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FULL-SERVICE OFFICE FACILITIES FOR LAWYERS? EXTRAORDINARY!

February 01, 2005

The Tax Court issued a rare taxpayer victory in a "passive loss" case yesterday, siding with the taxpayers in a case involving a busy part-time law instructor.

Rehab Assaf is an attorney in Oklahoma City. She is also a bit of an entrepreneur. She teaches at the Oklahoma City University Law School and owns an office building with her husband. The building is held in a partnership: AGI Consulting, LLC. AGI offers a ready-made law office setup for solo attorneys:

AGI employed an office staff consisting of at least three clerical support personnel to provide legal support services. Services included client intake, answering phones, taking messages, filing documents at the courthouse and State capitol, process serving, express mailing, binding briefs, conducting legal research, typing briefs and legal memoranda, taking dictation, managing a file room, and photocopying. AGI also maintained an updated law library and conference facilities for its tenants. AGI provided other services including a security service, trash removal, janitorial services, coffee service, and general utilities. AGI owned the office equipment it leased to the law firm and “nine or ten” other tenant attorneys.

AGI had losses of about $34,000 in 1999 and 2000. The IRS said the losses were "passive." Under rules enacted in 1986 "passive" losses can only offset passive income, unless the "passive activity" (great oxymoron) is disposed of.

The status of most businesses as "passive" or "non-passive" is based on the time spent in the business by the taxpayer. If you "materially participate" in an activity, it is not passive. Material participation" is usually based on whether you spend 500 hours in the activity.

Real estate is different. Real estate income is usually treated as passive no matter how much time is spent on the business. (click "Read more" at the bottom of this post if you want to subject yourself to more details on this)

An exception applies if the real estate is rented in conjunction with "extraordinary personal services"; tax regulations cite hospital rooms as an example.

Arguing for herself, Ms. Assaf convinced the court that these services met the test for "extraordinary":

Witnesses for petitioners testified that AGI’s services to its tenants were unique in the area close to the courthouse, and that they would not have moved onto the premises if the support services were not provided. We find of particular significance that AGI performed legal research for its attorney-tenants. Overall, testimony established that the services were the crucial determinant in attorneys’ choosing to lease from AGI, and we found the testimony on behalf of petitioners credible and compelling. We therefore find the payments to AGI were principally for the services provided and not for the space leased.
(Emphasis added; citation omitted).

Once the court ruled that the services were "extraordinary," Ms. Assaf still had to convince the court that she "materially participated" in the business. This meant she had to convince the court that she spent 500 hours in the business each year to escape passive treatment.

The Tax Court can be hard to persuade on this score, but Ms. Assaf was up to the job:

Although this Court has not always accepted a post-event narrative of participation, we find petitioner wife’s description of her participation, when combined with witness testimony and the objective evidence in the record, to be credible, and we therefore conclude that petitioner wife materially participated in the activity by participating for more than 500 hours during the year.

The Moral? If you provide serious business services with your lease space, you may not have a "passive activity."

Cite: Assaf v. Commissioner, T.C. Memo 2005-14.

UPDATE: More here from Raby and Raby on Assaf and related issues.

MATERIAL PARTICIPATION BASICS

The regulations say you achieve "material participation" in non-real estate activities for a tax year if:

-You participate at least 500 hours; or
-You participate at least 100 hours and at least 500 hours in that and other "100 hour" activities; or
-You participate at least 100 hours and more than anybody else, or
-You are the only participant; or
-You materially participated in five of the past ten years )or in any three years for a service activity).

There is also a "facts and circumstances" test, but don't count on it.

A special rule apples to real estate. If you are not a "real estate professional," losses are normally passive no matter what, unless you provide "extraordinary" personal services.

If you are a "real estate" professional," you can apply the normal material participation rules to determine whether you have a passive activity. To be a real estate professional, you have to spend at least half your working hours - not less than 750 hours annually - in "real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade."

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