Taxpayer Materially Participated in Activity, Investor and Work Not Customarily Done by Owner Exceptions Did Not Apply

The IRS has lost again on the question of material participation for a taxpayer helping the family business deal with the financial crisis of 2008.  In the case of Lamas v. Commissioner, TC Memo 2015-59, the issue was whether the taxpayer had materially participated in businesses in 2008 where the taxpayer’s share of losses generated multi-million refunds from a net operating loss carryback.

Mr. Lamas’s father had created three businesses with his children as majority owners.  The taxpayer in this case (Jose Lamas) had a 60% interest in one of the businesses (Adrimar Investments Corp.) and held a 20% interest in each of the other two (Continental Trust Mortgage Corp. and Shoma Development Corp).  All of the businesses were involved in real estate and had some relationship with each other.

The IRS was questioning Mr. Lamas’s claimed material participation in Shoma and an LLC that was formed with the same ownership structure (Greens at Doral, LLC).  The Tax Court described the relationship between the two as follows:

Shoma and Greens were closely intertwined.  Greens had the same ownership structure as Shoma and consolidated its financial information with Shoma’s.  Greens operated out of Shoma’s offices using Shoma’s employees, and the shareholders planned to liquidate Greens after the conversion project was completed.  Shoma was a subchapter S corporation, and Greens was treated as a partnership for tax purposes.

The issue was what Mr. Lamas did during 2008 related to these entities.  During 2008 Mr. Lamas was involved in a lawsuit against his brother-in-law (who, with his spouse, contolled 60% of Shoma) on behalf of Shoma to recover funds that he and his other sister (who also held 20% of Shoma) claimed had lost by Shoma due to misdeeds by the brother-in-law as President of Shoma and Greens.  The Tax Court found that Mr. Lamas spent approximately 112.5 hours acting on the corporation’s behalf in this case.

Mr. Lamas was also involved in attempting to deal with the issues created by 2008 financial crisis for Shoma.  Shoma had four major projects in progress during 2008 that needed additional cash—something not easy to come by for real estate projects in 2008.

To deal with these issues Mr. Lamas had numerous meetings with David Flinn, a trusted business adviser of Mr. Lamas’s father, to discuss potential investors or purchasers for the projects.  The Tax Court found that Mr. Lamas spent 74 hours in such discussions with Mr. Flinn.

Mr. Lamas also spoke with potential investors and purchasers based on contacts he had gained as CEO of his own company, as well as promoting the projects to various other potential investors and purchasers.

In the last half of 2008 Mr. Lamas was named Treasurer of Shoma, hired as an employee and received an office at corporate headquarters.  Taking all of these activities into account the Tax Court found Mr. Lamas had worked at least 691 hours for Shoma and Greens in 2008.

In addition, Mr. Lamas worked 294 hours in another real estate project during 2010 (Bella Vista) that he took over to salvage his investment when the owner of the LLC operating the condominium project declared bankruptcy.

Generally, per IRC §469, a taxpayer may not claim losses from passive activities to the extent they exceed the taxpayer’s income from passive activities for the year.  A passive activity is defined generally as one in which the taxpayer does not materially participate.

Reg. §1.469-5T(a) provides the following seven tests that a taxpayer uses to determine if he/she is materially participating in an activity:

  • The individual participates in the activity for more than 500 hours during such year;
  • 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;
  • 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;
  • The activity is a significant participation activity  for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;
  • 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;
  • The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or
  • Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during such year.

In applying these tests, the first key item that must be determined is what constitutes the “activity” in question as the limitations and test are applied on the basis of the activity in question. 

Reg. §1.469-4(c) provides the general rules for grouping activities.  The provision looks to whether a grouping creates an appropriate economic unit  [Reg. §1.469-4(c)(1)].

The determination of an “appropriate economic unit” is based on a facts and circumstances test.  Reg. §1.469-4(c)(2) provides the following guidance in applying the test:

(2) Facts and circumstances test.

Except as otherwise provided in this section, whether activities constitute an appropriate economic unit and, therefore, may be treated as a single activity depends upon all the relevant facts and circumstances. A taxpayer may use any reasonable method of applying the relevant facts and circumstances in grouping activities. The factors listed below, not all of which are necessary for a taxpayer to treat more than one activity as a single activity, are given the greatest weight in determining whether activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of section 469--

(i) Similarities and differences in types of trades or businesses;

(ii) The extent of common control;

(iii) The extent of common ownership;

(iv) Geographical location; and

(v) Interdependencies between or among the activities (for example, the extent to which the activities purchase or sell goods between or among themselves, involve products or services that are normally provided together, have the same customers, have the same employees, or are accounted for with a single set of books and records).

The Tax Court concluded the taxpayer’s grouping of Shoma and Greens into a single activity was appropriate.  Specifically the Court found:

  • The entities shared common control for the years in question;
  • The entities shared geographic locations, as Greens operated out of Shoma’s offices;
  • The entities were interdependent, as Greens operated out of the offices of Shoma, used Shoma employees, consolidated their financial data and Greens was formed as a condominium project by Shoma

As such, the total hours involved in both Shoma and Greens were found by the Court to be in excess of 500 hours.  But the Court noted that even if it found otherwise, the activities would have still amounted to significant participation activities (SPAs) along with Bella Vista) and that material participation would then have been established under that test, with total hours in SPAs being more than 500.

But the IRS wasn’t done yet with the challenge.  Under Reg. §1.469-5T(f)(2)(ii), participation as an investor is subject to additional rules. 

