The Tax Court in Brief – May 9th – May 13th, 2022
Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.
Tax Litigation: The Week of May 9th, 2022, through May 13th, 2022
- Lewis v. Commissioner, TC Memo. 2022-47| May 9, 2022 | Greaves, J. | Dkt. No. 10007-20W
- Jackson v. Comm’r, T.C. Memo. 2022-50 | May 12, 2022 | Vasquez, J. | Dkt. No. 19634-18L
- Evert v. Comm’r, T.C. Memo. 2022-48| May 9, 2022 | Marshall, A | Dkt. No. 12901-19
- Harrison v. Comm’r, T.C. Memo 2022-6 | May 12, 2022 | Panuthos, J | Dkt. No. 12170-19S
Rogerson v. Commissioner, TC Memo. 2022-49| May 12, 2022 | Toro, J. | Dkt. No. 5848-20
Summary: This deficiency case regards an evaluation of the passive activity loss rules of 26 U.S.C. § 469. Section 469 limits a taxpayer’s use of losses generated by passive activities to offset unrelated income generated by nonpassive activities. Michael Rogerson, the taxpayer, owned patents, and he led, for over 40 years as CEO, a number of companies in the aerospace industry. For the tax years in issue, he also owned two yachts that he intended for chartering and that sustained substantial losses in the tax years in issue. The federal income tax issues regarded section 469 and the consequences of Rogerson’s participation in these endeavors.
In 2014 and 2015, Rogerson reorganized the Rogerson companies into three corporations, referred to here as RAC, RAEG, and RC, each of which engaged in various lines of interrelated business and RC employed the executive team and provided administrative support to RAC and RAEG. Before and after the 2014 reorganization, the operations of RAEG’s business units remained generally the same. As he was before the reorganization, Rogerson continued to oversee and was very active in all aspects of the operations of the business as a whole, serving as CEO of RAC, RAEG, and RC from the time of their incorporation through the years at issue.
The yachts were called the TOTO and the Falcon Lair. In 2014, 2015, and 2016, Rogerson engaged a crew and contractors to manage, maintain, and repair TOTO, but the yacht was not charted. The Falcon Lair was not commercially registered during 2014, 2015, and 2016, nor was it chartered. But, Rogerson engaged a crew and a management company to manage the Falcon Lair.
In his personal income tax returns for 2014, 2015, and 2016, Rogerson reported his involvement in RAC and RC as nonpassive and his involvement in RAEG as passive. He reported income pursuant to Schedules K-1 issued to him by RAC, RAEG, and RC. Rogerson sought to apply a passive loss carryforward related to his pre-2014 TOTO activity to offset the passive income that he reported from RAEG. For 2014, 2015, and 2016, Rogerson reported his involvement in both the TOTO and the Falcon Lair as nonpassive. With respect to the TOTO and the Falcon Lair, Rogerson substantial claimed losses in 2014, 2015, and 2016.
Rogerson’s returns were examined, and the IRS concluded that Rogerson did not properly characterized his aerospace and yacht activities as passive and nonpassive. The IRS issued to Rogerson a notice of deficiency that recharacterized his activity with respect to RAEG as nonpassive and with respect to the yachts as passive. Regarding RAEG, the notice stated, among other things, that Rogerson “materially participated in RAEG” and therefore that “the income should be treated as non-passive income.” The notice determined deficiencies in Rogerson’s federal income tax of nearly $6,000,000, plus accuracy-related penalties of $1,115,934, for 2014, 2015, and 2016, combined. Rogerson petitioned the Tax Court seeking a redetermination of the deficiencies and penalties.
- Whether, for the tax years 2014, 2015, and 2016, Rogerson materially participated in certain of his aerospace activities, with the result that income from those activities must be treated as nonpassive?
- Whether Rogerson’s yacht activities during the same years were per se passive as rental activities?
- Whether Rogerson is liable for accuracy-related penalties on the underpayments of tax resulting from our first two holdings?
- Yes. Rogerson materially participated in his aerospace business as a whole from at least 2005 to 2013, and that participation remained substantially the same for the tax years following. A taxpayer is treated as materially participating in an activity during a preceding year if the activity was included in an activity, or substantially overlaps with an activity, in which the taxpayer materially participated for the preceding year. Treas. Reg. § 1.469- 5(j)(1). Thus, income from that activity must be treated as nonpassive in each of those years.
- Yes. The yacht activities were rental activities, as defined in the Treasury Regulations, and no exception applied. As such, Rogerson was not allowed to use the losses associated with the TOTO and the Falcon Lair endeavor to offset income from Rogerson’s nonpassive activities in RAEG.
- No. Rogerson reasonably and in good faith relied upon competent practitioner’s advice with respect to the passive versus nonpassive tax matters that resulted in the deficiency, and he provided all relevant and accurate information for the practitioner’s advice. Therefore, accuracy-related penalties were not warranted.
Key Points of Law:
- Burdens of Proof. In general, the IRS’s determinations set forth in a notice of deficiency are presumed to be correct, and the taxpayer bears the burden of showing that those determinations are in error. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). But the IRS bears the burden of proof with respect to any “new matter” he raises. See Rule 142(a).
- Section 469 and Passive Losses. Individual taxpayers may generally deduct, under sections 162 and 212 respectively, ordinary and necessary expenses paid or incurred in carrying on a trade or business or for the production of income. However, the Code disallows any current deduction for a “passive activity” loss. 26 U.S.C. § 469(a)(1), (b). A passive activity loss is the amount by which the aggregate losses from the taxpayer’s passive activities for a taxable year exceed the aggregate income from passive activities for that year. at § 469(d)(1).
