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Thursday, January 10, 2013
Section 469 - not passive income
Donald R. Fitch, et ux. v. Commissioner, TC Memo 2012-358 , Code Sec(s) 162; 453; 1001; 6662; 7491.
DONALD R. FITCH AND BRENDA T. FITCH, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent .
Code Sec(s): 162; 453; 1001; 6662; 7491
Docket: Docket Nos. 157-10, 27401-10,
Date Issued: 12/26/2012
I. General Rules The Commissioner's determinations are generally presumed correct, and the taxpayer bears the burden of proving the determinations erroneous. 8 Rule 142(a);
New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 [13 AFTR 1180] (1934). The taxpayer bears the burden of proving that he or she is entitled to the deductions claimed, and this includes the burden of substantiation. Hradesky v. Commissioner, 65 T.C. 87, 90 (1975), aff'd per curiam, 540 F.2d 821 [38 AFTR 2d 76-5935] (5th Cir. 1976). A taxpayer must substantiate amounts claimed as deductions by maintaining the records necessary to establish that he or she is entitled to the deductions. Sec. 6001; sec. 1.6001-1(a), Income Tax Regs.
Taxpayers are allowed a deduction for ordinary and necessary expenses paid or incurred in carrying on a trade or business. Sec. 162(a). Whether an expenditure is ordinary and necessary is generally a question of fact. Commissioner v. Heininger , 320 U.S. 467, 475 [31 AFTR 783] (1943). Generally, for an expenditure to be an ordinary and necessary business expense, the taxpayer must show a bona fide business purpose for the expenditure; there must be a proximate 8
Petitioners have neither claimed nor established that they satisfy the requirements of sec. 7491(a) for any of the issues remaining for decision. Accordingly, the burden of proof does not shift to respondent. [*10] relationship between the expenditure and the business of the taxpayer. Challenge Mfg. Co. v. Commissioner 37 T.C. 650 (1962); Henry v. Commissioner, , 36 T.C. 879 (1961). To be “necessary” within the meaning of section 162, an expense needs to be “appropriate and helpful” to the taxpayer's business. Welch v. Helvering, 290 U.S. 111, 113 [12 AFTR 1456] (1933). The requirement that an expense be “ordinary” connotes that “the transaction which gives rise to it must be of common or frequent occurrence in the type of business involved.” Deputy v. du Pont, 308 U.S. 488, 495 [23 AFTR 808] (1940) (citing Welch v. Helvering, 290 U.S. at 114).
When taxpayers establish that they have incurred deductible expenses but are unable to substantiate the exact amounts, we can estimate the deductible amount in some circumstances, but only if the taxpayers present sufficient evidence to establish a rational basis for making the estimate. See Cohan v. Commissioner, 39 F.2d 540, 543-544 [8 AFTR 10552] (2d Cir. 1930); Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985). In estimating the amount allowable, we bear heavily against taxpayers whose inexactitude is of their own making. See Cohan v. Commissioner, 39 F.2d at 544. There must be sufficient evidence in the record, however, to permit us to conclude that a deductible expense was paid or incurred. Williams v. United States, 245 F.2d 559, 560 [51 AFTR 594] (5th Cir. 1957). Furthermore, we may not use the Cohan doctrine to estimate expenses subject to the strict [*11] substantiation requirements of section 274(d). See Sanford v. Commissioner, 50 T.C. 823, 827 (1968), aff'd, 412 F.2d 201 [24 AFTR 2d 69-5021] (2d Cir. 1969).
II. Amortization of the C.P.A. Practice A taxpayer is entitled to an amortization deduction with respect to any amortizable section 197 intangible, the amount of which is determined by amortizing the adjusted basis of the intangible ratably over a 15-year period beginning with the month in which it was acquired. Sec. 197(a). An amortizable section 197 intangible is any section 197 intangible 9 acquired by a taxpayer after
August 10, 1993, and held in connection with the conduct of a trade or business. Sec. 197(c)(1). For purposes of depreciation and amortization, a taxpayer's basis in purchased property is the cost, including any valid liabilities incurred in acquiring the property. Crane v. Commissioner, 331 U.S. 1 [35 AFTR 776] (1947). Petitioners claimed a $900,000 cost basis in the C.P.A. practice as a result of the repurchase transaction, and they claimed an amortization deduction of $45,000 in each of the years in issue on their tax return. 10 Respondent principally argues that “the alleged [*12] sales agreements petitioners submitted are untrustworthy and the alleged sales did not take place”. Alternatively, respondent argues the sale and repurchase transactions were rescinded or that petitioners reacquired self-created intangibles of the C.P.A. practice in a series of related transactions. 11 We address each of respondent's arguments in turn.
