Stanley et al v. United States of America
Filing
60
ORDER granting Plaintiff's 21 Motion for Summary Judgment; denying Government's 24 Motion for Summary Judgment. Judgment will be entered upon resolution of the damages issue. Signed by Honorable P. K. Holmes, III on November 12, 2015. (src)
IN THE UNITED STATES DISTRICT COURT
WESTERN DISTRICT OF ARKANSAS
FAYETTEVILLE DIVISION
CAROL A. and ROY E. STANLEY
v.
PLAINTIFFS
Case No. 5:14-CV-05236
UNITED STATES OF AMERICA
DEFENDANT
ORDER
Currently before the Court are cross motions for summary judgment (Docs. 21, 24). Also
before the Court are the parties’ responsive filings, and various exhibits in support. After reviewing
the filings, the Court previously found that there was no genuine dispute of any material fact such
that this case should be presented to a jury. (Doc. 47). The Court directed the parties to submit
additional briefs specifically addressing certain questions raised by the Court in its order. Those
supplemental briefs (Docs. 51 and 53) have now been filed and reviewed by the Court. The Court
also heard additional argument and received evidence at a hearing held on September 29, 2015. At
the hearing, the Court heard testimony from Scott Rogerson and Roy Stanley. Having reviewed the
parties filings and considered the argument, testimony, and evidence of record, the Court finds that
the Stanleys’ motion for summary judgment (Doc. 21) should be GRANTED and the Government’s
motion for summary judgment (Doc. 24) should be DENIED.
I.
Background
Carol A. and Roy E. Stanley filed the complaint in this case on July 25, 2014 asserting a
claim pursuant to 26 U.S.C. § 7422 for the refund of money paid to the Internal Revenue Service
(“IRS”). For tax years 1994 through 2010, the Stanleys filed joint federal income tax returns. As
is relevant to this matter, the Stanleys reported certain non-passive income and losses on Schedule
-1-
E’s on their 2009 and 2010 returns. Before the IRS began its examination of the Stanleys’ 2009 and
2010 returns, the Stanleys had paid all their reported tax liabilities in full. On October 2, 2012, Luke
Pearson, an examiner with the Fayetteville, Arkansas office of the IRS, issued a report containing
his findings resulting from an audit of the Stanleys’ 2009 and 2010 returns. Mr. Pearson found that
a significant portion of the income the Stanleys claimed as non-passive should be reclassified as
passive income, resulting in an increase in the Stanleys’ tax liability for those years. The Stanleys
appealed Mr. Pearson’s findings to the Oklahoma City IRS appeals office. Ultimately, the IRS made
adjustments to the Stanleys’ 2009 and 2010 returns resulting in an increase in taxes and interest
owed of $69,851.08 for 2009 and $52,290.76 for 2010. The Stanleys paid the additional taxes
assessed under protest and filed claims for refunds. The IRS has not acted on the Stanleys’ refund
claims, and the issues are now before this Court.
From 1978 to February 1, 1994, Roy Stanley (“Roy”) practiced law in Springdale, Arkansas,
primarily representing real-estate clients and financial institutions. On February 1, 1994, Roy began
working full time as President of Lindsey Management Co., Inc., (“LMC”), a property-management
company based in Fayetteville, Arkansas. By 2009 and 2010, Roy worked half time at LMC.
Between February 1, 1994, and August 14, 2009, Roy also acted as general counsel for LMC. In
2008 or 2009, Roy’s title at LMC became President Emeritus, and on December 31, 2010, Roy
retired from LMC. Starting in November 1996, and during the relevant time period, Roy also served
as President of Lindsey Communications, Inc. (“LCI”), a company that provided telecommunications
services to certain properties managed by LMC.
From the beginning of Roy’s employment with LMC, the Stanleys acquired minority
ownership interests in business entities that owned or operated the rental properties and adjoining
-2-
golf courses managed by LMC. By 2009 and 2010, the Stanleys had an ownership interest in more
than 100 entities. The Stanleys also directly owned two rental properties, two percent of a third
rental property, and interests in 88 (in 2010) and 90 (in 2009) additional entities through the Roy E.
Stanley Family Limited Partnership. For 2009 and 2010, the Stanleys reported all income and losses
resulting from these ownership interests as non-passive on their Schedule E’s. When the IRS audited
the Stanleys’ 2009 and 2010 returns, it reclassified all of the Schedule E income and losses (except
for those related to Roy’s income from LMC) as passive, which resulted in the Stanleys owing
additional taxes for those years, as they were not able to use passive losses to offset non-passive
income.
The Stanleys claim that the IRS’s actions in regrouping their Schedule E activities and in
reclassifying claimed non-passive activity as passive were in error and that the resulting additional
owed taxes were wrongfully assessed. Specifically, the Stanleys assert that for tax years 2009 and
2010: (1) Roy was a qualifying taxpayer or “real estate professional,” as he met the requirements set
out in 26 U.S.C. § 469(c)(7); (2) the Stanleys’ rental real estate activities and business activities
could be grouped pursuant to 26 C.F.R. § 1.469-4(d)(1), as the rental and business activities
constituted an appropriate economic unit, and the business activities were insubstantial in relation
to the rental activities and/or each owner of the business activities had the same proportionate
ownership interest in the rental activities; (3) the Stanleys appropriately aggregated their rental real
estate activities pursuant to 26 C.F.R. § 1.469-9(g); and (4) the aggregated rental real estate activities
together with the grouped business activities should be non-passive, as Roy materially participated
in the grouped “Activity” in accordance with the criteria set forth in 26 C.F.R. § 1.469-5T(a). The
Stanleys seek a refund of $69,501.08 with respect to their 2009 federal income tax return and
-3-
$52,290.76 with respect to their 2010 federal income tax return plus interest from the date of
payment and costs incurred in bringing this action.
