Taxpayers Present Evidence Found to Show They Met the "More Than Others" Test for Material Participation

In the case of Kline v. Commissioner, TC Memo 2015-144 the question before the Tax Court was whether the taxpayers in this case met the requirements to be treated as materially participating in the activity.

Specifically the question was whether they had met the requirements of Reg. §1.469‑5T(a)(3) for the “more than others” test for material participation. 

Generally taxpayers are not allowed, per IRC §469, to offset losses from activities in which they do not materially participate against income from any sources except other passive activities. Material participation is defined in Reg. §1.469‑5T(a) which lists a series of tests.

The one in question here is found in Reg. §1.469‑5T(a)(3) which provides that a taxpayer will be treated as materially participating in any activity if:

(3) 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…

Just about a year earlier the Tax Court had looked at the same issue in the case of Williams v. Commissioner, TC Memo 2014‑158 and there had concluded the taxpayer failed to meet this test even though he had a contract with those who provided other services that no single person would allowed to be involved for more than 100 hours.

However, in the Kline case the taxpayers would prevail on the question.  The taxpayers were involved in chartering boats in the British Virgin Islands (BVI).  The taxpayers entered into a management agreement with an organization in BVI. That organization, per the agreement, “was responsible for marketing the boats, setting charter prices, booking charters, keeping records of all charters, collecting money due from customers, and cleaning and maintaining the boats.”

Generally the taxpayer was paid “net charter revenue” which was the gross revenue minus various expenses, including a management fee. As well the taxpayer paid the management company a “turnaround fee” for each charter which “covered cleaning and preparing the boat and dinghy for the next charter; changing linens; technical checks of the boat’s rigging, shipwright, electrical, plumbing, and mechanical systems; and briefing and debriefing customers.”

The agreement gave the taxpayer the use of each of his two boats for two periods each year of two weeks.  He chartered the boats generally under the standard agreement with the management company.  He did not pay the charter fee but did pay the charter company for various expenses, including the turnaround fee for each charter.  He would use these trips to provide a skippered charter for a fee to friends and acquaintances.

The taxpayer and his spouse were able to reconstruct evidence of their time spent on the activities related to the boats.  Their reconstructed time amounted to 470 hours for one year and 732.5 hours for the second.

The good news was the Court found their testimony and reconstructed time reports to be credible even if the amounts may not have been totally accurate.  The bad news was that 470 was less than 500, which meant even if the Court accepted the time spent as accurate they fell short of the 500 hour test in Reg. §1.469‑5T(a)(1) that would have made time spent by others irrelevant. 

The Court was convinced that the taxpayers had spent well in excess of 100 hours in each year so it was clear that if no other person had spent more hours in the activity the taxpayers would meet the “not less than others” test for material participation.

Unlike the taxpayer in Williams the taxpayers here did not have a contractual commitment from the management company that none of their employees would spend more than 100 hours with the boats.  But what they did have, which the taxpayer in Williams did not, was evidence from the management company regarding hours worked.

As the Court noted:

Mr. Kline received monthly billing statements for the years at issue from Horizon reflecting time spent by its employees in connection with Fly-Bye and Fly-Away.  

The director of operations for the management company testified with regard to what the company did and noted that it did not assign particular employees to a particular boat, but rather spread the work among the employees.  The greatest number of hours came from the turnaround work.

Based on the number of charters and other documents, the director was able to come up with total hours for the turnaround work for the year.  Given that no one was assigned to each boat, he determined that it made sense to average out those total hours.   Based on his calculations, the expected hours for the employees that would have spent the greatest time was less than 40 hours for each year.

The Court accepted this testimony and found that

  • The taxpayers had spent far more than 100 hours involved in the activity in each year and
  • Since no employee of the management company would be expected to have spent more than 100 hours, the taxpayers put more time in the activity than anyone else.

Thus, the Court found that the taxpayers had materially participated in the activity for the years in question.

The key difference here vs. the situation in the Williams case is that the taxpayers presented actual evidence of the hours for both their own work and that of other parties, rather than attempting to solely rely on a contractual commitment that there was little reason to believe would be enforced or carefully followed.