The IRS argued that the taxpayer in Barbara v. Commissioner, TC Memo 2019-50 did not materially participate in the trade or business of lending money, leading to a proposed assessment of tax of over $536,000 along with a 20% substantial underpayment penalty under §6662(a). But the Tax Court did not agree with the IRS’s view in this case.
After selling his trucking business, Fred Barbara used the money to start a money lending business. The office of the money lending business was in Chicago, IL. The business employed two full time employees: an accountant and a secretary.
Mr. Barbara performed the executive functions of the lending business, including deciding to make loans and how to handle defaulted loans. He handled over 40 outstanding loans during the years in question and did not have other major work-related responsibilities that would require his time and attention.
However, Mr. Barabara only spent 40% of the year in Chicago, living in Florida the remainder of the year. Presumably this made the IRS suspicious that Mr. Barabara was truly not materially participating in the business. Under IRC §469, if Mr. Barabara did not materially participate in the business, the losses claimed would have been suspended until such time as Mr. Barbara had passive income or disposed of this activity in a fully taxable transaction.
A person is treated as materially participating in an activity if he meets any one of the seven tests found in Reg. §1.469-5T(a). In situation this the Tax Court focused on the seventh test, which provides that a taxpayer materially participates if he:
· Participates more than 100 hours in the activity during the year and
· Facts and circumstances show that his participation was regular, continuous and substantial.
The Tax Court first looked at the hours that Mr. Barbara had participated in the activity during the years in question. The Court found initially that he worked 200 days during the year in the activity, with 40% of the work days being in Chicago and 60% in Florida.
The Court found that when Mr. Barabara was in Chicago, he spent 5.75 hours for each workday in the Chicago office. When he was in Florida, during his workdays he spent 2 hours working on the business. The Court found this meant he had worked 460 in Chicago and 240 hours in Florida each year, for a total of 700 hours. The Court noted this exceeded the 100 hours necessary to meet this test.
The Court also considered that what Mr. Barabara did in the business amounted to regular, continuous and substantial participation. Thus, the Court concluded Mr. Barbara had materially participated in the activity and should be allowed to deduct his losses.
The opinion is interesting in that the Court did not use the test at Reg. 1.469-1T(a)(1) to sustain the finding that Mr. Barbara materially participated in the years in question. That test provides a taxpayer materially participates in any activity that he/she participates in more than 500 hours in a year. Since the Court found that Mr. Barbara participated for 700 hours (which clearly is more than 500), why did the Court resort to the facts and circumstances test?
While the Court doesn’t comment specifically why it ignored the simpler test, it’s interesting to note that the Court did not comment on the documentation for Mr. Barbara’s hours and participation in this case. The lack of documentation has been used multiple times to deny taxpayers material participation when they claimed more than 500 hours.
The Tax Court had similarly resorted to using the “facts and circumstances” rather than the 500-hour test previously in the case Wade v. Commissioner, TC Memo 2014-169, even though in that case the taxpayer argued that he met the 500-hour test. Again, documentation was not mentioned in that case, just a finding that he had participated more than 100 hours and had regular, continuous and substantial participation.
It appears that the Tax Court is indirectly opening up a limited exception to the documentation rules—if the Court determines that a taxpayer had at least 100 hours per year and that it appears he/she was truly involved in the activity in a significant way, it is resorting to the facts and circumstances test rather than take the position that this sort of “estimated hours” reconstruction justifies qualifying under the 500 hour test of Reg. §1.469-5T(a)(1).
 Reg. 1.469-5T(a)(7), (b)(2)(iii)