The Government, in turn, argues that (1) Roy was not a 5% owner of LMC as would be
required for his services performed as an employee of LMC to constitute material participation in
a real property trade or business as set forth in 26 U.S.C. § 469(c)(7)(D)(ii) and 26 C.F.R. § 1.4699(c)(5); (2) Roy did not qualify as a real estate professional; (3) the Stanleys’ Schedule E activities
were not appropriately grouped; (4) Roy did not materially participate in an appropriately grouped
activity as required to show non-passive income or loss; and (5) Roy has, in any event, not
adequately substantiated that (a) he was a 5% owner in LMC, (b) he qualified as a real estate
professional, (c) he appropriately grouped rental activities with non-rental activities, or (d) he
materially participated in any appropriately grouped activity. The Government seeks a judgment
declaring that the Stanleys are not entitled to a refund because the IRS appropriately re-characterized
the Stanleys’ Schedule E activities as passive for tax years 2009 and 2010.
II.
Analysis
The standard of review for summary judgment is well established. Under Federal Rule of
Civil Procedure 56(a), “[t]he court shall grant summary judgment if the movant shows that there is
no genuine dispute as to any material fact and the movant is entitled to judgment as a matter of law.”
The moving party bears the burden of proving the absence of a genuine dispute of material fact and
that it is entitled to judgment as a matter of law. Fed. R. Civ. P. 56(c); Matsushita Elec. Indus. Co.
v. Zenith Radio Corp., 475 U.S. 574, 586–87 (1986); Nat’l. Bank of Commerce of El Dorado, Ark.
v. Dow Chem. Co., 165 F.3d 602 (8th Cir. 1999). When the moving party has met its burden, the
non-moving party must “come forward with ‘specific facts showing that there is a genuine issue for
-4-
trial.’” Matsushita, 475 U.S. at 587 (quoting Fed. R. Civ. P. 56(c)). This same standard applies
where, as here, the parties file cross motions for summary judgment. In this situation, it follows that
when the parties agree that there exists no genuine issue as to any material fact, “summary judgment
is a useful tool whereby needless trials may be avoided, and it should not be withheld in an
appropriate case.” United States v. Porter, 581 F.2d 698, 703 (8th Cir. 1978). Each motion should
be reviewed in its own right, with each side, respectively, “entitled to the benefit of all inferences
favorable to them which might reasonably be drawn from the record.” Wermager v. Cormorant Twp.
Bd., 716 F.2d 1211, 1214 (8th Cir. 1983). “Questions of law are ‘particularly appropriate for
summary judgment.’” Hammer v. Sam’s East, Inc., 754 F.3d 492, 501 (8th Cir. 2014) (quoting
TeamBank, N.A. v. McClure, 279 F.3d 614, 617 (8th Cir. 2002)).
“Generally, the I.R.S. determination on the existence of a tax deficiency is presumed correct;
thus, the taxpayer generally bears the burden of proving entitlement to a claimed deduction by a
preponderance of the evidence.” Blodgett v. C.I.R., 394 F.3d 1030, 1035 (8th Cir. 2005). The
burden may, however, shift to the IRS in certain circumstances. Id. Because the issues before the
Court turn on questions of law—to include questions as to what substantiation is required of a
taxpayer under the law—the issue of who has the burden of factual proof is largely immaterial in this
case, which the Court has found appropriate to decide on summary judgment. Where, however, the
Court has found that the Stanleys have failed to present evidence on an issue, the Court has held
them to their burden.
A.
Roy Stanley was a more-than-five-percent owner of LMC.
As a threshold matter, the Court must determine whether Roy was at least a five-percent
owner of LMC such that his services performed as an employee of LMC can be treated as performed
-5-
in a real property trade or business for purposes of determining if Roy was a “qualifying taxpayer”
for purposes of 26 U.S.C. § 469(c)(7). Generally, “personal services shall not be treated as
performed in real property trades or businesses.” 26 U.S.C. § 469(c)(7)(D)(ii). That restriction will
not apply, however, “if such employee is a 5-percent owner (as defined in section 416(i)(1)(B)) in
the employer.” Id. Section 416(i)(1)(B)(i) defines a “5-percent owner” as follows:
(I)
if the employer is a corporation, any person who owns (or is considered as
owning within the meaning of section 318) more than 5 percent of the
outstanding stock of the corporation or stock possessing more than 5 percent
of the total combined voting power of all stock of the corporation, or
(II)
if the employer is not a corporation, any person who owns more than 5
percent of the capital or profits interest in the employer.
26 U.S.C. § 416(i)(1)(B)(i)(I)-(II).
The Government first argued that any income Roy received as a portion of LMC’s profits was
more properly characterized as direct salary income and was not indicative of ownership in the
company. Roy testified that, from the time he began working at LMC in 1994, he owned ten percent
of the company. Roy admitted into evidence a stock certificate evidencing his ownership of 10
shares out of 100 shares of LMC stock issued. (Pl. Hearing Exh. 6). Scott Rogerson, Chief
Financial Officer and President of Corporate Operations for LMC, testified that the certificate was
in fact a stock certificate from LMC to Roy for ten shares of stock in LMC. (Doc. 59, p. 9). Mr.
