A recent case, Senty v. United States, provides several important lessons for tax return preparers [Senty v. United States, 132 AFTR 2d 2023-6735, (Dist. Ct. WD WI 12/15/2023)]. Mr. Senty was involved in several businesses, including gas companies, banks, and a surveillance camera company, three of which were at issue in the case. The IRS audited Senty’s joint income tax return for the years 2014 and 2015 and determined that the taxpayers owed net investment income tax (NIIT). The Sentys paid the tax and filed refund claims. This case provides important guidance on the interplay between passive activities and the NIIT surcharge under IRC §1411(a)(1), which imposes a 3.8% surtax on net investment income, including passive income. It also provides important lessons for documenting material participation in business and rental activities.
The taxpayers claimed that because Mr. Senty materially participated in the three companies, the NIIT surtax should not apply. The IRS denied their refund claims, alleging that Mr. Senty did not materially participate in any of the three applicable businesses for either year. Therefore, the resulting passive income is included in the NIIT surtax. The government also counterclaimed for a return of the 2014 refund which was issued to the taxpayers.
IRC § 469 and the passive activity rules generally prevent taxpayers from using passive losses to offset nonpassive income. Passive income is also included in the determination of NIIT [§1411(c)(2)(A)] and therefore, the passive activity rules of § 469 apply. The NIIT surtax is broadly imposed on income from interest, dividends, annuities, royalties, rents, passive activities, and on net capital gain from the disposition of such activities, when certain income thresholds are exceeded. It is therefore essential to be able to properly document whether business and rental activities are passive activities, and whether the taxpayer will be able to meet the material participation standards set forth in Treasury Regulations §1.469-5T. As described below, Mr. Senty was not able to prove material participation in his business activities.
Significant Participation Activity
A passive activity includes the conduct of any trade or business in which the taxpayer does not materially participate [§1.469(c)(1)]. Although Treasury Regulations provide seven tests for proving material participation, the Sentys relied on only one of those tests: the significant participation activity designation set forth in Treasury Regulations §1.469-5T(a) (4). The Treasury Regulations provide that an activity will qualify as a significant participation activity only if the individual participates in the activity for more than 100 hours during such taxable year and, the aggregate participation in all such activities during the year exceeds 500 hours. A significant participation activity must also be a trade or business activity encompassed within the meaning of Treasury Regulations §1.469-1T(e)(2).
The fundamental issue was whether the taxpayers met the significant participation standards required by the Treasury Regulations. The purpose of the significant participation activity exception is to enable taxpayers to combine several trade or business activities, provided the taxpayer worked over 100 hours in each of the activities and aggregated over 500 hours in all the relevant trade or business activities. The central inquiry was whether Mr. Senty was able to prove the level of personal services provided. Although he owned several businesses, the inquiry related only to three business activities which generated income relevant to the application of the NIIT. All parties agreed that Mr. Senty was a very diligent worker who worked between 65–70 hours every week; however, the court held that he failed to adequately substantiate the hours devoted to particular activities, and that he failed to provide meaningful contemporaneous records or evidence of his actual work. Mr. Senty rarely used email or text messages, conducting his business primarily with face-to-face meetings or by telephone. He did not, however, provide phone records or any supporting substantiation or alternative documentation with respect to the companies at issue in the case: Deerfield Financial Corporation, Reconyx, Inc., and Park Capital LLC. He provided unsubstantiated “ballpark estimates,” relying primarily on his own memory and that of his son. Without documentary evidence, Mr. Senty was unable to prove that he met the required test for significant participation activities. Therefore, the business income was held to be passive income subject to the NIIT 3.8% surtax.
Required Proof
With respect to his bank business, Mr. Senty provided a detailed list of substantial services that he provided to the bank and its management teams; however, he did not provide sufficient documentary evidence regarding precise hourly work activities. With respect to Reconyx, Inc., which sold surveillance equipment and cameras, Senty showed that he served on the board of directors and provided significant consulting, management, and strategic business services. In 2016, he signed an employment agreement which obligated him to provide at least 276 hours of service to the company. Senty was unable to show how such hours were determined, and he failed to provide documentation of actual services provided to the company. Similar documentation was missing with respect to Park Capital LLC, of which he was the sole manager.
The regulations describe how a taxpayer may prove participation in activities:
The extent of an individual’s participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries [Treasury Regulations in §1.469-5T(f)(4)].
Although the regulations allow reasonable flexibility in providing proof of participation, guesstimates and mere estimates which are uncorroborated by meaningful contemporaneous records will not be sufficient. Senty provided a “handful of board meeting minutes” which were not sufficient to meet the reporting burden. Senty’s testimony was vague and provided few precise details. Undocumented testimony provided in the case was also held insufficient. He also failed to provide a sufficient narrative summary of his participation.
