It is relatively common for Americans with day jobs to engage in side activities for profit. This might include owning rental properties, owning small family businesses, or investing in the businesses of others. Congress and the IRS certainly support and would like to encourage such activity, but they must also be concerned with loopholes in the tax system. Consequently, taxpayers are prohibited from creating passive investment losses to offset their W-2 income. IRC Sec. 469. For example, a doctor in the highest tax bracket (currently 39.6%) cannot invest her money in an outlet mall that is losing money to reduce her income below $400,000 a year – the 35% tax bracket. The doctor would only be able to take those deductions if she actively participated in the operations of that outlet mall.
Lamas v. IRS is a recent example of successfully proving such active participation under this section of the code. There, Mr. and Mrs. Lamas owned a collection of companies in the lumber wholesaling and construction industries in Florida. Ownership was also sprinkled among their children, with whom Mr. Lamas participated with and helped make successful. The Lamases had very good years between 2006 and 20087for which they were audited and assessed nearly $5 million in tax underpayments. In short, the Lamas’ tax strategy was to carry back some losses in 2008 to their 2006 and 2007 taxes in order to offset some of that income and reduce tax.
The IRS relied on these Section 469 passive investment loss limitations to argue that Mr. Lamas did not materially participate in the various business ventures for which losses were offsetting some of his income from active activities. In arriving at its ultimate decision – that the Lamases materially participated and were entitled to their deductions, the Tax Court explained:
“Generally, taxpayers materially participate if they are involved in the operations of the trade or business on a regular, continuous, and substantial basis. The regulations provide seven tests to determine whether a taxpayer materially participated, and a taxpayer only needs to satisfy one of those tests. We find that Mr. Lamas satisfies at least two of these seven tests. Under one of those tests, taxpayers can satisfy the material participation requirement if they participate in the trade or business activity for more than 500 hours during the taxable year. Under the other, taxpayers can satisfy the material participation requirement if “[t]he activity is a significant participation activity * * * for the taxable year, and the * * * [taxpayers’] aggregate participation in all significant participation activities during such year exceeds 500 hours.”
The Tax Court held: “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 [one of his company’s] 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.”
Some slightly confusing aggregation rules also applied in this case (he worked at two related businesses), but ultimately the taxpayers (Lamases) prevailed here. In short, material participation in one’s investment activities is necessary to offset active income by means of deductions on one’s annual 1040.
U.S. Tax Court Blog 