Rogerson testified that the stock certificate issued to Roy was restricted only by the terms of the
Roy’s employment agreement with LMC. (Doc. 59, p. 9). Roy testified under oath that his stock
in LMC was voting stock, but that meetings of the 2 or 3 shareholders at LMC were informal and
that, with only ten percent of the stock, his role was to give advice as opposed to making decisions.
Id. at 27, 55. Roy’s ownership of the stock was acknowledged in his February 1, 2004 employment
-6-
agreement and a subsequent employment agreement, which memorialized the understanding between
the parties to those agreements that Roy would relinquish his stock upon full retirement from LMC.
(Doc. 57, pp. 7 and 10). Roy’s salary from LMC was reported as W-2 income from wages or
salaries on line 7 of the Stanleys’ tax returns for 2009 and 2010. (Doc. 50-4, p. 3 and Doc. 50-5, p.
3). Income received as a result of Roy’s 10-percent ownership interest in LMC was reported on a
Form K-1 from LMC each year and reported on Schedule E of the returns as distributions from an
S corporation. (Doc. 50-4, p. 59 and Doc. 50-5, p. 61). Upon his resignation from LMC, and
pursuant to his employment agreement with LMC, Roy transferred the stock certificate back to
James Edgar Lindsey. (Pl. Hearing Exh. 7). While the Government argues that this evidence is not
sufficient to substantiate Roy’s alleged ownership, the Court finds that it is sufficient to show that
Roy held ten percent of the stock of LMC for tax years 2009 and 2010. While the Court construes
this as a legal issue of what may constitute or substantiate ownership under the applicable regulation,
in the event it may be construed as an issue of evidentiary sufficiency, the Court finds that Roy has
shown his ownership by a preponderance of the evidence.
The parties dispute whether Roy bore any risk of loss were LMC to experience a loss during
Roy’s tenure. This argument, however, does not factor into the Court’s analysis, as it is rooted in
speculation. LMC never experienced a loss during Roy’s tenure. Rather, the issue here is whether
Roy has adequately and reasonably substantiated his ownership for purposes of the tax code. The
Court finds that he has. Furthermore, the fact that Roy did not make a capital contribution for his
shares is not determinative of whether he nevertheless owned 10 percent of the stock of LMC. A
capital contribution is merely one avenue of acquiring ownership of stock or other property.
-7-
In the alternative to arguing that Roy’s income from his alleged ten-percent ownership in
LMC was salary income, the Government argued that Roy’s stock in LMC was not “outstanding
stock” as required by 26 U.S.C. § 416(i)(1)(B)(i)(I). Section 416(i)(1)(B)(i) defines a “5-percent
owner,” in the case of corporate employer, as “any person who owns (or is considered as owning
within the meaning of section 318) more than 5 percent of the outstanding stock of the corporation
or stock possessing more than 5 percent of the total combined voting power of all stock of the
corporation.” Section 318 in turn provides that, at least for purposes of subsection (a)(5) of that
statute, “an S corporation shall be treated as a partnership, and any shareholder of the S corporation
shall be treated as a partner of such partnership.” 26 U.S.C. § 318(a)(5)(E)(i)-(ii). Going back to
subsection 416(i)(1)(B)(i)(II), if an employer is not a corporation, a 5-percent owner is defined as
“any person who owns more than 5 percent of the capital or profits interest in the employer.”
LMC is an S corporation. The Government argues that, therefore, it is a corporate employer,
and Roy is required, pursuant to 26 U.S.C. § 416(i)(1)(B)(i)(I), to have owned 5 percent of the
“outstanding stock” of LMC for tax years 2009 and 2010 for him to count his work as an employee
of LMC towards the participation required to be a real estate professional. The Government argues
that Roy’s stock was restricted in that he was required to surrender it, pursuant to his employment
agreement with LMC, either at the end of his employment or five years after his disability or death.
The Government argued that, because of this restriction, Roy could not transfer his stock to anyone
other than back to LMC or to James E. Lindsey.
Roy argues that, although LMC is a corporation, because it is an S corporation, it should
actually be treated as a partnership for purposes of determining if he was a 5-percent owner of LMC,
-8-
pursuant to 26 U.S.C. § 318(a)(5)(E).1 Roy argues that, under section 318, as a shareholder of LMC,
he should be treated as a partner of the LMC “partnership” and he was, therefore, a 5-percent owner
of LMC as he owned more than 5 percent of the capital or profits interest in his employer, LMC as
required by 26 U.S.C. § 416(i)(1)(B)(i)(II). Alternatively, Roy argues that he did own at least 5
percent of the outstanding stock of LMC as required by 26 U.S.C. § 416(i)(1)(B)(i)(I), as evidenced
by his stock certificate and other evidence before the Court.
In advancing its argument that Roy did not own “outstanding” stock, the Government relies
on an unrelated section of the tax code, 26 U.S.C. § 83. Section 83 provides guidance for when a
taxpayer should report gross income for property received in connection with the performance of
services. “If, in connection with the performance of services, property is transferred to any person
other than the person for whom such services are performed,” Section 83 requires the person
performing the services to report as gross income the fair market value of the property over the
amount paid for the property “in the first taxable year in which the rights of the person having the
beneficial interest in such property are transferable or are not subject to a substantial risk of
forfeiture, whichever is applicable.” 26 U.S.C. § 83(a). Section 83 does not explicitly reference any
provisions of the code or regulations at issue in this case. The Government has not cited to any
authority that would require or allow application of Section 83 to 26 U.S.C. § 416(i)(1)(B)(i)(I), and
the Court has not otherwise found any such authority. At the hearing, counsel for the Government
argues that Section 83 was relevant to the issues in this case simply because it is entitled “Property
Received in Connection with the Provision of Services.” (Doc. 59, p. 95). The mere title of a
1
Section 318 provides, at least for purposes of subsection (a)(5) of that statute, that “an S
corporation shall be treated as a partnership, and any shareholder of the S corporation shall be treated
as a partner of such partnership.” 26 U.S.C. § 318(a)(5)(E)(i)-(ii).
