W.D. Tex. 2007)Glick v. United States, 96 F. Supp. 2d 850 (S.D. Ind. 2000). Because the test for insubstantiality is one that depends on the facts and circumstances of each individual case, the Court relies heavily on the evidence of record and finds that a lengthy legal analysis as to this point is unnecessary in this case.

The case is interesting because of the nature of the matters considered, especially the impact of restricted Section 83 stock held by an S shareholder in a real estate business.  But advisers should note this represents a single U.S. District Court case and it’s very possible that a different court (especially one that hears many more tax cases) might not react as favorably to the same arguments.