The Senty case is very similar to another recent case which involved meeting the requirements of a significant participation activity. In Gurpreet S. Padda, et al. v. Commissioner, a physician who owned several restaurants and a brewery met the test for significant participation activities with respect to his various businesses [Gurpreet S. Padda, et al. v. Commissioner, TC Memo 2020-154 (11/16/2020)]. Dr. Padda was able to provide sufficient documentation and detailed trial testimony involving his working hours and precise schedules at each of the respective businesses. Other witnesses provided corroborating testimony regarding his specific involvement and his management activities in all financial aspects of the restaurants and brewery. The court was impressed with Padda’s testimony and that of his corroborating witnesses.
Similarly, in Tolin v. Commissioner, the IRS asserted that the taxpayer incurred disallowed passive losses from a thoroughbred business which could not offset his active income [Tolin v. Commissioner, TC Memo 2014-65 (03/19/2018)]. The court found his activities met the “material participation” requirements. The taxpayer presented sufficient contemporaneous documentation, including telephone records and credit card statements. They were found to be sufficient, objective evidence to corroborate the taxpayer’s detailed narrative summary which described the work he performed. In Tolin, the substantiation was also corroborated by credible third-party witness testimony. In Lamas v. Commissioner, the taxpayer met his burden of proof by providing corroborating evidence consisting of phone records and detailed credible witness testimony [Lamas v. Commissioner, TC Memo 2015-59 (03/25/2015)]. The taxpayer also properly grouped activities to aggregate participation hours. In Senty, the court held that the taxpayer failed to meet his burden of proof.
In order to meet the material participation requirement and to avoid passive activity status, good recordkeeping and documentation is essential. Senty would likely have succeeded if he maintained a contemporaneous diary and included documentation such as letters, invoices, notes of meetings, phone logs, and other sufficient proof of issues and work involved. A detailed individual narrative describing his work history and daily work routine was also essential. Senty only needed to prove that he worked over 100 hours in each of the activities and over 500 hours in total for the three activities. Grouping is not required with respect to significant participation activities and, as described below, would likely not have been an option for Senty, because his history did not show sufficient business interdependence or similarities.
Grouping Election
When a taxpayer is involved in multiple activities, proof of participation is more complicated and detailed. To help meet the material participation threshold, the regulations provide taxpayers with a procedure to combine or group activities; grouping rules will be respected for purposes of the NIIT application, according to Treasury Regulations §§1.469-4 and 1.1411-5. In Padda, the tax court discussed the grouping rules for passive activities. It is extremely important for taxpayers and their advisors to consider proper elections with respect to trade and business activities. The tax court discussed passive activity grouping rules, which enable taxpayers to meet the material participation requirements described in the regulations. Treasury Regulations §1.469-4 permits grouping of activities that constitute an appropriate economic unit, which involves an analysis of the similarities and synergies between the businesses.
If Senty had grouped all his trade and business activities, he may have more easily met the material participation requirements. For example, if his businesses had similar location, management, control, and interdependence, grouping may have been appropriate and may have helped the taxpayer meet his burden of proof. Taxpayers must give proper consideration to grouping qualified activities. Revenue Procedure 2010-13 provides important information regarding grouping rules for trade or business activities and provides guidance for late elections. Grouping elections must be properly evidenced by a written statement and disclosure on the original income tax return; Revenue Procedure 2010-13 provides alternative rules for late elections.
Although it was not a part of the Senty decision, it is appropriate to discuss that several special rules apply to the classification of rental real estate activities; such activities may not be automatically classified as passive and may not be subject to the NIIT 3.8% surtax. For example, a rental activity that meets the definition of a §162 trade or business and in which the taxpayer materially participates will be exempt from the NIIT surtax [Treasury Regulations § 1.1411-1(d)(12)]. A qualifying taxpayer meeting the requirements of § 469(c)(7) as a real estate professional is also able to avoid the NIIT surtax, provided the rental activity constitutes a non-passive § 162 trade or business, if they participate in the rental real estate activity for more than 500 hours during the year, or have participated in such real estate activities for more than 500 hours in any five years during the ten immediately preceding taxable years [Treasury Regulations § 1.1411-4(g) (7)]. With respect to rental real estate activities, the aggregation election under Treasury Regulations § 1.469-9(g), also applies for the purposes of meeting the over 500-hour test for an exception to the NIIT [Treasury Regulations § 1.1411-4(g) (7)(ii)(B)].
Meeting the Burden of Proof
The passive activity rules were originally implemented in order to postpone the use of passive activity losses or any deduction which would flow from trade or business activities in which a taxpayer did not materially participate. Passive income will be subject to the NIIT 3.8% surtax when the income thresholds are exceeded. The recent cases discussed in this article provide valuable lessons for optimizing financial structure and assist tax preparers in making proper elections as required in the treasury regulations and procedures. Many taxpayers are engaged in multiple activities, and both the test for significant participation and the grouping and aggregation rules require a heightened focus, including those periods when business income is reported. The Senty case shows how important avoiding the NIIT surtax can become and provides a good roadmap for meeting the taxpayer’s burden of proof. General discussion and memory are not sufficient. The courts will look to see corroboration by contemporaneous objective evidence including emails, text messages, EZ Pass documentation, phone records, and charge card receipts and history. Detailed client narrative summaries are also required to precisely document that the required material participation test has been met.
