Nestor CruzBy Néstor Enrique Cruz

Mr. Cruz is an Attorney and Counsellor at Dunlap Bennett & Ludwig and concentrates on Estate Planning and Taxation

Part 2

More than 5% Ownership of LMC

[06.13.19 Tysons]  As a threshold matter, the court needed to determine whether Stanley was at least a 5% owner of LMC so his services performed as an employee of LMC could be treated as performed in a real property trade or business for purposes of determining whether he was a qualifying taxpayer.

Taxpayer introduced in evidence a stock certificate evidencing ownership of 10 shares out of the 100 shares of LMC stock issued.  His stock was voting stock but was restricted by his employment agreement which stated taxpayer would relinquish his shares upon retirement.  Taxpayer’s salary from LMC was reported on a W-2 and income received from his 10% ownership was reported on a K-1 as distributions from an S corporation.  When the taxpayer retired and in accordance with his employment agreement, he transferred his shares back to James E. Lindsey, the controlling shareholder.

Given these facts, the court had no problem in finding Stanley to be a 5% owner.  The fact he had not made a capital contribution for his shares was not determinative as a capital contribution is not the only avenue to acquire shares.  Similarly, the court discounted the fact the stock was restricted as there is no statutory prohibition on restricted stock.  Finally, the court held if LMC were to treated as a partnership, Stanley had proved he owned more than 5% of the capital or profits interest of LMC.

Stanley as a Qualifying Taxpayer Under Section 469(c)(7)

The court found undisputed taxpayer spent over half of his working time performing services for LMC as he had no other employment.  It was also undisputed he spent more than 750 hours per year as an employee of LMC in 2009 and 2010.  Since he spent in excess of 500 hours per year participating in the activity, he materially participated in the activity.

The IRS argued the taxpayer needed to show time records of time spent on real property business and other business, such as legal services.  The court held there was no such requirement in Section 469.  Rather, the services must simply be performed in a real property business in which the taxpayer materially participates.  Taxpayer easily met the test.

Aggregation of Rental Activities and Grouping Rental with Non-Rental Activities

The court immediately found taxpayer appropriately elected to aggregate all of his rental activities.  The IRS, however, argued Stanley was categorically prohibited from grouping rental activities with other activities.  The court found Treasury regulations under Section 469 barred grouping only for purposes of determining material participation but did not bar grouping for determining passive losses.   26 C.F.R. Section 1.469-9 states “only the participation of the taxpayer with respect to the rental real may be used to determine if the taxpayer materially participates in the rental activity.”  The regulations do not say a real estate professional may not group rental activities with other activities for purposes of applying the passive loss rules.

The court then examined the regulation which permits grouping of activities which constitute “an appropriate economic unit”.  The factors to be considered under the regulations are similarities and differences in the businesses, the extent of common control, the extent of common ownership, geographical location, and interdependencies among the activities.  Moreover, a rental activity may not be grouped with another trade of business unless the activities being grouped together constitute an appropriate economic unit and the other business is insubstantial in relation to the rental activity.

The court found the aggregated Rental Activity, plus LMC, LCI, and the golf courses formed an appropriate economic unit.  The rental properties aggregated in taxpayer’s Rental Activity were managed by LMC, with telecommunications provided by LCI.  Also, every LMC-managed golf course is located next to an LMC-managed apartment complex.  The rental properties, LMC, LCI, and the golf courses worked in concert in connection with the rental real estate business.

James E. Lindsey or his family exerted common control over the rental properties, LMC, LCI, and the golf courses.  LMC was an S corporation with majority ownership by Lindsey.  The activities were located in Arkansas and nearby states.  The business model of LMC called for providing golf courses to the apartment houses.  Finally, LMC, LCI, and the golf course activities were insubstantial in relation to the Rental Activity.  The combined revenues of LMC, LCI, and the golf courses came to less than 20% of total revenue for those activities plus the rental properties, thus satisfying a case-law 80/20 rule of thumb for substantiality.  Thus, the taxpayer had reasonably shown he could properly group his Rental Activity with LMC, LCI, and the golf courses.

Material Participation by Stanley in the Grouped Activity

Under the regulations, in determining whether the taxpayer materially participates in the rental activity, work the taxpayer performs in the management activity is taken into account only to the extent it is performed in managing taxpayer’s own real estate interests.  The taxpayer had an ownership interest in 86% of properties managed by LMC.  Thus, the regulations should be read to allow all work engaged in by Stanley for the benefit of LMC to be counted as work performed in managing his own rental real estate, for purposes of material participation.

The IRS argued taxpayer had to categorize when he was acting as general counsel, general manager, and directly managing the property.  The court rejected this argument since management of the real estate, especially on a large scale, will necessarily involve legal and compliance issues, such as those in which the taxpayer spent much time.  The Service finally argued taxpayer should be given credit for participation only to the extent of his actual percentage ownership in any given property.  The court rejected this argument since the government cited no authority to support it nor was the court able to find any.

The district judge batted 1,000 in this case, but the case is about much more than how to properly structure real estate rental activities.  It shows vividly how costly the complexity of the Internal Revenue Code can be.  In its effort to protect the fisc, the IRS presented a reasonable prima facie case; however, after careful review by the court, it turned out taxpayer was right all along.  The resources dedicated by all participants, including the court, probably equaled or exceeded the amount in controversy.  The ultimate question is whether, under our present tax system, the game is worth the candle.

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Posted in: Estate Planning, Real Estate