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Formerly Passive S Corp Owner Materially Participates in Loss Year, Reaps $5.2 Million Tax Benefit.

(Parker Tax Publishing March 29, 2015)

An S corporation owner who stepped in and worked 691 hours to help the company recover from the former president's malfeasance passed the material participation test, opening the door to a loss carryback and a $5.2 million tax refund. Lamas v. Comm'r, T.C. Memo. 2015-59.

Background

Jose Lamas, along with his two sisters and one of their husbands, Masoud Shojaee, collectively owned Shoma Development Corp. (Shoma), an S corporation in the business of building and developing homes. Lamas had previously served as CEO of his father's company, which provided the initial funding for Shoma.

In 2004, Shoma formed Greens at Doral, LLC (Greens), a condominium conversion project. Shojaee, while acting as president of Shoma and Greens, used the company's assets for personal gain and usurped business opportunities. Shojaee used the company to guarantee loans for his personal business, and caused Shoma to donate $1.5 million to the University of Miami on his behalf. Shojaee also took a business opportunity from Shoma when he chose to build a real estate project on the company's land using one of his personally owned companies.

In early 2008, Lamas initiated a lawsuit on behalf of Shoma against Shojaee and eventually settled. Throughout 2008, Lamas worked on behalf of Shoma and Greens to restore the corporate assets and to find additional investors for Shoma's projects to fill its capital needs during the year's widespread economic turmoil.

Shoma had four major ongoing projects that required significant cash infusions and needed additional funds to make loan payments. Lamas worked to find investors and purchasers for these projects in an attempt to cure Shoma's capital deficit, using the contacts he had gained from his years as CEO of his father's company.

Lamas also worked in tandem with his father's trusted business advisor, and one of Shoma's board members, David Flinn, to promote Shoma's projects. After Lamas would make the initial pitch, Flinn would have the follow-up conversations. The pair traveled the country throughout 2008, making numerous conference calls and frequently dining with potential clients. Lamas even spoke with foreign investors, though no deals were finalized that year.

On Shoma and Greens' 2008 returns, Lamas claimed the significant losses the companies suffered as a tentative net-operating-loss carryback adjustment to 2006, resulting in a tentative refund of $5,260,964. The IRS determined that the 2008 losses were passive and that Lamas was not entitled to the tentative carryback adjustment, issuing a notice of deficiency.

OBSERVATION: "Tentative carryback adjustments" are a special procedure under Code Sec. 6411(a) that allows a taxpayer to apply for a quick refund for carryback adjustments made for net operating losses, net capital losses, or excess general business credits.

Analysis

Code Sec. 469 prevents taxpayers from using losses from passive activities to offset nonpassive income. A passive activity is any trade or business in which the taxpayer does not materially participate (Code Sec. 469(c)). Generally, taxpayers materially participate if they are involved in the operations of the trade or business on a regular, continuous, and substantial basis (Code Sec. 469(h)(1)). Taxpayers can satisfy the material participation requirement if they participate in the trade or business activity for more than 500 hours during the year, as long as an exception does not apply (Reg. Sec. 1.469-5T(a)(1)).

Aggregation of Hours

The Tax Court first reviewed whether it was appropriate to aggregate the hours Lamas worked for Shoma and Greens for 2008 and treat them as a single activity under the five factor test in Reg Sec. 1.469-4(c). The factors are:

(1) Similarities and differences in types of trades or businesses;

(2) The extent of common control;

(3) The extent of common ownership;

(4) Geographical location; and

(5) Interdependencies between or among the activities.

The court found that the two companies meet all five factors and could be treated as a single activity for purposes of aggregating the hours Lamas worked: Shoma and Greens were similar businesses as both engaged in commercial and residential real estate development; they shared common control and ownership; they shared geographic locations as Greens operated out of Shoma offices; and finally, they were interdependent as Greens used Shoma employees and consolidated its financial reporting with Shoma's.

After aggregating the hours Lamas spent working for Shoma and Greens, the court found that he materially participated in managing the companies. Lamas presented witness testimony and phone records to show that he worked at least 691 hours for Shoma and Greens during 2008, restoring corporate assets to Shoma and seeking potential investors. The only conflicting testimony was from Shojaee, but the court gave it little weight, noting it was rife with inconsistencies and his personal conflicts with Lamas which called his credibility into question.

Overcoming Exceptions to the 500-Hour Requirement

The tax court then evaluated whether an exception applied that would preclude counting Lamas' hours as participation, noting the two potentially relevant exceptions under Reg. Sec. 1.469-5T(f)(2) were (1) work not customarily done by owners and (2) participation as an investor.

Under the first exception, a taxpayer's participation is not counted toward the requisite hours if the taxpayer does work that is not customarily done by an owner, and does such work in an attempt to avoid the disallowance of passive losses.

The tax court found Lamas participated in work customarily done by owners, and he did not do the work with a purpose of avoiding the Code Sec. 469 loss limitations. The court noted Lamas worked restoring Shoma assets and opportunities and finding potential investors for company projects. In contrast to the example in the regulations, the court found those activities were customarily done by owners. Further, Lamas' purpose was to protect his investment in Shoma by helping the company to survive, and accordingly, the court found the avoidance exception did not apply.

Under the second exception, a taxpayer is prevented from counting time he worked in his capacity as an investor unless he was directly involved in the day-to-day management or operations of the activity. Investor activity includes:

(1) studying and reviewing financial statements or reports on operations of the activity;

(2) preparing or compiling summaries or analyses of the finances or operations of the activity for the individual's own use; and

(3) monitoring the finances or operations of the activity in a non-managerial capacity.

The IRS argued Lamas was merely acting as an investor when he was promoting Shoma and looking for new purchasers, citing Tolin v. Comm'r, T.C. Memo. 2014-65.

The court found the exception did not apply as Lamas' work restoring capital and promoting the companies was an integral part of the day-to-day operations during 2008. The court concluded that the IRS had mischaracterized the Tax Court's findings in Tolin by stating that it did not reach the issue of whether the taxpayer's promotional efforts, such as talking with people over lunch in a social context, amounted to day-to-day management of the taxpayer's stallion breeding business. The court noted that in fact, the Court found the core part of the taxpayer's business in Tolin was the promotional efforts involved his personal solicitation of individuals to breed their mares to his stallion.

The Tax Court ultimately concluded that, like the taxpayer in Tolin, most of Lamas' work was promotion, and this promotion went to the core goal for Shoma at the time, which was to find project investors. Accordingly, the investor exception did not apply, and all of Lamas' work for Shoma, including investor activity, qualified as participation.

Conclusion

Lamas materially participated in Shoma and Greens for 2008, working to restore lost assets, promoting the company, and seeking out potential investors and purchasers for ongoing projects. Lamas' time spent working on these matters during 2008 totaled at least 691 hours, well in excess of the regulations' 500 hour requirement. In addition, neither the avoidance nor investor exceptions applied, as Lamas' promotional activities were activities customarily done by owners and he was involved in the day-to-day operations of the companies. Accordingly, the Tax Court held that the flow-through losses from Shoma and Greens were not passive and allowed the tentative carryback and associated refund.

For a discussion of the material participation requirements, see Parker ¶247,115.(Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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