Tax Court Holds Losses From Micro-Utility Activities Were Passive Activity Losses

The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.

By David I. Kempler, Esq., and Elizabeth Carrott Minnigh, Esq.  

Buchanan Ingersoll & Rooney PC, Washington, DC

In three separate cases - Wilson v. Comr. , T.C. Memo 2012-101, Uyemura v. Comr. , T.C. Memo 2012-102, and Lum v. Comr. , T.C. Memo 2012-103 - involving solar incentives offered by the same Hawaiian solar company, the Tax Court held that losses and a business energy investment credit claimed with respect to the three taxpayers' "micro-utility" sales activities were limited by the passive activity rules of §469 because the taxpayers failed to prove that they had materially participated in the activities. This trio of cases provide an important reminder that the ability to take losses currently is contingent on a taxpayer both "materially participating" and providing contemporaneous records of that participation.

As a general rule, §469(a)(1)(A) and (d)(1) provide that losses from a passive activity are allowed for the year they are sustained only to the extent of passive activity income.  Under §469(c)(1), a passive activity is a trade or business in which the taxpayer does not materially participate. A taxpayer is deemed to materially participate in an activity when he or she is involved on a regular, continuous and substantial basis. Regs. §1.469-5(f) provide that participation generally means all work performed in connection with an activity by an individual who owns an interest therein.

Under Regs. §§1.469-5T(a) and (b), a taxpayer can establish material participation by satisfying any one of seven tests provided in the regulations, including the following three tests: (i) the taxpayer's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals for such year; (ii) the taxpayer participated in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual for such year; or (iii) based on all of the facts and circumstance, the taxpayer participated in the activity for more than 100 hours and such participation was on a regular, continuous, and substantial basis during such year. Regs. §1.469-5T(f)(4) provides that a taxpayer can prove participation by any reasonable means, including but 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."

In each of the three cases, taxpayer, an architect, a manager and an executive, respectively, met with representatives at Hawaii Environmental Holdings d.b.a. Mercury Solar ("Mercury Solar") to learn about its solar equipment in connection with acquiring a solar water heater for home use. Each of the taxpayers elected to participate in one of Mercury Solar's purchase programs, which was marketed as a "zero net/free" program. Under this program, the taxpayer purchased one heater for personal use and one for investment purposes. The investment heater was then installed at the home or business of a "ratepayer," who paid the taxpayer a monthly fee for the solar energy. Mercury Solar represented that a purchase of solar equipment through this program was potentially "free" through a combination of financing, tax refunds resulting from credits and deductions and referral and ratepayer payments. Once the investment heater was installed, Power Change Co., LLC (PCC) was engaged to collect and process the monthly payments from the ratepayer and the taxpayer had little or no on-going responsibilities with respect to the investment heater. Each taxpayer claimed net losses in connection with the micro-utility activity on their respective tax returns. The IRS disallowed the losses as passive activity losses under §469.

Upon review of each case, the Tax Court concluded that each taxpayer had failed to prove that he had participated in the micro-utility activity for more than 100 hours during each of the years in issue, because none of the taxpayers had maintained appointment books, calendars, logs or other records to substantiate their participation.  The Tax Court noted that, while the regulations permit some flexibility regarding the records required to prove material participation, they do not allow this type of post-event guesstimates by a taxpayer.1 Additionally, the Tax Court concluded that each of the taxpayers had failed to establish that his participation was not less than that of individuals associated with PCC or Mercury Solar.

Accordingly, the Tax Court concluded that none of the taxpayers had materially participated in the micro-utility activity during the years in issue and that micro-utility activity was a passive activity under §469(c)(1), and thus any losses with respect to the micro-utility activity were subject to the passive loss limitations imposed by §469 and were disallowed.

The decisions by the Tax Court are reminder to taxpayers that it is rarely possible to get something for nothing when tax deductions are involved. Although Mercury Solar apparently warned participants that they have some income tax liability and that they must "meaningfully participate" in the solar business in order to claim the losses, the structure of the program was set up so that it was highly unlikely any participant could in fact qualify.

 For more information, in the Tax Management Portfolios, see Shaviro, 549 T.M., Passive Loss Rules,  and in Tax Practice Series, see ¶2980, Passive Loss Rules.

 1 See Estate of Stangeland v. Comr., T.C. Memo 2010-185; Shaw v. Comr., T.C. Memo 2002-35; Scheiner v. Comr., T.C. Memo 1996-554.

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