-9-
section of the tax code does not act as a net that might ensnare any other provision falling within its
broad subject-matter reach. The purpose of Section 83 appears to be to provide guidance on when
a taxpayer should report certain property received in exchange for services (i.e. stock options) as
gross income on a tax return, and further provides taxpayers with the option to elect to include such
property in gross income in the year of transfer notwithstanding any restriction on its transferability
or any substantial risk of forfeiture. 26 U.S.C. § 83(b). The Court finds that the section provides
no authoritative, or even persuasive, guidance on the issue of whether Roy was a 5-percent owner
of LMC.
The Court further finds that it is immaterial to this case whether LMC should be treated as
a corporation or a partnership for purposes of 26 U.S.C. § 416(i)(1)(B)(i). If LMC is treated as a
corporation, the Court finds that Roy has shown he owned 10 percent of the “outstanding stock.”
The Court has already set out the evidence of record substantiating Roy’s ownership of the stock,
and the Court does not find that the word “outstanding” imposes some additional requirement that
the stock be readily transferable or not at risk of forfeiture that would operate to prevent Roy from
claiming ownership for purposes of 26 U.S.C. § 469(c)(7)(D)(ii). Rather, Roy owned 10 shares of
100 shares of stock issued by LMC. Therefore, in the ordinary understanding of the term, Roy
owned 10 percent of outstanding LMC stock.2 Furthermore, Roy argues that his interest in the stock
(an interest that was subject to being surrendered upon the occurrence of certain events, such as Roy
leaving LMC’s employment) would have been transferable, and the Government has not persuaded
the Court that Roy’s argument is incorrect. If, alternatively, LMC should be treated as a partnership
2
See www.investopedia.com/terms/o/outstandingshares.asp (“Outstanding shares refer to a
company’s stock currently held by all its shareholders, including share blocks held by institutional
investors and restricted shares owned by the company’s officers and insiders.”).
-10-
for purposes of 26 U.S.C. § 416(i)(1)(B)(I), the Court finds that Roy has substantiated that he
“own[ed] more than 5 percent of the capital or profits interest in the employer” as required. In either
event, the Court finds that Roy was a ten-percent owner of LMC for purposes of 26 U.S.C. §
469(c)(7)(D)(ii).
B.
Roy Stanley was a qualifying taxpayer pursuant to 26 U.S.C. § 469(c)(7).
By rule, all rental activity is per se passive under the tax code. 26 U.S.C. § 469(c)(2)
(“Except as provided in paragraph (7), the term ‘passive activity’ includes any rental activity.”). The
per se passive rule does not apply, however, to any rental real estate activity of a taxpayer for a
taxable year if the taxpayer can show that “(i) more than one-half of the personal services performed
in trades or businesses by the taxpayer during such taxable year are performed in real property trades
or businesses in which the taxpayer materially participates, and (ii) such taxpayer performs more
than 750 hours of services during the taxable year in real property trades or businesses in which the
taxpayer materially participates.” 26 U.S.C. § 469(c)(7)(B). In common parlance, the per se passive
rule does not apply to a taxpayer who satisfies the two requirements listed above and therefore
qualifies as a “real estate professional.” For real estate professionals, a rental real estate activity is
a passive activity unless the qualifying taxpayer materially participates in the activity (in other words,
the general rules for passive activity apply instead of the per se passive rule). 26 C.F.R. § 1.469-9(e).
For purposes of determining whether a taxpayer qualifies as a real estate professional, “real property
trade or business” includes any real property management trade or business. 26 U.S.C. §
469(c)(7)(C). “[P]ersonal services performed as an employee shall not be treated as performed in
real property trades or businesses” unless “such employee is a 5-percent owner . . . in the employer.”
26 U.S.C. § 469(c)(7)(D)(ii).
-11-
As set forth above, the Court has already found that Roy was a 10-percent owner of LMC
during the relevant time period of tax years 2009 and 2010. It is undisputed that Roy spent over half
of his working time performing services for LMC, as Roy had no employment other than his
employment at LMC. It is also undisputed that Roy performed more than 750 hours of services as
an employee of LMC in 2009 and 2010.3 It is undisputed that LMC is a real property management
business. Roy also materially participated in LMC for tax years 2009 and 2010, as he spent more
than 500 hours participating in the activity during each year. 26 C.F.R. § 1.469-5(a)(1) and (f)(1).
The Government argues that, in order for Roy to substantiate his claim that he was a real estate
professional, he “needed to keep track of time spent using a minimum of two categories:activities
in real property trades or businesses and activities not in real property trades or businesses, such as
the provision of legal services.” (Doc. 37, p. 6). Section 469 does not, however, require that the
services performed in a real property trade or business be of any specific character or that all such
services must be directly related to real estate. Rather, the services must simply be performed “in
real property trades or business in which the taxpayer materially participates.” 26 U.S.C. §
469(c)(7)(B)(i) and (ii). Because LMC was a real property business in which Roy materially
participated, Roy satisfied the requirements of 26 U.S.C. § 469(c)(7) and was properly considered
a real estate professional for tax years 2009 and 2010.
C.
