In a recent Memorandum Opinion, the Tax
Court held that a taxpayer satisfied the requirements for materially
participating in his Chicago based business despite living in Florida
approximately 60 percent of the year. Satisfying the test for material
participation is important because it allows you to use your business losses to
offset other sources of business income. Meanwhile, deductions and losses
generated by a “passive activity” are limited to income from passive
activities.
The Tax Court’s ruling
in Barbara v. Commissioner, TC Memo 2019-50, is good news for
business owners because it confirms that working remotely will not be treated
any differently than working in a physical office with respect to calculating
the time spent towards an activity for purposes of material participation. Accordingly,
you may live in one state and operate a business in another while still
satisfying the material participation requirements.
Material Participation
Tests
Red state, blue state, high tax
state, low tax state; with the passage of the TCJA, these issues have become
more significant. The income tax rates
for several states are as follow:
New
Jersey 8.97%
New
York 8.82%
Vermont 8.95%
Illinois 4.95%
New
York City (in addition to the New York
State
Tax Rate) 3.876%
On the other hand, seven states
do not have income taxes. They are:
Florida
Nevada
South
Dakota
Texas
Washington
Alaska
Wyoming
If you were to select a place to
live and your focus was the least amount of state and local income taxes, the
choices are obvious. The issue is,
however, if you are conducting a business in a high tax state, can you have
your domicile in a low tax state. Perhaps under the right circumstances, you
may utilize Puerto Rico’s incentive provisions. Act 20 and Act 22, to
substantially reduce your combined federal and state income tax burden. These acts were designed to bring service
businesses and wealthy individuals to Puerto Rico. Act 20 and Act 22 are attractive to service
providers who do not need to be physically present in one of the fifty states.
Aside from the obvious
geographical challenges and perhaps time zones, there is also an IRS tax
section that might prevent you from utilizing a loss in a tax year to offset
gains in current or subsequent years.
Normally if a taxpayer, who is in a trade or business and suffers a net
operating loss, under the TCJA 80% of the loss can be carried forward to offset
income in a future year. The key element
is the loss occurs in a trade or business in which the taxpayer is active. Being an active participant allows losses in
the activity to offset other current ordinary income or future income. See Section 162(a) and Section 212(1).
On the other hand, if the
taxpayer is not active in the business, the losses cannot be used because the
losses are passive losses passive losses can only be used against passive
income. Section 469 limits those
deductions when they arise from “passive activities.” A passive activity is any activity involving
the conduct of a trade or business in which the taxpayer does not materially
participate. Section 469(c)(1). A taxpayer materially participates in an
activity if such participation is regular, continuous and substantial. Section 469(h)(1). Regulations provide seven alternative tests
to determine whether a taxpayer has materially participated in an activity for
the taxable year.
These are:
Tests Based on Current
Participation
1. The individual participates in the activity for more than
500 hours during the year.
2. The individual’s participation in the activity for the taxable year
constitutes substantially all of the participation in the activity of all individuals (including
nonowner employees) for the year.
3. The individual participates in the activity for more than
100 hours during the year, and this participation is
not less than that participation of
any other individual (including nonowner employees) for the year.
4. The activity is a significant participation activity (where
the person’s participation exceeds 100
hours during the year), and the hours for all significant participation activities during the
year is more than 500 hours.
Tests Based on Prior
Participation
1. The individual materially
participated in the activity for any 5 taxable years during the 10 taxable
years that immediately precede the current taxable year.
2. The activity is a personal service
activity, and the individual materially participated in the activity for any 3
preceding taxable years.
Tests Based on Facts and
Circumstances
1. Based on all of the facts and circumstances, the individual participates
in the activity on a regular, continuous, and substantial basis during the
year.
The IRS regulations contained
substantial detail on how to meet one of the seven tests. Mr. Fred Barbara managed to be a Florida
domiciliary and operated a business in Chicago and yet satisfy the material
participation test of the passive activity rules.
Barbara v. Commissioner, TC Memo 2019-50
The Barbaras reside in Florida
when they filed their petition.
Presumably, they were domiciled in Florida.
For many years, Fred Barbara
owned and managed Barbara Trucking, a Chicago-area garbage collection and waste
management business.