Respondent contends that petitioners presented false testimony and fabricated documents in an attempt to prove that the transactions took place. We disagree. We find petitioners' testimony to be credible and persuasive. See Diaz v. Commissioner, 58 T.C. 560, 564 (1972) (stating that the process of distilling truth from the testimony of witnesses, whose demeanor we observe and whose credibility we evaluate, is the daily grist of judicial life). Furthermore, we find the sale and repurchase agreements to be genuine and trustworthy. [*13] Respondent attacks the agreements for their brevity, arguing that they lack “details that would certainly be present on an authentic sales contract of nearly one million dollars.” 12 However, the circumstances surrounding the sale and repurchase transactions present a different story. Mr. Fitch was recovering from an aneurysm at the time he sold the C.P.A. practice to Mr. Gronke. They had a working relationship dating back to 1996, and they understood the need to effect a quick sale on account of Mr. Fitch's medical condition. They put the basic elements of their agreement into writing and left the details to be sorted out later. Likewise, when Mr. Gronke suffered a seizure, they signed a similar agreement to effect a quick repurchase. In these circumstances, we find it hard to believe that a lack of details somehow suggests the agreements were fabricated. Respondent does not argue that the sale and repurchase agreements are invalid or unenforceable under State law. Accordingly, we find that petitioners have proven that the sale and repurchase transactions actually took place.
Next, respondent argues that the sale and repurchase transactions were rescinded. Rev. Rul. 80-58, 1980-1 C.B. 181, defines rescission as “the abrogation, canceling, or voiding of a contract that has the effect of releasing the [*14] contracting parties from further obligations to each other and restoring the parties to the relative positions that they would have occupied had no contract been made.” “For the rescission to be effective, both buyer and seller must be put back in their original positions.” Hutcheson v. Commissioner, T.C. Memo. 1996-127 [1996 RIA TC Memo ¶96,127] (citing Rev. Rul. 80-58, 1980-1 C.B. at 181). “A rescission may be effected by mutual agreement of the parties, by one of the parties declaring a rescission of the contract without the consent of the other if sufficient grounds exist, or by applying to the court for a decree of rescission.” Rev. Rul. 80-58, 1980-1 C.B. at 181-182.
The repurchase agreement, by its own terms, effected a sale of the C.P.A. practice from Mr. Gronke to Mr. Fitch and not an unwinding of the earlier sale. There is no evidence that Mr. Fitch and Mr. Gronke intended to abrogate, cancel, or void the sale agreement. Furthermore, we do not believe that the repurchase agreement returned them to their original positions. The C.P.A. practice continued as a dynamic, ongoing enterprise for approximately 4-1/2 months after the sale transaction, and we cannot say that Mr. Fitch received the C.P.A. practice back in the exact same condition in which he had sold it. Accordingly, we find that the sale and repurchase transactions were not rescinded. [*15] Respondent cursorily cites section 1.197-2(d)(2)(iii)(C), Income Tax Regs., in support of the position that “no amortization is available under I.R.C. § 197 for self-created intangibles that are repurchased as part of a series of related transactions”. Self-created intangibles generally are not amortizable. Sec. 197(c)(2). However, an exception is provided if a taxpayer disposes of a self-created intangible and subsequently reacquires the intangible from a seller (in whose hands the intangible is amortizable) in an unrelated transaction. Sec. 1.197- 2(d)(2)(iii)(C), Income Tax Regs.
Almost all of the intangibles that Mr. Fitch reacquired in the repurchase transaction were originally created by him. The issue therefore turns on whether the sale and repurchase transactions were related transactions. We find that the transactions were impelled by separate business exigencies, namely Mr. Fitch's anuerysm and Mr. Gronke's seizure. It is hard to believe these medical conditions could have been predicted or the transactions necessitated by them preplanned. We find that the sale and repurchase transactions are not related transactions, and therefore the rules generally disallowing the amortization of self-created intangibles do not apply. 13 [*16] Accordingly, petitioners are entitled to an amortization deduction of $60,000 for each of the years in issue.
