Airplane Rental Was Passive Activity Where Owner Failed to Show Material Participation

Transcription

1 Airplane Rental Was Passive Activity Where Owner Failed to Show Material Participation Williams, TC Memo The Tax Court has held that a part-time attorney's rental of an airplane he purchased was a passive activity under the Code Sec. 469 passive activity loss (PAL) rules because he failed to show that he materially participated in the airplane activity. Under Code Sec. 469(c)(1), the PAL disallowance rules apply to any trade or business in which the taxpayer does not materially participate. These rules provide that PALs cannot offset nonpassive activity income, such as wages, dividends, or profits from nonpassive activities. In general, any rental activity is per se a passive activity regardless of the taxpayer's participation in the activity. (Code Sec. 469(c)(2)) However, under the exception in Reg T(e)(3)(ii), a rental activity doesn't include an activity involving the use of tangible property if, among other reasons, the average period customers use the property is seven days or less. Thus, if the average period of customer use is seven days or less, the property is treated as a trade or business in which the taxpayer can materially participate in order to avoid the PAL rules for that property. A taxpayer is treated as materially participating in an activity if he meets at least one of the seven tests in Reg T(a). For example, under the first test in that reg, an individual must participate in the activity for more than 500 hours during the year. Under the third test in that reg, the individual must participate in the activity for more than 100 hours during the tax year, and, in addition, his participation in the activity must not be less than any other individual's participation in the activity. Under the seventh test in that reg, an individual must 1

2 participate in the activity (for more than 100 hours) on a regular, continuous, and substantial basis during the year; and an individual's participation in the management of an activity isn't taken into account if a paid manager participates in the activity or if the management services performed by the individual are exceeded by those performed by any other individual. (Reg T(b)) Work done in the taxpayer's capacity as an investor in the activity is not treated as participation in the activity unless that person is directly involved in the day-today management or operations of the activity. (Reg T(f)(2)(ii)(A)) Work as an investor includes study and review of financial statements, preparing summaries or analyses of finances or operations, and monitoring the finances or operations in a nonmanagerial capacity. (Reg T(f)(2)(ii)(B)) Mr. Scott Wesley Williams maintained a part-time law practice focusing on business and aviation law and owned and operated a separate business unrelated to aviation, Worldwide Phone Pops (WPP), a telephone skills training business. For the year at issue, he spent more than 2,000 hours running WPP, and operated his law practice out of the same office as WPP. He also actively participated in the rental of five properties that he owned. Mr. Williams, a former U.S. Air Force officer, received his private pilot's license in '87 and his commercial pilot's license in '90. He also held an MBA in aviation. He purchased an airplane through WPP, which he made available for rent, used for personal purposes, and used in his WPP business. WPP entered into an aircraft marketing agreement with a rental and flight school company, Sky Blue (and after that company ceased doing business late in the year, with another such company, Mach 1). The Sky Blue agreement required Sky Blue to maintain a schedule book for the airplane, to promote the use of the airplane, to act as collection agent for the owner, to schedule flights and training, to arrange for fuel and oil, to tie down the airplane when not in use, to wash the 2

3 airplane weekly if the owner did not wash it, and to act as service center for the airplane manufacturer so that it could perform warranty maintenance on the airplane. The agreement with Mach 1 placed many more obligations on Mach 1 than the Sky Blue agreement. Among other things, it required Mach 1 to: maintain insurance on the airplane; maintain the master schedule via its own scheduling system; collect rental fees and fuel surcharges; coordinate with WPP to ensure that maintenance was done; track the tachometer, maintain FAA requirements and governmental licenses for flight schools; calculate monthly income; provide a detailed financial statement itemizing income and expenses; require renters to pass minimum proficiency standards; promptly report damage or injury to the aircraft, renter, or flight school agent to WPP; and undertake reasonable commercial efforts to ensure the aircraft was rented out as many hours as possible. Mr. Williams performed a variety of tasks relating to WPP's ownership of the airplane. He downloaded the updates to the navigation system, coordinated maintenance, hired people to wash and wax the airplane, drafted both aircraft marketing agreements, rewrote two template contracts that the flight schools used with individual renters, assisted Sky Blue and Mach 1 in marketing the airplane, had meetings with other flight schools about transferring the airplane, wrote a 1-page flyer for use by Sky Blue, and wrote a 1-page list of special instructions for the airplane. Mr. Williams estimated he spent approximately 150 hours solely on the airplane activity in year at issue. Mr. Williams did not provide a log of his hours spent on the airplane activity, not even for the amount of time he spent drafting the legal documents. Mr. Williams claimed to have spent more than 25 hours having dinner with Blue Sky's representative discussing how to better market WPP's airplane, but no contemporaneous records corroborate this. Mr. Williams claimed he had 3

4 extensive discussions with the representative almost daily regarding bills for maintenance that should have been covered by the airplane's warranty, but he did not provide any of the disputed invoices, or any invoices or statements. He testified that he spent over 10 hours poring through student records and calling Sky Blue students and asking them to continue to train in the airplane with Mach 1, but no corroborating evidence was provided. On his return, Mr. Williams offset losses related to the ownership of the airplane against his income from his other business. On audit, IRS challenged the deductions connected with the airplane activity, contending that it was a passive activity. Mr. Williams sought relief in the Tax Court and argued (1) that he met the 7-day exception to treating a rental activity as passive, and (2) that he materially participated in the airplane activity by meeting the first, third and seventh tests in Reg T(a). The Tax Court, upholding IRS's recharacterization of the activity as passive, determined that Mr. Williams did not materially participate in the airplane activity. Accordingly, he could not deduct losses for that activity in excess of the income from that activity. In reaching its conclusion, the Court skirted the threshold question of whether the 7-day exception to treating a rental activity as passive applied. This issue would be determined based upon whether the Court found that the customer was properly the pilot trainees (who used the plane only for brief periods less than 7 days) or the two flight schools (who each used the plane for months). The Court reasoned that, even if it assumed that Mr. Williams had met the exception and the airplane activity was not per se rental, he still had to show that he materially participated in the airplane activity-which he failed to do. The Court found that Mr. Williams failed the first test in Reg T(a). While he asserted that he met the 500-hour test because he spent more than 2,000 4

5 hours running WPP, the Court found that WPP and the airplane activity did not constitute an appropriate economic unit for the PAL rules. There was no evidence that WPP and the airplane activity had any of the same customers or that the two activities were integrated in any meaningful way. Most of the airplane's use and income came from renting the airplane outside WPP, which had no effect on the business of WPP. Similarly, there was no indication that the airplane activity depended on WPP since it was only an occasional user of the airplane. The Court therefore looked at the airplane activity separately to determine whether the activity was passive. Mr. Williams, who did not claim that he independently spent more than 500 hours on the airplane activity, did not materially participate in the airline activity under this test. The Court also found that Mr. Williams failed the third and seventh tests in Reg T(a). He failed to show that he spent more than 100 hours on the airplane activity exclusive of his time spent as an investor. While Mr. Williams asserted that he was involved in the activity almost daily, primarily because he would argue about the maintenance bills, the Court found that the review of the bills was work done in the capacity of an investor and so wasn't treated as participation in the airplane activity. Further, his own testimony, coupled with that of the Mach 1's owner and operator, showed that Mach 1's owner and operator spent more time on the airplane activity in the few months the airplane was with Mach 1 than Mr. Williams spent on the activity in the entire year. 5