In the 1980s taxpayers often created losses by structuring transactions to generate accelerated depreciation, interest and other deductions, which they used to offset other earned and unearned income. As a result, Congress enacted the IRC section 469 passive activity loss (PAL) rules, specifically designed to limit a taxpayer’s ability to use business deductions to offset income from an unrelated activity unless he or she had materially participated in the operation of the business. In essence, the PAL rules prevented nonpassive-activity income from being offset by deductions generated from passive activities.
The legislative history of IRC section 469 makes it clear that Congress intended to stop tax-sheltering activities. Yet Congress also recognized that certain transactions such as “self-charged” interest should be allowed. For example, if a sole shareholder charged $100 interest on a loan to his passive S corporation, he should be able to offset his $100 portfolio interest income by the $100 passive activity interest expense.
Congress recognized there would be similar instances where such netting also should be allowed, so it gave the IRS the power and responsibility to issue regulations governing “self-charged” items in nonloan situations. The IRS failed to issue any such regulations.
The Tax Court recently gave the IRS a wake-up call by allowing an S corporation shareholder to offset passive management fee deductions against related nonpassive management fee income.
In Hillman v. Commissioner (114 TC no. 6, 2000), David Hillman owned and materially participated in Southern Management Corp. (SMC), an S corporation that provided real-estate-management services for several partnerships in which he held interests but did not materially participate. The management fees received by SMC were passed through to Hillman as nonpassive activity income. However, the management fee expenses of the partnerships were passed through as passive activity deductions.
Although the regulations allowed only the netting of interest, Hillman offset the management fees in his return. The IRS disallowed the offset. The IRS did not argue that the offset was incorrect, inappropriate or unjustified. It took the position that the failure to issue a regulation allowing a deduction was sufficient to disallow the deduction.
The court found that the service’s failure to issue regulations covering nonlending transactions was insufficient to preclude a taxpayer from congressionally intended, and appropriate, relief. According to Judge Gerber, the IRS’s refusal to issue the regulations was “peculiarly Draconian.” In addition, the court found Hillman merely “moved management fees from his ‘passive pocket’ to his ‘nonpassive pocket’.” Since there was no accretion to Hillman’s wealth, the offset was allowed.
Observation. CPAs should advise their clients to file amended returns for any open years in which they failed to offset passive “self-charged” nonloan deductions against any related nonpassive income.
—Michael Lynch, Esq.,
professor of tax accounting at Bryant College,
Smithfield, Rhode Island.