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CLASS-ACTION LAWYER TRIUMPHS IN PASSIVE ACTIVITY BATTLE WITH IRS

July 07, 2005

NOTE: THIS ENTRY HAS BEEN UPDATED AND AMENDED.

Fred Misko, veteran of many class-action lawsuits in Texas, added a different sort of notch to his belt yesterday. He prevailed in a tax case where he was allowed losses for renting office equipment to his C corporation law firm.

Mr. Misko faced the typical problem of running a law practice out of a P.C. Every dollar of earnings left in the PC is taxed at 35%, so he has to take it all out as salary and bonus to avoid double taxation. Yet when he does so, he has to pay employment taxes - the 2.9% medicare tax - on the amounts withdrawn.

His accountant suggested that he rent office equipment to his P.C. That worked out well until the firm had a lean year due to a delay in closing a class action settlement. The law firm delayed paying Mr. Misko his rent, so the depreciation deductions on the office equipment threw him into a loss.

BUT RENTAL LOSSES ARE PASSIVE, RIGHT?

The "passive loss" rules generally treat rental losses as "passive." Taxpayers can deduct passive losses only to the extent they have passive income; any net losses carry forward until they can offset other passive income, or until the "passive activity" is disposed of.

The passive loss rules have several exceptions. One of them is that rental losses are treated as nonpassive if:

The rental of such property is treated as incidental to a nonrental activity of the taxpayer (Regs. 1.469-1T(e)(3)(ii)(D)).

Mr. Misko convinced the Tax Court that this exception applied. He wasn't out of the woods yet, because he had to then convince the court that he "materially participated" in the activity. He did so by demonstrating that that he performed "substantially all" of the participation in the activity for the year.

IS THIS GOING TO HOLD UP?

This case opens up a nice loophole tax planning opportunity. Taxpayers would be able to rent property to their C corporations at a loss, but still suck enough cash in rents to cover their payments on the property.

The "incidental" activities exception applies to property rented to a trade or business "of the taxpayer." A C corporation is not normally considered the same "taxpayer" as its owner.

The Tax Court justifies treating the law firm activities as Mr. Misko's activities because he owns 100% of the firm; it cites a 1998 case, Schwalbach v. Commissioner, as support.

Schwalbach deals with a somewhat related, but distinct, passive loss issue. Stephen Schwalbach rented a building to his dental practice. The rent generated taxable income to him, which enabled him to use passive losses from other sources that would otherwise have been disallowed. The Tax Court ruled that Mr. Schwalbach violated a part of the passive loss rules that keeps taxpayers from artificially generating passive income -- Reg. Sec. 1.469-2(f)(6):

Property rented to a nonpassive activity. An amount of the taxpayer's gross rental activity income for the taxable year from an item of property equal to the net rental activity income for the year from that item of property is treated as not from a passive activity if the property—

(i) Is rented for use in a trade or business activity (within the meaning of paragraph (e)(2) of this section) in which the taxpayer materially participates (within the meaning of §1.469-5T) for the taxable year;

There is would appear to be a problem with using Schwalbach to support treating Mr. Misko's losses from rental to his C corporation. The regulation that applies in Schwalbach addresses activities "in which the taxpayer materially participates." This is different from the exception for "incidental activities," which applies to activities "of the taxpayer." The Schwalbach regulation covers where you work, while the regulation that applies in Misko seems to address who you are. Tax Court Judge Kroupa doesn't address this distinction in his Misko decision, but the IRS is likely to raise it on appeal or in other cases.

Another regulation appears to square the circle. Regs. Sec. 1.469-4(a) holds

A taxpayer's activities include those conducted through C corporations that are subject to section 469, S corporations, and partnerships.

While there are limits on the ability to use this provision, it seems to be written broadly enough to cover Mr. Misko. That may not be what the regulation writers had in mind, as the history of the provision seems to indicate that it was intended to control how activities are grouped for measuring participation only. Still, it's worded quite broadly, and it looks like the IRS is stuck with it.

WHAT TO DO?

While Mr. Misko's victory may or may not ultimately hold up, it does provide support for similarly situated taxpayers. It would not be unreasonable to follow Misko to take losses on "incidental" rentals to a C corporation where a taxpayer meets the material partipation tests on the rentals. The requirement that the rental activity be merely "incidental" does limit its potential.

Cite: Misko v. Commissioner, T.C. Memo 2005-166

UPDATE: Our summary of "material participation" requirements for passive losses is reproduced in the extended entry below.

UPDATE II I changed my mind about the soundness of the decision after looking at it again later in the day; I initially thought it appeared wrong. Good thing I'm going on vacation - I obviously need it.

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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