IRS Practice and Procedures News Briefs for January 2017

PASSIVE INCOME AND LOSSES – Hardy v. Commissioner, T.C. Memo. 2017-16 (2017)

Why This Case is Important: For tax purposes, activities entered into for profit, and the income and losses from those activities, are characterized as active or passive. This characterization is important because passive losses can only be used to offset passive income (and not active income). This case analyzes the differences between active and passive activities.

Facts: In Hardy, the taxpayer was a plastic surgeon who had been practicing for over 20 years. He conducted his practice through his LLC. In 2006, he purchased an interest in MBJ, a surgical center. By doing so, he would be able perform surgeries there rather than at hospitals, reducing his patients’ facility fees. The taxpayer had no management or day-to-day responsibilities with respect to MBJ. His only involvement was performing surgeries there when necessary. His only income from MBJ was income he earned as an owner, which amounted to a share of all MBJ patients’ facility fees, not just the fees from his patients. In 2006 and 2007, the taxpayer’s accountant reported his income from MBJ as active. In 2008, he determined that the MBJ income was more properly characterized as passive income because the taxpayer had no active participation in MBJ’s management and he report it as such. This enabled them to offset $250,000 of passive losses. They used the same reporting method in 2009 and 2010. The IRS examined the returns and determined that the MBJ income was active. It adjusted the taxpayer’s returns and issued a notice of deficiency. The taxpayer contested the adjustments in the U.S. Tax Court.

Law and Analysis: Section 469 of the Internal Revenue Code disallows losses from passive activities in excess of income from such activities. A passive activity is defined as a trade or business in which the taxpayer does not materially participate. A taxpayer materially participates in an activity if the taxpayer is involved in the operations of the activity on a regular, continuous, and substantial basis. The IRS argued that, in analyzing the taxpayer’s involvement in MBJ, his active participation in his operating LLC must be taken into account – the activities must be “grouped.” The Court disagreed. Because the taxpayer had never grouped the activities together for tax purposes, and because the taxpayer’s interests and involvement in the two entities were clearly separate, the Court found that they should be grouped separately for tax purposes. With the taxpayer having no active involvement in MBJ’s operations, his income from MBJ was properly characterized as passive and could be used to offset passive losses.

CORPORATE OR PERSONAL INCOME – Fleischer v. Commissioner, T.C. Memo. 2016-238 (2016)

Why this Case is Important: For tax purposes, it is often advantageous for self-employed individuals to operate their business through an S corporation. As this case demonstrates, forming an S corporation is not enough; proactive steps must be taken for income to be earned by and taxed to the corporation and not the individual.

Facts: In Fleischer, the taxpayer was a licensed financial planner and consultant. In 2006, he left his employment with a financial firm to start his own practice. He personally entered into an independent contractor agreement with LPL Financial, a broker-dealer. He then incorporated FWP, of which he was the sole shareholder. FWP elected to be taxed as an S corporation. He entered into an employment agreement with FWP and FWP agreed to pay him an annual salary for providing financial services to its clients. In 2008, the taxpayer personally entered into another broker agreement with Mass Mutual. The agreement did not reference FWP. In 2009, FWP filed a tax return reporting income of $148,000 (the compensation reported on Forms 1099 issued to the taxpayer by LPL and Mass Mutual) and expenses of $136,000. FWP then issued a Form K-1 to the taxpayer reporting flow-through income of $12,000. He reported this on his personal return along with $35,000 of wages from FWP. Similar returns were filed in 2010 and 2011. The IRS examined these returns and determined that the 1099 income should have been reported on the taxpayer’s personal returns (rather than FWP’s returns) and subjected to self-employment tax. It issued notices of deficiency assessing taxes of $40,000 and the taxpayer filed a Tax Court petition contesting these notices.

Law and Conclusion: When determining whether income should be attributed to an individual service provider or his corporation, the question is who controlled the earning of the income. For a corporation to control the earning of income: (1) the individual providing the services must be an employee of the corporation whom the corporation can direct and control in a meaningful sense, and (2) there must exist between the corporation and the client a contract or other indicium recognizing the corporation’s controlling position. In this case, because the agreements with LPL and Mass Mutual made no reference to FPW, the second requirement was not met. That being the case, the Court held that the IRS was correct in treating the 1099 income as the taxpayer’s income, meaning it was subject to self-employment taxes.

DEDUCTION OF TRAVEL EXPENSES – Engstrom v. Commissioner, No. 15-70591 (9th Cir. 2016)

Why This Case is Important: For taxpayers to deduct certain types of business expenses, they must satisfy heightened substantiation requirements. One of these categories of expenses is travel expenses. This case discusses the strict requirements and is a good example of the result of failing to meet these requirements.

Facts: In Engstrom, the taxpayer was a law firm. One of taxpayer’s owners (Mr. Lack) and another attorney who had no interest in the taxpayer were partners in a partnership (G & L) that owned two airplanes. From 2007 through 2010, the taxpayer claimed approximately $4 million in tax deductions related to its use of the airplanes - $1.7 million of these expenses were paid directly by the taxpayer, with the other $2.3 million having been paid by Mr. Lack, personally. The IRS found that the taxpayer failed to substantiate all of the G & L related deductions and disallowed them in full. The taxpayer contested this disallowance in Tax Court. The Court held that the taxpayer could not deduct flights paid for by Mr. Lack, personally, despite the taxpayer’s argument that those payments constituted loans to the taxpayer for which Mr. Lack would be repaid. With respect to taxpayer’s direct payments to G & L, the Court found that payments for flights transporting taxpayer’s employees other than Mr. Lack were deductible, as were payments for flights that transported Mr. Lack to law conferences and legal proceedings. It upheld the IRS’s disallowance of all other payments to G & L. The taxpayer appealed these disallowances to the Ninth Circuit Court of Appeals.

Law and Analysis: Under Section 274(d) of the Internal Revenue Code, to claim a travel expenses as a deduction, the taxpayer must substantiate the amount of the expense, the time and place of travel, and the business purpose of the expense. Unlike expenses that are subject to Section 274, travel expenses cannot be estimated, though a taxpayer is not required to substantiate the business purpose of a travel expense where the purpose is evident from all facts and circumstances. With respect to the Tax Court’s disallowance of all expenses paid by Mr. Lack, the Appeals Court agreed that there was not sufficient evidence to show that the taxpayer intended to repay those amounts. With respect to the other disallowances, the Appeals Court agreed that the taxpayer either did not substantiate the business purpose or specific expense of the flights in question. Based on these findings, the Appeals Court upheld the Tax Court’s disallowances.

If you would like more details about these cases, please contact me at 312-888-4113 or jnesser@lavellelaw.com