Proof of Material Participation Must Be Credible


A taxpayer must prove material participation in an activity to deduct losses from that activity against nonpassive income. The Ninth Circuit reaffirmed that credible evidence must be presented to prove that one of the material participation tests of IRC § 469 has been met.

In 2007, the U.S. District Court for the Western District of Washington granted the IRS summary judgment disallowing a taxpayer’s attempt to carry back losses without sufficient evidence of material participation in the family company. However, the IRS’s alternate argument that the taxpayer’s claim should also be disallowed pursuant to capital loss rules/limitations was rejected because it wasn’t clear whether the activities in question were conducted in a dealer or trader capacity. In September 2008, the Ninth Circuit Court of Appeals upheld the decision without oral argument. Started in the 1970s, family-run partnership Dean Securities brokered stocks and bonds. In 1998, sharp declines in securities values caused large losses for the company.

Loren Dean, a 20% partner, claimed a refund for carryback losses for 1996 based on his 1998 partnership losses. By his testimony and that of his brother/partner, Dean was unable to satisfy the court that he had materially participated for 500 hours or more in the company in 1998. The firm did not keep records of the partners’ hours, nor did Dean have any other corroborating written records. The Ninth Circuit acknowledged that substantiation requirements for material participation in Temp. Treas. Reg. § 1.469-5T are “somewhat vague” but said that “ballpark guesstimates” are not enough. Therefore, Dean’s losses were deemed to be passive.

Under section 469(b), passive activity losses are generally deductible only to the extent of passive activity gains. If no passive gains exist to offset the loss, the taxpayer may carry the passive loss forward to the next year.

n Dean v. IRS, 99 AFTR2d 2007-988, aff’d, 102 AFTR2d 2008-6051 (9th Cir. 2008)

By Laura J. Kreissl, Ph.D., assistant professor of accounting, and Darlene Pulliam, CPA, Ph.D., McCray Professor of Business and professor of accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.



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