Determination of a Profit Motive

Tax Matters

IRS States Position on Hybrid Plan Arrangements

T he IRS released a coordinated issue paper for all industries on the use of pension plan distributions to pay for certain benefits. The paper says the portion of pension plan distributions former employees use to purchase benefits in their employer’s cafeteria plan under a tax-free salary reduction does not reduce the amount of the taxable distribution. An employer cannot utilize this cafeteria plan/qualified retirement plan hybrid arrangement to lower health care expenses or taxable pension distributions for its former employees.

FASB Statement no. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions, created an incentive for employers to use alternative methods to provide accident and health benefits to retirees. The purpose was to offset the effect of retiree health obligations on employers’ financial statements and reduce the escalating costs of accident and health coverage to employers.

One method, prompted by the observations in Statement no. 106, permitted retirees to apply a salary reduction agreement to their pension distributions. The employers would then use the distributions to purchase accident and health coverage for the former employees through their cafeteria plan. The employers would then report the retirement distributions on forms 1099R, less the benefit costs, effectively paying the health benefits with pretax dollars.

The IRS rejected the proposed method. It said IRC section 125, which governs cafeteria plans, allows employees to defer, tax-free, part of their salaries to purchase certain benefits. But pension distributions are taxable under section 402; the IRS noted that Congress had neither enacted nor intended any exception to section 402 to allow pension distributions to be tax deferred under section 125.

The IRS also stated that its position is consistent with two pre-ERISA rulings. Revenue ruling 61-164 (1961-2 CB 99) states that the use of trust funds to purchase accident and health coverage would not disqualify a pension plan. However, it goes on to say that such use is a distribution within the meaning of section 402. Also, revenue ruling 69-141 (1969-1 CB 48), states that distributions from a qualified plan to pay an employee-participant’s medical expenses are not accident and health benefits excludable under section 105(b), but are taxable under section 402(a) as previously earned deferred compensation.

Recommendation. Practitioners should review their clients’ pension and cafeteria plans to amend or eliminate any provisions that would conflict with the position the IRS has taken in the issue paper.

Coordinated Issue Paper—All Industries: Cafeteria Plan/Qualified Retirement Plan Hybrid Arrangement, 2/1/00.

—James Ozello, Esq.,
Ozello Tax and Legal Consulting,
Ringwood, NJ.

INDIVIDUAL

Self-Rental Income Considered “Active”

I RC section 469 states that a taxpayer can use losses from a passive activity only to offset passive activity income. In other words, passive losses cannot shelter active income such as salaries, commissions, wages or portfolio income such as interest, dividend or annuity income.

Under IRC sections 469(c)(2) and (c)(4), income from rental real estate is generally considered passive activity income, regardless of the taxpayer’s level of involvement in the property. However, the recharacterization or self-rental rule of regulations section 1.469-2(f)(6) provides that rental realty income is not passive activity income if the property is rented for use in a trade or business in which the taxpayer materially participates. This rule prevents a taxpayer with passive activity losses from artificially creating passive activity income to absorb the losses.

In Krukowski v. Commissioner (114 TC no. 25), the taxpayer was the president and sole shareholder of two C corporations. One corporation operated a health club; the other a law firm for which he worked as an attorney. Each corporation rented its respective building from the taxpayer. The original five-year lease to the law firm was signed in 1987. In 1991 the lease was renewed for another three years.

In 1994, the taxpayer reported a $69,100 rental loss from the health club and $175,149 in rental income from the law firm. On his 1994 federal return, he treated the two rentals as separate passive activities and offset the passive activity loss from the health club against the rental income from the law firm; he reported total taxable rental income of $106,049.

On audit, the IRS disallowed the offset and recharacterized the rental income from the law firm as nonpassive under regulations section 1.469-2(f)(6) because the taxpayer materially participated in the firm.

The taxpayer argued that this rule was arbitrary and contrary to the code. The court sided with the government and found that the recharacterization rule was a proper regulation.

The taxpayer also argued that regulations section 1.469-11(c) prevents the recharacterization rule from applying to contracts executed before 1988. The court agreed with the taxpayer, but found that based on state law the 1991 lease renewal was not an extension of the 1987 lease but a separate lease contract.

Observation. This case confirms the validity of the 1994 regulations that recharacterize self-rental income from passive to active when a taxpayer materially participates in a C corporation. However, if a taxpayer can show that, based upon applicable state law, a post-1987 lease renewal is an extension of a pre-1988 lease, and not a new contract, then the recharacterization rule can be avoided.

—Michael Lynch, Esq.,
professor of tax accounting at Bryant College,
Smithfield, Rhode Island.