Roy Stanley appropriately aggregated his rental activities pursuant to 26 C.F.R. §
1.469-9(g) and, with certain exceptions, appropriately grouped his rental and nonrental activities pursuant to 26 C.F.R. § 1.469-4.
3
The parties stipulated that Roy’s time spent working for LMC/LCI in 2009 and 2010
averaged between 28.25 and 29.25 hours per week (Doc. 26-4, ¶¶ 70-71).
-12-
“Each interest in rental real estate of a [real estate professional taxpayer] will be treated as
a separate rental real estate activity, unless the taxpayer makes an election . . . to treat all interests
in rental real estate as a single rental real estate activity.” 26 C.F.R. § 1.469-9(e)(1). The Stanleys
made the appropriate election to aggregate their rental real estate activities, pursuant to 26 C.F.R.
§ 1.469-9(g), for tax years 2009 and 2010.
The Government does not dispute that the Stanleys properly aggregated their rental real estate
activities (except insofar as they argue that Roy was not a real estate professional who qualified to
aggregate his rentals pursuant to 26 C.F.R. § 1.469-9(g)—an argument the Court has already
rejected). The Government does, however, argue that the Stanleys could not group their aggregated
“Rental Activity” with any other non-rental activity, because such grouping is categorically
prohibited by 26 C.F.R. § 1.469-9(e)(3)(i). Subsection 1.469-9(e)(3)(i) is entitled “Grouping rental
real estate activities with other activities—In general” and provides as follows:
For purposes of this section, a qualifying taxpayer may not group a rental real estate
activity with any other activity of the taxpayer. For example, if a qualifying taxpayer
develops real property, constructs buildings, and owns an interest in rental real estate,
the taxpayer’s interest in rental real estate may not be grouped with the taxpayer’s
development activity or construction activity. Thus, only the participation of the
taxpayer with respect to the rental real estate may be used to determine if the
taxpayer materially participates in the rental real estate activity under § 1.469-5T.
(emphases added). The Court cannot agree with the Government’s interpretation that this section
categorically prohibits real estate professionals from grouping rental activity with other activity for
all purposes. While this particular argument was not raised in the parties’ original briefs, the Court
requested briefing on the issue of whether subsection 1.469-9(e)(3)(i) “prohibit[s] grouping of rental
real estate activities (whether singular or aggregated) with non-rental real estate activities for
purposes of determining material participation in the rental real estate activity.” (Doc. 56, p. 2).
-13-
Implicit in that question was the Court’s initial understanding that 1.469-9(e)(3)(i) likely limited
grouping but only for purposes of determining material participation in a rental activity. The
Government’s arguments in its supplemental brief and at the hearing did not convince the Court that
its initial understanding was wrong. Read in context, subsection 1.469-9(e)(3)(i) bars grouping only
for purposes of determining material participation and does not categorically bar a real estate
professional from grouping rental and non-rental activities for other purposes, including for purposes
of determining passive activity loss and credit.
First, subsection 1.469-9(e)(3)(i) is self-limiting, as it begins with the words, “for purposes
of this section.” “This section” refers to 1.469-9, entitled “Rules for certain rental real estate
activities” with the stated purpose of “provid[ing] guidance to taxpayers engaged in certain real
property trades or businesses on applying section 469(c)(7) to their rental real estate activities.” 26
C.F.R. § 1.469-9(a) (emphasis added). Subsection 1.469-9(e)(3)(i) does not otherwise purport to
prohibit real estate professionals from taking advantage of the rules set out in 26 C.F.R. § 1.469-4,
allowing taxpayers to group certain activities and, specifically, allowing grouping of rental activities
with other trade or business activities in certain circumstances, § 1.469-4(d)(1), “for purposes of
applying the passive activity loss and credit limitation rules of section 469,” § 1.469-4(a). This is
especially telling given that § 1.469-4 is explicitly referenced in other subsections of § 1.469-9. See,
e.g., 26 C.F.R. § 1.469-9(b)(3) (“any rental real estate that the taxpayer grouped with a trade or
business activity under § 1.469-4(d)(1)(i)(A) or (C)4 is not an interest in rental real estate for
4
With the possible exception of their golf activities, the Stanleys assert that they grouped
their rental activities with other trade or business activities pursuant to § 1.469-4(d)(1)(i)(B), such
that this section would not apply. This section would, then, appear to contemplate that the Stanleys
could not only group their rental activities with other trade and business activities but also that the
grouped “Activity” could still be considered to be an interest in rental real estate for purposes of
-14-
purposes of this section”); 26 C.F.R. § 1.469-9(d)(1) (“A taxpayer’s grouping of activities under §
1.469-4 does not control the determination of the taxpayer’s real property trades or businesses under
this paragraph (d)”).
Second, subsection 1.469-9(e)(3)(i) ends with the summary conclusion that, because a real
estate professional may not group a rental real estate activity with any other activity of the taxpayer
for purposes of § 1.469-9, “only the participation of the taxpayer with respect to the rental real estate
may be used to determine if the taxpayer materially participates in the rental real estate activity under
§ 1.469-5T.” The conclusion does not say that a real estate professional cannot, thus, group rental
activities with any other activity for purposes of applying the passive activity loss and credit
limitation rules of § 469. Rather, read in context, the subsection appears to apply to grouping for
purposes of determining material participation or, perhaps, to aggregating rental activities pursuant
to subsection 1.469-9(g) (which would be done, in part, to meet material participation requirements).
