United States

Taxpayers prove participation based on facts and circumstances

TAX ALERT  | 

In a recent memorandum opinion involving the application of the passive activity rules (see Brown v. Commissioner T.C. Memo. 2019-69), the U.S. Tax Court held that the taxpayers, despite failing to prove they met any of the quantitative material participation tests provided for in regulatory guidance, nonetheless materially participated in their restaurant business. As such, the court affirmed the taxpayers’ ability to deduct currently their share of the restaurant’s operating losses. In its decision, the court found that the taxpayers were able to prove based on all the facts and circumstances that they participated in the activity on a regular, continuous and substantial basis.

In Brown, the taxpayers and another couple opened a restaurant in New Mexico in 2008 – the taxpayers providing the funding and business experience, while another couple ran the day-to-day operations. The restaurant ultimately proved unsuccessful and eventually closed in 2010. The taxpayers claimed business losses in full on their tax returns for the years the restaurant was in operation. Upon exam, the IRS challenged the deductibility of these losses, arguing that the taxpayers did not materially participate in the restaurant's business.

Generally, a taxpayer may not deduct net losses from passive activities – defined as any activity involving the conduct of a trade or business in which the taxpayer does not materially participate.  Treasury regulations provide several quantitative tests a taxpayer can meet in order to establish material participation – with the majority of those tests relying on various quantitative hours thresholds (most notably, the 500+ hours test). The taxpayers in Brown believed they satisfied several of these quantitative tests, but the court disagreed.

However, the regulations also provide a “facts and circumstances” test. To satisfy this test, taxpayers must prove, based on all facts and circumstances that, they participated in an activity on a regular, continuous and substantial basis. Although the taxpayers in Brown did not have detailed records of the time spent in the activity, the court concluded that in each relevant year the taxpayers:

  1. Participated for more than 100 hours (i.e., the minimum threshold to potentially rely on the facts and circumstances test)
  2. Performed important operational roles in the restaurant – including finance/accounting, product development and other activities

The court ultimately found that the taxpayers’ participation was integral to the company’s operation, and as such was sufficient to satisfy the facts and circumstances test.

The case is interesting in that it provides rare insight into the circumstances where taxpayers may be able to rely on the facts and circumstances test to establish material participation. It also serves as a useful reminder of the importance of maintaining sufficient records in order support the objective hours-based tests. Satisfying one of the quantitative tests provides much more certainty than does relying on the facts and circumstances test at issue in this case.  

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