Automatic Consent to Change Accounting Method Available

U nder IRC section 446, taxpayers generally can choose any method of accounting to compute taxable income as long as that method clearly reflects income. However, many small business taxpayers who wish to use the cash method are prevented from doing so because of Treasury regulations section 1.446-1(c)(2)(i), which states a taxpayer must use the accrual method for purchases and sales if he or she is required to account for inventories under IRC section 471. Regulations section 1.471-1 states that any time the production, purchase or sale of merchandise is an income-producing factor in a taxpayer’s business, the taxpayer must consider the merchandise inventory. Numerous cases hold the sale of merchandise is an income-producing factor, and therefore, the accrual method of accounting is required even when the taxpayer does not keep inventories in the usual sense. In Thompson Electric (TC Memo 1995-292), for example, an electrical contractor was required to maintain inventories because he regularly kept on hand certain electrical parts used in his work.

Other taxpayers—otherwise eligible to use the cash method—may have elected to use the accrual method in a previous period and may want to change their overall accounting methods to the cash method.

For both types of taxpayers, revenue procedure 2000-22 may help. In it, the IRS outlines circumstances under which it will give certain small business taxpayers automatic consent to change their method of accounting from the accrual basis to cash. To be eligible for this, a taxpayer’s average annual gross receipts for the three years preceding the year of change must be no more than $1 million.

Qualifying taxpayers will file form 3115 according to the automatic-change-in-accounting-method provisions of revenue procedure 99-49. The IRC section 481 adjustment for the accounting method change is recognized over the period specified under revenue procedure 99-49—four years for most taxpayers.

Other important aspects of revenue procedure 2000-22 are as follows:

• Even though the benefits of the revenue procedure are available to taxpayers that maintain inventories, they can deduct only the cost of materials and supplies actually consumed or sold during the year. See regulations section 1.162-3.
• Related party aggregation rules apply for purposes of determining gross receipts.
• A taxpayer that has not been in existence for three years must determine its average annual gross receipts over the number of years it has been in existence. Short years are prorated.
• A conformity rule prevents a taxpayer, who regularly uses some other accounting method to determine income to owners and others for purposes of its books and financial statements, from using this revenue procedure to switch to the cash method.. However, a one-time use of another method, to obtain a loan for example, does not violate this rule.
• Taxpayers covered under revenue procedure 2000-22 are also exempted from the uniform capitalization rules of IRC section 263A with respect to merchandise inventory.
• The revenue procedure is effective for tax years ending after December 17, 1999, and therefore calendar-year taxpayers may be able to take advantage of it for 1999. Eligible taxpayers who filed original 1999 returns on or before July 14, 2000, will need to file an amended return by November 13, 2000.

While the option of using the cash method is certainly welcome news to eligible taxpayers, CPAs must remember that its use under revenue procedure 2000-22 is not a permanent change. An increase in gross receipts for example, could cause a taxpayer to become ineligible under this procedure and therefore may require a change back to the accrual method. The taxpayer’s eligibility must be determined every year.

—Vinay Navani, CPA,
tax manager, Wilkin & Guttenplan, PC,
East Brunswick, New Jersey.

Mortgage Interest and Bankruptcy

T axpayers often are forced to file for bankruptcy as the result of business reversals. In such cases, their assets are sold to pay off creditors. When one of the assets is a taxpayer’s personal residence, issues arise concerning the deductibility of interest and other expenses.

To purchase his residence, Patrick E. Catalano, an attorney, borrowed $1.4 million in a nonrecourse loan. In 1994, he and his law firm filed for voluntary bankruptcy under chapter 11. The lender, who had received permission from the bankruptcy trustee to sell the house, sold it for $1,215,000 in January 1995—at which time the principal balance was $1,341,352, including $126,352 of accrued but unpaid interest. Following the sale, Catalano deducted the accrued interest plus $46,412 in bankruptcy fees. The IRS objected to the deductions.

Result. For the taxpayer. The first question the Tax Court had to decide was who sold the residence. For the bankruptcy estate to have sold it, all related items should have appeared on the estate’s return, not the taxpayer’s. For the taxpayer himself to have reported the sale, the bankruptcy trustee would have had to abandon the property. Based on bankruptcy precedent, the Tax Court concluded that the estate’s release of the residence for sale by the lender was an abandonment that caused the sale to be treated as having been made by the taxpayer.

The Tax Court next determined the sale price and the amount, if any, of accrued interest paid. Normally the sale price would be the amount paid for the residence—in this case $1,215,000. However, based on the U.S. Supreme Court decision in Tufts, (461 U.S. 300), since the debt was nonrecourse, the sale price was deemed to be the full amount of the debt. Based on Harris (TC Memo 1975-125, aff’d 554 F.2d 1068), the debt includes the full amount of accrued interest. Therefore, the sale price equals the principal and accrued interest up to the date of the sale—in this case, $1,341,352. Catalano is treated as having paid the accrued interest. Since the debt was to acquire a personal residence, the interest is deductible. However, under IRC section 163(h), the maximum amount of residential debt that qualifies is $1 million. Therefore, Catalano is entitled to only a pro-rata interest deduction—in this case, $83,425.

