Originally published on Forbes.com April 16th, 2014
Ballpark guesstimate” (BG) is a lovely term. It lets you know that although there is some affinity between the number thrown out and the “exact number”. Even if it turns out they are not in the same ballpark at least the different ballparks are in the same city.
Even though BG clearly has slang origins, it has become something of a term of art in tax litigation. BG actually appears in over sixty tax cases. People make “ballpark guesstimates” about all sorts of things, but when the term is used in federal tax litigation they are always talking about time records – specifically records required by Code Section 469, which in the Tax Reform Act of 1986 introduced that marvelous oxymoron “passive activities”.
Passive activities are trade or business activities, not collecting interest and dividends, although interest and dividends are considered passive income in other sections of the Code. Trade or business activities that fall in the “passive activity” bucket can not, on net, produce losses that shelter income from non-passive activities. If all your passive activities net negative, the loss is suspended. The loss is carried forward indefinitely until there is either passive income or an activity is entirely disposed.
It used to be that someone with the Midas touch, did not have to worry about these rules. That changed beginning with 2013 returns. Net income from passive activities is subject to the Net Investment Income (a/k/a Obamacare) tax.
A trade or business activity is one in which you do not “materially participate”. The gold standard for material participation is 500 hours per year, although there are other possible ways to meet the standard. Rental activities are “per se” passive, regardless of material participation. There is an exception to that rule for people who are engaged in real property trades or businesses such as real estate brokers. There is a stiffer requirement to meet that standard. 750 hours and, what is even more challenging, more time than you spend on anything else.
The rules are confusing enough that a lot of people go into Tax Court already losing even if the judge believes them. For example, someone might meet the real estate trade or business exception but not elect to aggregate their rental properties. If you have more than a couple of properties it is virtually impossible to materially participate in each of them, which is why the election is required. Several taxpayers have made great effort to show they had 750 hours working on real estate only to realize that they needed even more than that since they spent so much time on their day jobs. Engineers seem to be particularly prone to that error.
The greatest obstacle to material participation in side businesses and the real estate trade or business exception for people with substantial day jobs is IRS skepticism about time spent, which is almost always backed up by the Tax Court. I believe the first case that referred to “post-event ballpark guesstimate” was that of William Goshorn. Mr. Goshorn worked for UPS in Connecticut and had posted losses on a yacht chartering activity in Texas. Mr. Goshorn was shooting to qualify under the standard that he spent more than 100 hours and also more time than anybody else involved in the activity. He did not make it.
First, while the regulations are somewhat ambivalent concerning the records to be maintained, they by no means allow the type of post-event ballpark guesstimate that petitioner used.
The year under audit was 1988, only the second year that the rules were in effect, so the “ballpark guesstimate” and Code Section 469 are practically Irish twins.
Talbot Matthew Alquist was in Tax Court last month for fairly high stakes as these cases go, over $150,000 in losses for the year 2008. The losses were from trying to rent two fully furnished homes – one in California and the other in Florida.
Petitioners provided one calendar and two different logs describing the hours worked on the rental properties. At the start of respondent’s examination of petitioners’ 2008 tax return petitioners created the calendar from very brief cryptic notes in Mr. Almquist’s personal spiral notebook daily records. He did this about a year after the fact, long after the asserted work was completed. The calendar’s short notes about the days Mr. Almquist worked on the rental properties occasionally included the hours worked as respondent’s revenue agent requested that this information be included when petitioners prepared the calendar. Mr. Almquist contends that the calendar was created on the advice of petitioners’ certified public accountant and was, as noted, purportedly based on Mr. Almquist’s daily record handwritten notes. Petitioners did not provide the purported supporting handwritten notes to the Court.
I added the emphasis. Here is the thing. When you are reading a Tax Court decision and you see any of the forms of the work “purport”, you can be pretty sure that things are not going to go well for the taxpayer. Not far down, the Court reiterates that “a postevent” ballpark guesstimate” will not suffice.
If you are involved in a money-losing side activity (or money-making if your income is over the NII threshold), try to keep contemporaneous records of the time you spend. Ideally, you should cross-reference the time log with invoices and e-mail print-outs, and vendor invoices. Of course, if your goal is to be featured in one of my blog posts, it might not happen, since there is a decent chance that you win at appeals. Whatever you do, never refer to whatever reconstruction you come up with as a “ballpark guesstimate”. That will cause you to strike out.
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