- Passive losses cannot be used to offset income from nonpassive activities. See Beecher v. Commissioner, 481 F.3d 717, 721 (9th Cir. 2007), aff’g Cal Interiors Inc. v. Commissioner, T.C. Memo. 2004-99. A disallowed passive activity loss is not lost; rather, it is deferred or suspended and remains available as a deduction against future passive income. 26 U.S.C.S. § 469(b).
- Passive Activities. A passive activity generally is an activity involving the conduct of a trade or business in which the taxpayer does not materially participate. at § 469(c)(1). Subject to certain exceptions, rental activities are passive regardless of whether the taxpayer materially participates. Id. at § 469(c)(2), (4), (7).
- Material Participation. A taxpayer’s participation in an activity is “material” only if his or her involvement in the operations of the activity is regular, continuous, and substantial. at§ 469(h)(1). Temporary regulations first issued in 1988 provide seven tests for determining when this standard is satisfied. See Temp. Treas. Reg. § 1.469-5T(a) (stating that an individual will be treated as materially participating in an activity “if and only if” one of the seven tests is satisfied).
- Five of Ten Test. For purposes of section 469(h)(1), a taxpayer is treated as materially participating in an activity if he or she materially participated in the activity for any five out of the ten years immediately preceding the taxable year. Temp. Treas. Reg. § 1.469-5T(a)(5). The five of ten test applies to an activity that is the same over time, but the regulations also explain how to apply the test when a taxpayer’s activities change over time. In these circumstances, final regulations call for a comparison of the taxpayer’s current-year activities with the taxpayer’s preceding-year activities. See Reg. § 1.469-5(j)(1).
- Thus, if there is substantial similarity between the current-year activity and activities that the taxpayer materially participated in during a preceding year, then that preceding year counts as one year in applying the five of ten test to the current-year activity. If there is substantial similarity between the current-year activity and activities that the taxpayer materially participated in for five of the last ten years, then the five of ten test is satisfied and the taxpayer is treated as materially participating in the current-year activity for the current year. See id.; Temp. Treas. Reg. § 1.469-5T(a)(5), (j)(1).
- Rental Activities. Rental activities are passive regardless of a taxpayer’s participation, subject to certain exceptions. See 26 U.S.C. § 469(c)(2), (4), (7). A rental activity is “any activity where payments are principally for the use of tangible property.” at § 469(j)(8); see also Temp. Treas. Reg. § 1.469-1T(e)(3)(i) (stating that an activity is a rental activity if during the taxable year tangible property held in connection with the activity is used by customers or held for use by customers and gross income attributable to the activity represents amounts paid or to be paid principally for the use of the tangible property).
- Exceptions to Rental Activity. Six exceptions exist to the definition of “rental activity.” See Reg. § 1.469-1T(e)(3)(ii)(A)-(F). For one, an activity involving the use of tangible property is not a rental activity if for the taxable year—(1) the average period of customer use for the property is seven days or less; or (2) the average period of customer use for such property is 30 days or less, and significant personal services are provided by or on behalf of the owner of the property in connection with making the property available for use by customers. See id. at § 1.469-1T(e)(3)(ii)(A) and (B). A period of customer use is the period “during which a customer has a continuous or recurring right to use” the property. Id. at § 1.469-1(e)(3)(iii)(D). The average period of customer use is calculated by dividing the aggregate number of days in all periods of customer use of the property by the number of periods of customer use. Id. at § 1.469-1(e)(3)(iii)(C). To determine whether services are significant personal services, all of the relevant facts and circumstances are considered. See Temp. Treas. Reg. § 1.469-1T(e)(3)(iv)(A).
- Section 6662(a) Penalty. Section 6662(a) and (b)(1) and (2) imposes a penalty equal to 20% of the portion of an underpayment of tax required to be shown on a taxpayer’s return that is attributable to “[n]egligence or disregard of rules or regulations” and/or a “substantial understatement of income tax.” Negligence includes “any failure to make a reasonable attempt to comply with the provisions of this title.” 26 U.S.C. § 6662(c). An understatement of income tax is a “substantial understatement” if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. at § 6662(d)(1)(A). The Commissioner here has asserted section 6662(a) penalties on the basis of both negligence and substantial understatement.
- Reasonable Cause and Good Faith. A taxpayer may avoid a section 6662(a) penalty by showing that there was reasonable cause for the underpayment and that the taxpayer acted in good faith. 26 U.S.C. § 6664(c)(1). The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all of the pertinent facts and circumstances, including the taxpayer’s efforts to assess the proper tax liability and the taxpayer’s knowledge, experience, and education. Reg. § 1.6664-4(b)(1).
- Reasonable reliance on professional advice may constitute reasonable cause and good faith if the taxpayer proves, by a preponderance of the evidence, that (1) the adviser was a competent professional with sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser’s judgment. See Alt. Health Care Advocates v. Commissioner, 151 T.C. 225, 246 (2018); Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).
- “Most taxpayers are not competent to discern error in the substantive advice of an accountant or attorney. To require the taxpayer to challenge the attorney, to seek a ‘second opinion,’ or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place.’ ‘Ordinary business care and prudence’ do not demand such actions.” United States v. Boyle, 469 U.S. 241, 251 (1985).
Insights: Michael Rogerson appears to be an extraordinary individual and entrepreneur in the aerospace industry. But, his substantial losses associated with the intended passive activity of renting out his tangible property—the yachts, TOTO and the Falcon Lair—could not be used to offset income from Rogerson’s nonpassive activities in his business endeavor. From a penalty-assessment perspective, Roberson was able to stave off $1,115,934 in accuracy-related penalties by showing the Tax Court that he engaged competent tax counsel, provided that tax counsel with all necessary and accurate information relevant to Roberson’s business and yachting endeavors, and relied, in good faith, on that tax counsel’s advice.