The Tax Court next turned its attention to the bankruptcy fees. Normally, these amounts are nondeductible personal expenses. However, since a business failure caused the bankruptcy, a portion of the fees was deductible. In this case, lawsuits stemming from Catalano’s law practice caused the bankruptcy. Since $159,823 of the total liabilities of $163,820 were business liabilities, the Tax Court allowed Catalano to deduct 93.7% of the bankruptcy fees. The IRS argued that the allocation should be based on the time Catalano spent on business items as a percent of the total time he billed. The Tax Court rejected this in favor of an allocation based on the percentage of liabilities related to the failed business. As a result Catalano was allowed to deduct $41,574 of the bankruptcy fees.

Patrick E. Catalano, TC Memo 2000-82.

—Prepared by Edward J. Schnee, CPA, PhD,
Joe Lane Professor of Accounting and director,
MTA program, Culverhouse School of Accountancy,
University of Alabama, Tuscaloosa.

Determination of a Profit Motive

I ndividual taxpayers often engage in more than one business venture. However, when a business also involves personal pleasure or recreation, the IRS may take notice. If the operation generates large losses that offset income from other sources, a taxpayer should consider all facts and circumstances before deciding to deduct the losses. IRC section 183, “Activities Not Engaged in For Profit,” contains nine factors a taxpayer can use to determine whether an activity has a profit motive or is a hobby.

Harold and Julia Kahla were the sole shareholders of a profitable S corporation. They also owned two ranches in Texas. One had 300 head of cattle and the other was being developed for professionally guided deer hunts. Mr. Kahla grew up on a ranch and had extensive experience breeding and raising cattle. He also was an experienced deer hunter. He maintained a home at each ranch and spent approximately 40% of his time there—for both professional and personal purposes.

Accounting records for the ranches were combined with the Kahlas personal bank accounts and consisted only of canceled checks and invoices. Contract labor and employees of the couple’s S corporation worked on the ranches. The Kahlas reported net losses of more than $1.8 million over a 21-year period on their schedule F. Only one year during that period showed net income—$3,873.

The IRS maintained that the Kahlas did not engage in ranching for a profit. It disallowed losses for 1992 to 1994, the period under examination, and assessed deficiencies of $204,423.

Result. For the IRS. The Tax Court examined all the facts and circumstances in relation to the nine factors in Treasury regulations section 1.183-2(b), as follows:

1. Manner of carrying on the activity. Poor recordkeeping was a major indicator the Kahlas lacked a profit motive.
2. Expertise of taxpayers or advisers. Mr. Kahla had cattle-ranching experience and sought advice from expert ranchers and others. Nevertheless, he did nothing to turn the ranches into profitable undertakings and did not “demonstrate an expertise for the economics of these operations.”
3. Time and effort expended in the activity. While the taxpayer spent a good deal of time at the ranches, it was unclear whether it was for personal or professional activities.
4. Expectation that assets may appreciate. Both ranches appreciated in value over the years in question, but accumulated losses exceeded any actual or anticipated increase.
5. Past success in other activities. During the trial, Mr. Kahla said if his S-corporation were losing money, he would just “fix it.” This attitude contrasted with the ranch losses and his failure to stop them.
6. History of income or losses from the activity. The taxpayer maintained the losses occurred due to start-up costs and unforeseen circumstances such as drought and price fluctuations in the cattle market. Mr. Kahla testified that he did not expect the operation to be profitable in the near future and yet he did not take corrective action.
7. The amount of occasional profits earned, if any. One year of profits in a 21-year period without any foreseeable change indicated to the Tax Court the Kahlas had undertaken the operation for purposes other than to earn income.
8. Taxpayer’s financial status. For the three years under examination, taxable income from other sources ranged from $500,000 to more than $800,000. The ranch losses provided considerable tax savings.
9. Elements of personal pleasure or recreation. The taxpayers frequently used the homes on the ranches for personal entertainment.

The regulations specify that no one factor should be considered decisive; the 1990 case of Keanini v. Commissioner (94 TC) affirmed this. Given the facts and circumstances surrounding both of the Kahlas’ ranches, the Tax Court concluded there was no profit motive and disallowed all losses for the three years under examination. Expenses related to the operations were allowed only to the extent of revenues generated from the “hobby,” as mandated by section 183.

Business expenses are fully deductible only if a taxpayer incurs them in a profit-motivated activity. For an operation with frequent net losses, the IRS and the courts will closely examine the facts and circumstances in relation to the details set forth in the regulations. If the taxpayer derives apparent personal pleasure from an endeavor and has substantial income from other sources, taxpayer actions must support the intention to generate a profit; otherwise, the IRS will disallow the losses and expenses will be deductible only to the extent of revenue generated.

Harold S. and Julia A. Kahla v. Commissioner, TC Memo 2000-127.

—Prepared by Cynthia Bolt Lee, CPA,
assistant professor, Department of Business Administration,
the Citadel, Charleston, South Carolina.