In 1997, Mr. Barbara sold Barbara
Trucking for tens of millions of dollars.
Mr. Barbara used the proceeds
from the sale of Barbara Trucking to start a money lending business. This business capitalized on the network of
contacts in the Chicago construction industry that he had developed while
running Barbara Trucking.
In conducting the lending
business, he usually lent the money in his personal capacity. But on a few occasions, he lent the money
through a family trust or a closely held limited liability company, Barbara
Capital II, LLC. This LLC is treated as
a partnership for federal tax purposes.
The
office of the lending business was in Chicago. The office was staffed by two
full-time employees: an accountant and a secretary.
Mr. Barbara performed all executive functions for the
lending business. He decided when to make loans. He decided how to handle
defaulted loans. He managed over 40 outstanding loans during the years at
issue. He had no other significant work-related demands on his time besides the
lending business.
During
the years 2009-2012, Mr. Barbara split his time between Chicago and Florida.
For each year he was in Chicago, 40% of his time and in Florida 60% of his
time. He worked at least 200 days in a year, proportioned between Chicago and
Florida on a 40/60 basis.
When
in Chicago, Mr. Barbara lived in residences he owned. He was in the Chicago
office for about 5-3/4 hours each work day. When there he was working on the
lending business. He kept a regular schedule. Therefore, he was in the Chicago
office at least 460 hours per year working on the lending business, computed as
follows:
200 days x 40% × 5.75 hours = 460 hours per
year
When
in Florida, Mr. Barbara lived in a house that he had purchased in 1995. He
called the Chicago office every day when it opened at 9:00 a.m. He also
communicated with the office at other times, through telephone, fax, and
e-mail. He averaged at least two hours of work per day on the lending business
while in Florida. This means that he worked at
least 240 hours per year on the lending business while he lived in Florida,
computed as follows:
200 days × 60% × 2 hours = 240 hours per year
One
of the issues determined by the US Tax Court was whether Mr. Barbara materially
participated in his money lending business.
The significance was that if he did not materially participate the
income and losses would be passive.
The
court agreed that the activity at issue is all of Mr. Barbara’s lending,
whether loans were made individual or through an entity, was active and that he
materially participated in the lending business.
For
each year, Mr. Barbara’s total hours participating in the lending business were
(1) 460 hours or more while in Chicago and (2) 240 hours or more while in
Florida. Thus, his total hours
participating in the lending business each year were 700 or more. This exceeds the 100-hour threshold that is
part of the material participation test.
Both
while he was in Chicago and in Florida, Mr. Barbara’s participation in the
lending business was regular, continuous and substantial. Accordingly, losses were deductible under IRS
Section 162. Moreover, the losses suffered in the prior year could be used to
offset income in another year.
The
case is significant for two reasons:
First, the material participation test has no geographic limitations;
second, the material participation test rest on quantitative i.e. number of
hours spent, and qualitative, i.e. the significance of the individuals’
participation, good record keeping is essential. What kind of record keeping would be needed? A journal or daily diary detailing the nature
of the activity, i.e. telephone calls, examination of records, agreements, etc.
and the maintenance of regular business financial records as well as time spent
on each activity and so forth.
Meeting
the material participation requirements among other requirements might allow a
taxpayer to live in a low tax state and yet manage a business in a high tax state.
Consider an additional possibility, one that may allow one to avoid these
rules.
Puerto Rico enacted a corporate
incentive scheme Act 20, that provides a 4% corporate tax on income and zero
percent on dividends and capital gains.
A software company could easily avail itself of this opportunity. There are requirements, such as the hiring of
local employees and a business presence, which require more than a nameplate on
a wall in a foreign jurisdiction.
Individuals, under Act 22, who are present in Puerto Rico for six months
in the prior year, receive government approval and draw a reasonable salary
form the relocated business may benefit from this regime. There is a 100% exemption from Puerto Rican
taxes on dividends, interest and capital gains accrued after residency. Act 20
and Act 22 offer an alternative to expatriation and may prove valuable in the
right situation.
While there are obvious
geographical and other challenges, the Tax Court has provided a path for the
operation of a remote business from a tax friendly jurisdiction.
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