Originally published on Forbes.com Aug 21st, 2014
The way the Tax Court judge put it, Scott Williams was an aviation buff with a business unrelated to aviation. The IRS objected to Mr. Williams integrating his aviation activity into his business Worldwide Phone Pops (WPP), which provides telephone skills training and telephone mystery shopping for automobile dealerships. The Tax Court backed them up. The case involved the activity grouping rules of Code Section 469, the silver bullet of the Tax Reform Act of 1986, which was supposed to end all tax shelters forever. When it comes to the activity grouping rules, there are three types of tax practitioners: those who are, at most, vaguely aware of them; those who have studied them intently and remain somewhat bewildered; those who claim to understand them. The third group can be divided between people who have deluded themselves and liars.
Some Background
The essence of Code Section 469 is that we need to divide our trade and business activities into two buckets – passive and non-passive. Losses in the passive bucket can only be used to the extent that there are gains in the passive bucket. To the extent the passive bucket is net negative, losses are carried forward indefinitely to be used either when there are gains in the future or the associated activity is entirely disposed of.
Quite often the litigation in this area is about whether a particular activity is active or passive. Generally speaking, if you have a full-time day job and lose money doing something else – like chartering your yacht – and the IRS decides to use 469 against you, they will claim that you are lying about how many hours you are spending on the side activity. The Tax Court usually backs them up.
Tax Wisdom From Airplane Salesmen?
This case is different. Mr. Williams started out working for his father in the business, which he eventually took over. ]There was a lot of air travel involved and Mr. Williams got tired of being felt up by TSA minions, so he asked his father if he could do things differently. He began renting planes from flight schools and flying himself. After a while, they determined that the practice was not cost-effective and abandoned it.
There is a fascinating phenomenon that pervades any activity that has a hint of tax sheltering about it. The people who are involved in selling the products become tax experts in the field. So Mr. Williams learned about the passive activity loss rules (Code Section 469) from an airplane salesman.
In November 2006 Mr. Williams attended the Aircraft Owners and Pilots Association Expo where he spoke to several airplane manufacturers about purchasing an airplane. Mr. Williams researched the fixed expenses of owning an airplane and determined that it was not “a good financial decision” for WPP. He then attended an aviation tax seminar at the Expo “describing how a leaseback arrangement can be structured such that it becomes active, meeting either a 500-hour or a 100-hour material participation rule.” He came to believe that if a leasing activity was properly structured and carried out, the losses the airplane generated could be used to offset ordinary income.
After the seminar, Mr. Williams read Web sites and books “studying and essentially mastering the deductibility of a general aviation airplane in a business in conjunction with a flight school leaseback arrangement.” He testified that at some later date he purchased two books written by Raymond C. Speciale, one of the people who had spoken at the aviation tax seminar.
Some of Speciale’s books are available on Amazon if you are interested.
A Belt And Suspenders
Mr. Williams went ahead and bought an airplane. He reported it on the Schedule C for his phone training business. So he staked out a position that he was not really going into the airplane business. He was using the airplane in his business but letting others use it to offset the cost.
In the event the argument that it was part of his business did not fly, so to speak, Mr. Williams was ready to maintain that the aircraft business was one that he materially participated in and was not a rental activity (which would make it per se passive). The contract that he entered into with the flight school that cared for his plane and arranged to have it rented to students provided that no one would spend more than 100 hours working on the plane. (One of the ways to materially participate short of spending 500 hours, is to spend more than 100 and more than anybody else.)
And The Pants Still Fall Down
The judge snipped the suspenders in the way Tax Court judges doom most passive activity cases. Mr. Williams claimed 150 hours on the airplane business but had not maintained logs. Also, beyond the contractual provision, he did not provide documentation showing that nobody else had spent more time than he had. There is really nothing that unusual here, except that 100 hours is not really that hard to do, so it is a bit surprising that there was still an expectation of logs being maintained.
What is of more interest, because it does not come up that often is Mr. Williams’s main argument that the airplane was part of his primary business. This hinges on the question of whether the two activities are an “appropriate economic unit”. Joe Kristan’s headline on this case was “Telemarketing isn’t an airplane” which makes the IRS point. (Not to be critical of Joe, but Mr. Williams’s business is not about telemarketing. It’s about training people how to answer the phone. Nonetheless, the tax analysis is the same.)
The Judge Leaves Something Out – Deliberately?
In the hundreds of cases concerning Code Section 469 decided since it first passed in 1986, the phrase “appropriate economic unit” only comes up about a dozen times. The judge in this case took the trouble to quote from the regulations.
Section 1.469-4(c), Income Tax Regs., sets rules for determining what constitutes a single “activity”. That regulation provides: “One or more trade or business activities or rental activities may be treated as a single activity if the activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of section 469.” Whether activities constitute an “appropriate economic unit” depends on the facts and circumstances, giving the following five factors the greatest weight:
(i) Similarities and differences in types of trades or businesses;
(ii) The extent of common control;
(iii) The extent of common ownership;
(iv) Geographic location; and
(v) Interdependencies between or among the activities (for example, the extent to which the activities purchase or sell goods between or among themselves, involve products or services that are normally provided together, have the same customers, have the same employees, or are accounted for with a single set of books and records.)
It happens that I spent the day yesterday listening to Lucien Gauthier of the Boston Tax Institute. The seminar was on how real estate professionals will be affected by the new Obamacare tax, which is intricately related to the passive activity loss rules. Lu is rather passionate that the Williams case may have been wrongly decided on the “appropriate economic unit” issue. In particular, he points out a key sentence in the regulations that the judge left out:
A taxpayer may use any reasonable method of applying the relevant facts and circumstances in grouping activities.
In Lu’s analysis, Mr. Williams probably has three and a half of the five factors, which should be enough.
Lu is rooting for Mr. Williams to appeal. So maybe we will get to revisit this case in the future.