This interpretation is further supported when the subsection is read in context with its accompanying
subpart. Subsection 1.469-9(e)(3)(ii) sets out an exception to the general rule set out in subsection
1.469-9(e)(3)(i) in providing that a real estate professional may nonetheless “participate in a rental
real estate activity through participation, within the meaning of §§ 1.469-5(f) and 5T(f) [setting out
rules for determining material participation], in an activity involving the management of rental real
estate.” This subsection again directly addresses only material participation. The examples
following subsection 1.469-9(e) also address determinations of whether a taxpayer materially
participates in rental real estate activities. 26 C.F.R. § 1.469-9(e)(4). An attentive reading of
subsection 1.469-9(e)(3)(i) leads to the conclusion that grouping of rental activities and other
§ 1.469-9.
-15-
activities is prohibited only for purposes of determining material participation pursuant to § 1.469-5
and 5T and not for purposes of applying the passive activity loss and credit limitation rules of 26
U.S.C. § 469.
Finally, 26 C.F.R. § 1.469-4(c)(1) explicitly allows for grouping of rental and non-rental
activities in certain circumstances. This regulation on grouping does not include any provision
indicating that real estate professionals are prohibited from availing themselves of the benefits of
grouping their rental real estate activities with any other activity if they otherwise meet the
requirements of the grouping regulation.
Because the Court finds that the Stanleys were not categorically prohibited from grouping
their aggregated Rental Activity with their other trade or business activities, the Court must analyze
whether the Stanleys’ grouping of their Schedule E activities was appropriate under 26 C.F.R. §
1.469-4. Generally, “[o]ne 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.” 26 C.F.R. § 1.469-4(c)(1). “[W]hether activities constitute an
appropriate economic unit . . . depends upon all the relevant facts and circumstances,” with the
greatest weight given to the following factors: “(i) Similarities and differences in types of trades or
businesses; (ii) The extent of common control; (iii) The extent of common ownership; (iv)
Geographical location; and (v) Interdependencies between or among the activities.” 26 C.F.R.
§ 1.469-4(c)(2). “A taxpayer may use any reasonable method of applying the relevant facts and
circumstances in grouping activities.” Id. A rental activity, however, “may not be grouped with a
trade or business activity unless the activities being grouped together constitute an appropriate
economic unit . . . and (A) The rental activity is insubstantial in relation to the trade or business
-16-
activity; (B) The trade or business activity is insubstantial in relation to the rental activity; or (C)
Each owner of the trade or business activity has the same proportionate ownership interest in the
rental activity.” 26 C.F.R. § 1.469-4(d)(1).
The Government argues that the IRS correctly determined that the Stanleys could not
properly group all their Schedule E activities together. The Stanleys argue that their grouping was
reasonable and appropriate, as the grouped Activity was an appropriate economic unit and the
grouped trade or business activities were all insubstantial in relation to the aggregated Rental
Activity.
The Stanleys grouped their aggregated Rental Activity with other trade or business activities,
including LMC, LCI, and the activity of golf courses adjoining LMC-managed properties. Having
considered the relevant facts and circumstances, the Court first finds that the Rental Activity, LMC,
LCI, and the golf courses formed an appropriate economic unit. With few exceptions, the rental
properties aggregated in the Stanleys’ Rental Activity were all managed by LMC, with
telecommunications services provided by LCI. LMC is a property-management company that
manages rental apartment complexes, golf courses, and commercial properties in Arkansas and
surrounding states. The parties stipulated that “[t]he vast majority of LMC’s revenues came from
property management fees.” (Doc. 26-4, ¶ 31). LCI “provided telecommunications services . . . to
some apartment complexes and golf courses managed by [LMC] or negotiated with third-party
providers to provide telecommunications services to certain LMC-managed apartment complexes
and golf courses.” (Doc. 26-4, ¶ 25(a)). As for the golf courses, “[e]very LMC-managed golf course
[is] located next to an LMC-managed apartment complex.” (Doc. 26-4, ¶ 39). Some LMC
apartment complexes have no adjoining golf course; some have 9-hole courses that are free for
-17-
tenants to use; and some have 18-hole courses that tenants may be able to use at a reduced rate. All
courses are also open to the public for a fee.
While there are certainly significant differences in the types of services offered by the rental
properties, LMC, LCI, and the golf courses, all four services worked in concert in connection with
the same trade or business category—rental real estate. While the precise ownership of the various
rental properties was technically diverse, it appears from the record that James E. Lindsey and/or his
family exerted common control over the rental properties, LMC, LCI, and the golf courses. All the
rental real estate properties as well as the golf courses were also under common control to the extent
that they were all managed by LMC, which was an S corporation with a majority shareholder—Mr.
Lindsey. As to the geographic location of the various activities, LMC is headquartered in Northwest
Arkansas and the rental properties and golf courses it manages (and for which LCI provides services)
are all concentrated in Arkansas and nearby states. Finally, the interdependencies of the rental
properties with LMC and LCI and with the golf courses is apparent. As already stated, LMC and
LCI were entities whose function was to perform services on behalf of LMC-managed rental
properties. Those rental properties included certain complexes whose business model was to provide
tenants with access—for free or at a reduced rate—to an adjoining golf course. While golf and
apartment rentals are not inherently related, LMC created an apparently successful business model
that linked the two, and the regulations allow for consideration of all relevant facts and
circumstances—not just those factors that are specifically enumerated. Much as a fast food
restaurant might attract customers via a playground area or a savings club might have an adjoining
gas station or restaurant, LMC’s model sought to attract tenants through golf. Roy testified that
developing golf courses in conjunction with apartment rentals generally decreased neighborhood
-18-
opposition that would otherwise be encountered in response to a proposed apartment rental
development on its own. Grouping these two activities in this context represents a “reasonable
method of applying the relevant facts and circumstances in grouping activities.” 26 C.F.R. § 1.4694(c)(2).