III. Deductibility of the Rental Real Estate Losses
A. The E Street Property
Section 212 allows as a deduction all the ordinary and necessary expenses paid during the year for the production or collection of income, sec. 212(1), or for the management, conservation, or maintenance of property “held for the production of income”, sec. 212(2). Section 167(a)(2) allows as a deduction a reasonable allowance for depreciation of property “held for the production of income.” The phrase “held for the production of income” has the same meaning in section 212 and section 167. Mitchell v. Commissioner, 47 T.C. 120, 129 (1966). Expenses and depreciation may be deducted only if the property is held for production of income during the taxable year at issue. Meredith v. Commissioner, 65 T.C. 34, 41 (1975). Section 1.212-1(b), Income Tax Regs., provides: “ordinary and necessary expenses paid or incurred in the management, conservation, or maintenance of a building devoted to rental purposes are deductible notwithstanding that there is actually no income therefrom in the taxable year, and regardless of the manner in which or the purpose for which the property in question was acquired.” Furthermore, expenses paid or incurred in [*17] connection with investment property may be deductible under this regulation, “even though the property is not currently productive and there is no likelihood that the property will be sold at a profit or will otherwise be productive of income and even though the property is held merely to minimize a loss with respect thereto.” Sec. 1.212-1(b), Income Tax Regs. Whether property is held for the production of income is a question of fact to be determined from all the facts and circumstances. Johnson v. Commissioner, 59 T.C. 791 (1973), aff'd, 495 F.2d 1079 [33 AFTR 2d 74-1102] (6th Cir. 1974).
Mr. Fitch and his two brothers each inherited a one-third interest in the E Street property in early 2005 when their mother passed away. They immediately tried to sell the property but did not receive a satisfactory offer. Toward the end of 2005 Mr. Fitch purchased an additional one-third interest from one of his brothers and as of the time of trial owned a two-thirds tenancy in common with his other brother.
While Mr. Fitch did not succeed in renting the E Street property in 2005 to 2007, we find that he held the property for the production of income. 14 He credibly testified that he intended to make the property into a rental when he [*18] purchased the one-third interest from his brother. To that effect, he posted a “for rent” sign on the property, placed an advertisement on Craigslist, and secured bids with insurance companies for a landlord protection policy. He further credibly testified that he performed property management services at least weekly in 2005 and continued performing those services in 2006 and 2007. Accordingly, he incurred expenses for the management, conservation, or maintenance of property held for the production of income, and he is entitled to deduct those expenses under section 212.
B. Passive Activity Loss Limitation Rules
Deductions for certain business and investment expenses pursuant to sections 162 and 212 may be limited under section 469, which generally disallows any passive activity loss for the tax year. A passive activity is any trade or business in which the taxpayer does not materially participate. Sec. 469(c)(1). A passive activity loss is defined as the excess of the aggregate losses from all passive activities for the year over the aggregate income from all passive activities for such year. Sec. 469(d)(1). A rental activity is generally treated as a per se [*19] passive activity regardless of whether the taxpayer materially participates. 15 Sec. 469(c)(2).
Pursuant to section 469(c)(7), the rental activities of a taxpayer who is in the real property business (real estate professional) are not per se passive activities but are treated as a trade or business subject to the material participation requirements of section 469(c)(1). Sec. 1.469-9(e)(1), Income Tax Regs. A taxpayer qualifies as a real estate professional and is not engaged in a passive activity under section 469(c)(2) if:
(i) more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
(ii) such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates. Sec. 469(c)(7)(B). A real property trade or business is defined in section 469(c)(7)(C) as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.” In the case of a joint return, the foregoing [*20] requirements for qualification as a real estate professional are satisfied if, and only if, either spouse separately satisfies the requirements. Sec. 469(c)(7)(B). All of a taxpayer's real estate activities are taken into account to determine whether the 750-hour requirement is satisfied. See Fowler v. Commissioner, T.C. Memo. 2002-223 [TC Memo 2002-223]; Bailey v. Commissioner, T.C. Memo. 2001-296 [TC Memo 2001-296].
