The Tax Court held that a taxpayer established material participation in his businesses in Lamas v. Commissioner,T.C. Memo 2015-59 (March 25, 2015), and the decision provides insight into how the court views substantiation of participation, the rule regarding investor hours and the validity of a grouping election. The case also serves as a cautionary tale regarding the tax exposure and costly litigation taxpayers can face when they don't document their participation in their business activities.
The taxpayer in Lamas sought to establish material participation to avoid passive characterization under Section 469. Generally, losses from passive activities can be deducted against income from passive activities, with the excess carried forward. The rules have become more important since Section 1411 was enacted. Section 1411 and the related regulations began imposing a 3.8% tax on net investment income (NII) in 2013, and NII generally includes any passive income under Section 469.
Under Section 469, a taxpayer must generally materially participate in an activity to avoid passive status. A taxpayer can use any of seven tests to establish material participation, and the IRS argued that Lamas did not meet any of them. The court ruled that Lamas met at least two, including the most common test: 500 hours of participation.
The court largely accepted phone records and witness testimony as substantiation for many of the hours Lamas claimed to have worked in the activity. The regulations provide that taxpayers can prove participation by "any reasonable means" and specifically state that contemporaneous logs aren't required. However, the Tax Court ruled in 1993 (Goshorn v. Commissioner, T.C. Memo. 1993-578) and many times since that a "ballpark guesstimate" made in hindsight is not acceptable documentation. These decisions created uncertainty over what kind of testimony and affidavits are sufficient documentation.
In Lamas, the court found the testimony of 10 witnesses backed by phone records to be credible enough to establish the taxpayer's participation. It also accepted the taxpayer's election to group his two activities together as one under Section 469, although there appeared to be little question they represented an appropriate economic unit.
The analysis of whether any of the hours of participation were disqualified as investor hours is more valuable. Treas. Reg. Sec. 1.469-5T(f)(2) excludes any work done in an "individual's capacity as an investor," and the IRS had argued that Lamas' hours didn't qualify under this rule. The Tax Court noted that under the regulation, investor hours can be counted toward material participation if the "individual is directly involved in the day-to-day management or operations of the activity." The court determined that Lamas' efforts to secure capital for development projects and promote the business were essential to the company and should be considered participation in the day-to-day management of the activity. Thus, all of his hours — even those that were arguably investor hours — counted toward the material participation threshold.
The Tax Court cited Tolin v. Commissioner (T.C. Memo 2014-65), in which the court ruled that promoting a stallion for stud by promoting the horse and soliciting interest in networking and industry events qualified as participation. The court said the IRS's characterization of the Tolin ruling was too narrow and that the case directly supports the idea that promotional activity can be considered part of day-to-day management and operation of a business.
Finally, it's important note why the IRS challenged the participation. While this was a clear and decisive victory for the taxpayer, the victory required litigation in the Tax Court. The IRS's decision to challenge appears to result from two factors. The taxpayer had kept no record of his efforts on behalf of the businesses. When Lamas couldn't produce appointment books, calendars or other documentation of his involvement with the entities, the IRS was likely skeptical. The second factor was the taxpayer's brother-in-law. A business dispute seems to have motivated the brother-in-law to write a letter to the IRS during audit that said that "Mr. Lamas had no direct or indirect involvement with" the entities. This letter appears to have caused the IRS to dismiss as self-serving the declarations from Mr. Lamas' business associates. If Lamas kept an electronic calendar of his business appointments (with notes regarding the purpose of the meetings) or similar records, the IRS might have been satisfied despite the declaration of a disgruntled business partner.
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