The Court also finds that LMC, LCI, and the golf activities were insubstantial in relation to
the Rental Activity. In making this determination, the Court has endeavored to consider all the
“pertinent factors.” TD 8565, 1994-43 I.R.B. 4 (rejecting a bright-line rule for determining
insubstantiality “ to avoid complex and mechanical rules,” stating that “the regulations already adopt
a facts-and-circumstances test that looks at all the pertinent factors”); Candelaria v. United States,
518 F. Supp. 2d 852, 859-60 (W.D. Tex. 2007); Glick v. United States, 96 F. Supp. 2d 850 (S.D. Ind.
2000). Because the test for insubstantiality is one that depends on the facts and circumstances of
each individual case, the Court relies heavily on the evidence of record and finds that a lengthy legal
analysis as to this point is unnecessary in this case.
The only business of LMC was to manage rental real estate properties, including those
grouped in the Stanleys’ Rental Activity; the only business of LCI was to provide
telecommunications services to those rental real estate properties; and the golf courses were created
incidentally to the rental real estate properties to which they are connected. “The vast majority of
LMC’s revenues came from property management fees” generated by management of the rental real
estate properties. (Doc. 26-4, ¶ 31). Roy testified that LCI was created in order to be able to market
bundled telecommunication services with property rentals to increase competitiveness in the rental
market as well as to create a profit that was divided with the apartment ownership entities at the end
of each year. (Doc. 59, pp. 43-44). Finally, Roy testified that the combined revenues of the golf
-19-
courses, LMC, and LCI came to less than twenty percent of the total revenue for those activities and
the rental properties managed by LMC,5 satisfying an “80/20 rule” to the extent such a rule still
applies,6 and in any event demonstrating that both collectively and independently, LMC, LCI, and
the golf course activities were insubstantial to the rental properties in an economic sense. The
Government has challenged Roy’s calculations as not fully substantiated, but even taking the
revenues presented by Roy as a rough estimate, and given the practical and operational reality in
which LMC, LCI, and the golf activities co-existed with the rental properties as set forth above, the
Court finds that Roy has reasonably shown that he could properly group his Rental Activity with
LMC, LCI and his golf activities.
While the parties initially stipulated that “Beacon Hill, Inc. cannot be grouped with Lindsey
Management Company, Inc. or Lindsey Communications, Inc. under 26 C.F.R. § 1.469-4 or § 1.4699 on [the Stanleys’] 2009 and 2010 income tax returns,” (Doc. 26-5, ¶ 2) Roy represents that he later
asked Government counsel to remove that stipulation (Doc. 34, p. 6). Roy states that, while he “did
not participate in the day-to-day management or operation of Beacon Hill, Inc.” he “believe[s] it can
be properly remain [sic] a part of the group because of Plaintiffs’ participation in the group as a
whole.” Id. Even if the Court were to allow Roy to withdraw his stipulation, the Court would
otherwise find that the Stanleys have not adequately shown that Beacon Hill, Inc. should be grouped
with their other Schedule E activities. The parties devoted little argument or analysis to this entity
5
Doc. 59, p. 90.
6
See Candelaria, 518 F.Supp.2d at 858-59 (noting that “Treasury Regulations do not define
the term ‘insubstantial’ in the context of comparing rental and other business activities” and looking
to other statutes and regulations before concluding that “the 80/20 Test is an appropriate
representation of what constitutes ‘insubstantial’ with regard[] to income as the test’s percentages
fall within the range used in these other statutes and regulations”).
-20-
or to LGC Construction Management, LLC or Lindsey-Green Commercial Properties Management,
Inc.7 The Court cannot find that the Stanleys have met their burden of proof of showing that they
are entitled to relief as to these entities and the Court finds, therefore, that the following
entities/activities should not be grouped with the Stanleys’ Schedule E activities on their tax returns
for 2009 and 2010 and should, instead, each be considered as a separate activity, which would make
any income or losses attributable to those activities passive:
•
Beacon Hill, Inc.;
•
LGC Construction Management, LLC; and
•
Lindsey-Green Commercial Properties Management, Inc.
The Stanleys have agreed that Property Tax Services, Inc. should not be grouped with the
other Schedule E activities. (Doc. 36, p. 13). The Stanleys have also conceded that their nonoperational activities can be removed from the group as well. Id.
D.
Roy Stanley materially participated in the grouped activity.
Generally, “any work done by an individual (without regard to the capacity in which the
individual does the work) in connection with an activity in which the individual owns an interest at
the time the work is done shall be treated for purposes of this section as participation of the
individual in the activity.” 26 C.F.R. § 1.469-5(f)(1). As already discussed above, a real estate
professional “may participate in a rental real estate activity through participation, within the meaning
of §§ 1.469-5(f) and 5T(f), in an activity involving the management of rental real estate (even if the
7
If the Court has missed any other entities/activities that either party believes is not properly
a part of the aggregated “Rental Activity” and not appropriately grouped with the Rental Activity
pursuant to subsection 1.469-4(d)(1), the parties should so inform the Court via stipulation or in their
briefs on damages.
