As a tax guy, I feel obligated to peruse the Tax Court decisions each day when they’re released. Most days, it’s the same old thing: real estate professional case here, innocent spouse case there, prostitution medical deduction case here, and so on…But every now and again, you stumble upon a bit of an anomaly that breaks up the monotony and stimulates your inner dork, like finding a mutant conjoined Honeycomb in your morning cereal. Today was one of those days.
See, occasionally, the Tax Court will hear cases with a similar fact pattern or unifying characteristic all in the same day. Consider, for example, the “Joseph M. Grey” day, in which five separate S corporation shareholder/employees — all clients of Grey’s, a CPA — wound up in front of the Tax Court on reasonable compensation issues. Or for a more recent example, look no further than December 28, 2011, when the Tax Court decided two nearly identical constructive liquidation” cases on the same afternoon.
Today, in three separate cases tried by the same attorney and centering around solar incentives offered by the same Hawaiian company, the Tax Court held that the “solar sale activities” of three taxpayers were passive activities, and thus the losses generated by the activities could not offset non-passive income.
In each of the cases, the fact pattern, taxpayer argument, and ultimate decision were virtually identical, so we’ll address them all together:
Each taxpayer wished to acquire a solar water heater for personal use, but were enticed by a program run by a local solar provider that was billed as a way to get your heater for “free.” To do so, the solar company required the taxpayer to buy one heater for personal use, and one for investment purposes. The investment heater would then be installed at the home or business of a “ratepayer,” who would pay a monthly fee to the taxpayer for the solar energy. Through the combination of financing available on the purchases and the tax benefits provided by a Section 179 deduction on the investment heater, the taxpayer could essentially pay for the personal heater used in his home.
Once the investment heater was installed, the taxpayer had little responsibility. A separate LLC was engaged to collect the monthly payments from the ratepayer and make certain payments on behalf of the taxpayer.
The solar activity invariably generated a loss, which all three taxpayers deducted in full on their tax return. The IRS, however, argued that the losses were passive and thus were limited to offsetting passive income.[i]
Continuing the theme it established on Monday, the Tax Court looked to I.R.C. § 469 to settle the dispute. Section 469 defines a passive activity as a trade or business in which the taxpayer does not materially participate. The point, obviously, is that a taxpayer should not be permitted to offset earned income with losses that a taxpayer did little to create.
There are seven tests a taxpayer can satisfy to prove material participation under the proposed regulations[ii], two of which were at issue in today’s cases:
Test #2: The individual’s participation in the activity constitutes substantially all of the participation by all individuals in the activity for the year;
Test #3: The individual spends more than 100 hours on the activity for the year, and no other individual spends more; and
The Tax Court held that the taxpayers failed to satisfy both of these material participation tests, as a combination of inactivity and inadequate records doomed their claims:
Test #2: …because individuals with PCC collected payments, maintained records regarding the income, and made petitioner’s loan and State excise tax payments and individuals with Mercury Solar installed the equipment at his ratepayers’ homes, petitioner’s participation did not constitute substantially all of the participation of any individual in the microutility activity.
Test #3: Petitioners also have failed to prove that petitioner participated in the microutility activity for more than 100 hours during each of the years in issue. Petitioner maintained no records or documentation of his participation such as appointment books, calendars, or logs, and he did not provide any type of narrative summary of his participation. Petitioner admitted that Mercury Solar provided him with his ratepayers and that he has never met any of them. Apart from very general statements that he talked to some people about becoming ratepayers and referred sales leads to Mercury Solar, petitioner offered virtually no evidence of duties he performed, the dates they were performed, or the approximate time he spent performing them.
As a result, the taxpayers were unable to deduct the losses generated by the solar activity against non-passive income. The lesson? Just because you feel like you materially participate in an activity doesn’t make it so; you have to be prepared to prove that you satisfy one of the seven tests under the temporary regulations, and as with all tax deductions, substantiation is key.