The regulation provides:

(ii) Participation as an investor

(A) In general.

Work done by an individual in the individual's capacity as an investor in an activity shall not be treated as participation in the activity for purposes of this section unless the individual is directly involved in the day-to-day management or operations of the activity.

(B) Work done in individual's capacity as an investor.

For purposes of this paragraph (f)(2)(ii), work done by an individual in the individual's capacity as an investor in an activity includes--

(1) Studying and reviewing financial statements or reports on operations of the activity;

(2) Preparing or compiling summaries or analyses of the finances or operations of the activity for the individual's own use; and

(3) Monitoring the finances or operations of the activity in a non-managerial capacity.

The IRS argued that Mr. Lamas’ activities were just such “investor” activities and thus those hours could not count towards material participation.

The Tax Court did not agree, finding that Mr. Lamas’ work went beyond that of a “mere investor.”  The Court agreed with the taxpayers that Mr. Lamas’ situation was similar to that of the taxpayer in the case of Tolin v. Commissioner, TC Memo 2014-65.

Reality was that what Mr. Lamas was doing involved the key issues that the entities needed to deal with in the 2008 environment.  As the Court notes:

Mr. Lamas worked in the day-to-day management and operations of Shoma because he was working to meet Shoma’s need for capital for its projects, an essential part of Shoma’s business during 2008. Like Mr. Tolin’s, most of Mr. Lamas’ work was promotion. Mr. Lamas’ promotion went to the core goal for Shoma at the time, which was to find project investors. Accordingly, the investor exception does not apply, and all of Mr. Lamas’ work for Shoma, including investor activity, qualifies as participation.

But the IRS was not finished at that point—another exclusion exists if a taxpayer performs work “not normally done by owners” merely to meet the hours test.

Reg. §1.469-5T(f)(2)(i) provides:

(i) Certain work not customarily done by owners.

Work done in connection with an activity shall not be treated as participation in the activity for purposes of this section if--

(A) Such work is not of a type that is customarily done by an owner of such an activity; and

(B) One of the principal purposes for the performance of such work is to avoid the disallowance, under section 469 and the regulations thereunder, of any loss or credit from such activity.

Not surprisingly, the Court did not accept this view either.  The Court noted:

We find Mr. Lamas participated in work customarily done by owners, and he did not do this work with a purpose of avoiding the section 469 loss limitations. Mr. Lamas worked restoring Shoma assets and opportunities and finding potential investors for Shoma projects. In contrast to the example in the regulations, these activities are customarily done by owners. Further, Mr. Lamas' purpose was to protect his investment in Shoma by helping Shoma to survive. Accordingly, the avoidance exception does not apply.

So how did this case end up at this point?  Most likely due to that dispute with Mr. Lamas’ brother-in-law who, as you may recall, owned 60% of the entities in question.  The brother-in-law initially supported Mr. Lamas’ claim to material participation in the activities, but as disputes continued he eventually repudiated his story and sent the IRS a letter claiming Mr. Lamas did not actually participate in the activities.

However the Tax Court did not find the brother-in-law credible, noting that all other testimony and phone records supported Mr. Lamas’ claims and, in many cases, discredited the brother-in-law’s.

Specifically the Court found fault with the brother-in-law’s letter to the IRS stating that Mr. Lamas had no direct or indirect involvement with Shoma in 2008.  As the Court noted:

This last statement by Mr. Shojaee is directly contradicted by contemporaneous documents and Mr. Shojaee himself. The Lamases produced Shoma corporate board meeting minutes and resolutions from 2008 naming Mr. Lamas as a director and treasurer of Shoma. They also produced a Form W-2, Wage and Tax Statement, and biweekly earnings statements issued by Shoma to Mr. Lamas for 2008 confirming he was an employee. And moreover, Mr. Shojaee's own testimony at trial is contradictory. Mr. Shojaee attempted to convey that Mr. Lamas was doing "nothing" for Shoma and that he had "zero" expectations for him. In direct conflict with his own testimony, Mr. Shojaee also stated that Mr. Lamas arranged a conference call to find investors for Shoma projects, and that he and Mr. Lamas were "talking terms" about real estate deals on phone calls in 2008.

The Court, therefore found that this witness’s testimony should be disregarded, noting:

Although the maxim “falsus in uno, falsus in omnibus” does not always apply, given Mr. Shojaee’s evident bias and conflicting statements, coupled with the lack of corroborating testimony, it fits Mr. Shojaee’s testimony. Accordingly, we give Mr. Shojaee’s testimony no weight. And as previously noted, Mr. Shojaee is the only source of evidence that conflicts with the otherwise extensive evidence that Mr. Lamas materially participated in Shoma and Greens for more than 500 hours during 2008.

For those not up to speed in Latin, the phrase above is translated “False in one thing, false in all.” 

Although it was the IRS that was tripped up this time by putting too much faith in testimony where there were issues, the problem more often crops up with taxpayers in cases.  Like it or not, the credibility of a taxpayer is crucial in defending many tax deductions, often being the only available source of support. 

Taxpayers should be reminded that being “caught in a lie” on an exam is likely to do damage far beyond merely the specific issue where the falsehood was caught.  The reality is that the maxim cited above is quite often used in dealing with tax issues—and, conversely, the Court often goes out of its way in accepting testimony where it is clear the taxpayer has had his/her other statement corroborated by other parties and independent evidence (as was the case for Mr. Lamas).