-21-
management is conducted through a separate entity).” 26 C.F.R. § 1.469-9(e)(3)(ii). “In determining
whether the taxpayer materially participates in the rental real estate activity, however, work the
taxpayer performs in the management activity is taken into account only to the extent it is performed
in managing the taxpayer’s own rental real estate interests.” Id. Otherwise, an individual can
generally show material participation in an activity for a taxable year if he meets any one of several
tests set out in 26 C.F.R. § 1.469-5T(a), including through participation in the activity for more than
500 hours during a taxable year. 26. C.F.R. § 1.469-5T(a)(1). “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.” 26 C.F.R. § 1.469-5T(f)(4).
The Court finds that the Stanleys can show material participation in their grouped Schedule
E Activity. Roy had an ownership interest in a large majority of properties managed by LMC.8 The
Court finds that 26 C.F.R. § 1.469-9(e)(3)(ii) should be read to allow all work engaged in by Roy
for the benefit of LMC to be counted as work performed in managing Roy’s own rental real estate
interests such that Roy’s time at LMC should be counted towards determining whether Roy
materially participated in his rental real estate activity. It would be unreasonable, in the limited
scenario presented by this case of a real estate professional who works at a real estate management
company and also has ownership interests in the vast majority of properties managed by the
company, to delineate the time he spent on an individual property, especially where much of the
work performed by Roy was done for the benefit of multiple properties or LMC generally.
8
Roy admitted into evidence an exhibit purporting to show that he had an ownership interest
in 86 percent of the apartment units managed by LMC. (Pl. Hearing Exh. 13).
-22-
Furthermore, subsection 1.469-9(e)(3)(ii) does not require a taxpayer to delineate or categorize work
performed in a management activity, as the Government would require Roy to do (i.e. when was he
acting as general counsel or as a general manager as opposed to directly “managing” properties).
Rather, subsection 1.469-9(e)(3)(ii) allows a taxpayer to generally credit towards material
participation all “work the taxpayer performs in the management activity” as long as it is performed
in managing the taxpayer’s own rental real estate interests. “Management” of rental real estate,
especially on a large scale, will necessarily involve legal issues or issues of compliance, such as
those on which Roy spent a significant amount of time.9 “Management” should not be construed so
narrowly so as to exclude these categories—or other categories—of services inherently necessary
to the functioning of a successful real estate management entity.
Finally, the Government has cited to no authority, nor has the Court found any authority, to
support the proposition that Roy’s time spent managing his rental real estate interests should be
discounted to reflect his actual percentage ownership interest in any given property. Rather, “any
work done by an individual (without regard to the capacity in which the individual does the work)
in connection with an activity in which the individual owns an interest at the time the work is done
shall be treated for purposes of this section as participation of the individual in the activity.” 26
C.F.R. § 1.469-5(f)(1). The regulations do not require a certain percentage of ownership in an
9
The parties are largely in agreement as to how Roy Stanley spent his time at LMC. (Doc.
26 and Doc. 34). For instance, “[i]n 2009 and 2010 . . . Roy Stanley continued to have oversight
over the legal issues related to LMC’s operations and the development of new properties;” “was
involved in legal matters related to property development and management, such as drafting and
reviewing documents to obtain easements and to keep the property entities in good standing, draft
and interpret leases, as well as contracts with banks;” “trained other LMC attorneys;” and “reviewed
the leases of golf courses, easements related to the golf courses, and documents related to lawsuits.”
(Doc. 26, ¶¶ 95-97).
-23-
activity before an owner may be deemed to participate when working “in connection with [that]
activity,” and the Court will not read such a requirement into the regulations where it does not exist.
Because the Stanleys’ rental real estate activity is grouped with other trade or business
activities, and because the trade or business activities are insubstantial in relation to the rental
activities, the grouped Activity takes on the nature of a rental real estate activity, for which
subsection 1.469-9(e)(3)(i) does not allow consideration of participation in the non-rental activities
to be credited towards determining material participation in the grouped rental Activity. The Court
will not and need not, therefore, consider whether the Stanleys may have otherwise materially
participated in any trade or business activity pursuant to the tests set out in 26 C.F.R. § 1.469-5T(a).
III.
Conclusion
For the reasons set forth above, the Court finds and ORDERS that Plaintiffs’ motion for
summary judgment (Doc. 21) should be and is GRANTED, except to the extent that the Court has
found that the following entities should not be grouped on the Stanleys’ Schedule E for tax years
2009 and 2010 and should, instead, each be considered to be a separate activity generating passive
losses or income:
•
Beacon Hill, Inc.
•
LGC Construction Management, LLC
•
Lindsey-Green Commercial Properties Management, Inc.10
•
Property Tax Services, Inc.
10
If the Court has missed any other entities/activities that either party believes is not properly
a part of the aggregated “Rental Activity” and not appropriately grouped with the Rental Activity
pursuant to subsection 1.469-4(d)(1), the parties should so inform the Court via stipulation or in their
briefs on damages.
-24-
•
Any non-operational activities
It is further ordered that the Government’s motion for summary judgment (Doc. 24) is
DENIED.
The parties are encouraged to submit a stipulation as to what damages the Stanleys are
entitled to as a result of this ruling by December 1, 2015. If the parties are unable to agree on
damages, simultaneous briefs should be filed by that same date. The stipulation or briefs should
include consideration of whether the Stanleys are entitled to recover interest and costs. Judgment
will be entered upon resolution of the damages issue.
IT IS SO ORDERED this 12th day of November, 2015.
/s/P. K. Holmes, III
P.K. HOLMES, III
CHIEF U.S. DISTRICT JUDGE
-25-
Disclaimer: Justia Dockets & Filings provides public litigation records from the federal appellate and district courts. These filings and docket sheets should not be considered findings of fact or liability, nor do they necessarily reflect the view of Justia.
Why Is My Information Online?