Equipment Leasing Losses Were Not Passive

I n Misko, Jr., TC Memo 2005-166, the Tax Court permitted a taxpayer to deduct losses for equipment he leased to his wholly owned corporation.

Facts

The taxpayer was the sole shareholder of a C corporation engaged in the practice of law. As the law practice became more successful, concerns arose about tax planning.

The taxpayer entered into an arrangement under which he leased computer and video equipment to his corporation, which used it in the business of practicing law. The original intent was for the lease payments to approximate the depreciation deductions.

The leasing arrangement was profitable during each of the years the firm was in business, except for 1998 and 1999. In those years, due to lower revenue and expenses in contingent fee suits, the firm did not make the requisite rental payments, nor did it pay the taxpayer a salary.

The IRS denied the depreciation deductions claimed in 1998 and 1999, stating that the leasing activity was passive; thus, the losses were not deductible in those years, under Sec. 469. The IRS also later argued that, under Sec. 183, the taxpayer was not engaged in an activity for profit.

Engaged in for Profit?                    

In Tax Court, the taxpayer argued that the activity was engaged in for profit, because it generated gross income in every year except the two at issue. He contended that the equipment was used solely by the law firm, not for his personal recreation or pleasure. The taxpayer maintained records on the rental income and expenses, amounts invested and deprecation deductions.

The Tax Court held that the IRS failed to demonstrate that the taxpayer was not engaged in the activity for profit. It also looked to the Fifth Circuit, to which the case was appealable, and noted that it requires a taxpayer to engage in an activity with the primary purpose of realizing a profit; see Westbrook, 68 F3d 868 (5th Cir. 1995). The court concluded that the taxpayer met this standard.

Passive Activity?

The court next turned to the passive activity argument. The parties agreed that because the activity was a rental activity, it was inherently passive; thus, for the taxpayer to be able to deduct the losses, it needed to meet one of the exceptions enumerated in Temp. Regs. Sec. 1.469-1T(e)(3)(ii)(A)(F). The relevant exception applicable here, Temp. Regs. Sec. 1.469-1T(e)(3)(ii)(D), applies when a rental activity is incidental to a nonrental activity of the taxpayer. Because the taxpayer owned 100% of the law firms stock, his activities included the corporations activities. However, three other requirements had to be met:

1. The taxpayer had to own an interest in the trade or business.

2. The property had to be used predominately in the business during the tax year or in a minimum of two of the five immediately preceding tax years.

3. The gross rental income from the rental property for the tax year had to be less than 2% of the lesser of the propertys unadjusted basis or fair market value.

The court found that the taxpayer met each of these criteria and qualified for the incidental rental exception.

Material Participation?

Finally, the court determined whether the taxpayer materially participated in the activity (i.e., whether his participation constituted substantially all of the participation in the activity for that year, under Temp. Regs. Sec. 1.469-5T(a)(2)). It concluded that because the taxpayer exclusively engaged in and managed the leasing activity, this standard was met.

Conclusion

The taxpayers losses from 1998 and 1999 were held not to be from a rental activity, nor subject to the Sec. 469 passive activity rules. Further, the court held that the taxpayers activity was engaged in for profit and not subject to Sec. 183s limits.

From John W. Lindbloom, CPA/PFS, Huber, Ring, Helm & Co., P.C., St. Louis, MO