Section 1.469-5T(f)(4), Temporary Income Tax Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988), provides:
The extent of an individual's participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries. We have held that the regulations do not allow a postevent “ballpark guesstimate”. Bailey v. Commissioner, T.C. Memo. 2001-296 [TC Memo 2001-296]; Goshorn v. Commissioner, T.C. Memo. 1993-578 [1993 RIA TC Memo ¶93,578]. Mrs. Fitch works full time as a licensed real estate agent. She credibly testified that she works weekdays and many weekends, and typically wakes up at 6 a.m. to review business emails, new real estate listings, and buyer criteria for her clients. She credibly testified that in addition to the time she spent managing her [*21] rental real estate, she spent more than 750 hours each year in 2005 to 2007 performing real estate related activities as an independent contractor with Remax, which we find qualifies as a real property trade or business under section 469(c)(7)(C). She further credibly testified that she was not involved in any activities besides real estate. We find Mrs. Fitch has established that she separately satisfies the requirements to qualify as a real estate professional under section 469(c)(7), and therefore petitioners' rental activities are subject to the material participation requirements of section 469(c)(1).
Material participation is defined as involvement in the operations of the activity that is regular, continuous, and substantial. Sec. 469(h)(1). As explained insection 1.469-5T(a), Temporary Income Tax Regs., 53 Fed. Reg. 5696 (Feb. 25, 1988), a taxpayer can satisfy the material participation requirement if the individual meets any one of the seven regulatory tests:
(1) The individual participates in the activity for more than 500 hours during such year;
(2) The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;
(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in [*22] the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;
(4) The activity is a significant participation activity *** for the taxable year, and the individual's aggregate participation in all significant participation activities during the year exceeds 500 hours;
(5) The individual materially participated in the activity *** for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;
(6) The activity is a personal service activity *** , and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the taxable year; or
(7) Based on all of the facts and circumstances *** , the individual participates in the activity on a regular, continuous, and substantial basis during such year. “Participation” generally means all work done in an activity by an individual who owns an interest in the activity. Sec. 1.469-5(f), Income Tax Regs. Work done by an individual in the individual's capacity as an investor in an activity is not treated as participation in the activity unless the individual is directly involved in the day-to-day management or operations of the activity. Sec. 1.469-5T(f)(2)(ii)(A), Temporary Income Tax Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988).
In determining whether a taxpayer materially participates, the participation of the spouse of the taxpayer shall be taken into account. Sec. 469(h)(5). We therefore treat petitioners as one unit for the purpose of determining their [*23] participation in an activity. However, petitioners did not make the election to treat all of their interests in real property as one activity pursuant to section 469(c)(7)(A) and section 1.469-9(g)(1), Income Tax Regs., and must therefore satisfy the material participation requirements with respect to each of their rental properties separately. See Shaw v. Commissioner, T.C. Memo. 2002-35 [TC Memo 2002-35].
We find that petitioners satisfy the second enumerated test for material participation: their participation in the rental real estate constituted substantially all of the participation. Mr. Fitch testified extensively as to the activities he performed with respect to his rental properties, 16 including, inter alia, advertising, bookkeeping, accounting, dealing with contractors, decorating, resolving fence disputes, making repairs, paying taxes, and procuring insurance. He further testified that no one else performed any services for his properties. Mrs. Fitch similarly testified as to the activities she performed in managing her rental properties, including, inter alia, advertising, decorating, dealing with contractors and the homeowners' associations, screening tenants, filling out paperwork, making repairs, and handling the lockbox and keys. She further testified that no one other than she and Mr. Fitch performed any services for her properties. [*24] Respondent argues that we should disregard petitioners' testimony as self-serving; however, we find their testimony credible and persuasive. We do not believe that petitioners' decision to occasionally hire a contractor to perform technical tasks disqualifies their substantial day-to-day management of their rental properties from constituting “substantially all of the participation”. 17 See sec. 1.469-5T(a)(2), Temporary Income Tax Regs, supra. Accordingly, petitioners' losses attributable to their rental real estate in 2005 to 2007 are not limited by the passive activity loss limitation rules of section 469. 18
In reaching our holdings herein, we have considered all arguments made, and, to the extent not mentioned above, we conclude they are moot, irrelevant, or without merit. [*32] To reflect the foregoing and the parties' concessions,
Decisions will be entered under Rule 155.
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