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August 2015

Victory Over the IRS in Material Participation Challenge

In U.S. Tax Court, Frazer Ryan attorneys affirm that a couple materially participated in the operation of a yacht chartering business.

On August 5, 2015, Derek Kaczmarek and David Jojola won a significant victory for their clients in U.S. Tax Court, reducing to less than $4,000 an IRS claim of over $100,000.

In Kline v. Commissioner (T.C. Memo. 2015-144), the IRS argued that the taxpayers did not materially participate in their yacht chartering business, failed to properly substantiate their claimed expenses, and owed a negligence penalty of 20%, resulting in a determination of tax, penalties and interest of over $100,000.

The Tax Court found that the IRS determination was in error and that the taxpayers owed less than $4,000 in taxes, with no penalties.

Material Participation

Material participation in a business allows a taxpayer to offset any losses incurred in the business against their ordinary income. A lack of material participation limits the available loss to offset only passive income. (Internal Revenue Code § 469) Any rental activity is generally passive, unless an exception applies. (I.R.C. § 469(c)(1), (3))

There are several ways to prove material participation. In this case, the court ruled that the taxpayers met the “100 hour” test found in Treasury Regulation 1.469-5T(a)(3). The U.S. Tax Court accepted the taxpayers’ reconstruction of the hours they spent working in the business and further recognized that the business use of the rentals fit within the seven-day exception of Treasury Regulation 1.469-1T(e)(3)(ii).

Negligence Penalty

In disallowing the IRS’s claim of a negligence penalty against the taxpayers (I.R.C. § 6662), the Tax Court found that the taxpayers reasonably relied on a tax professional to prepare their tax returns.

The taxpayers demonstrated that (a) the advisor was a competent tax professional, (b) the taxpayers provided necessary and accurate information to the advisor, and (c) the taxpayers relied in good faith on the advisor’s judgment. (I.R.C. § 6664)

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The IRS is becoming increasingly aggressive in disallowing business losses when the losses have the effect of reducing ordinary income. In tax disputes with the IRS, Derek Kaczmarek and David Jojola can evaluate a taxpayer’s options for responding to an examination and ultimately developing a strategy for resolution.

About the Authors

A Certified Specialist in Tax Law, Derek W. Kaczmarek represents taxpayers and employers in federal and state income, gift, estate, excise and employment tax controversies. For seven years, he was a trial attorney with the IRS. Derek earned his law degree at Indiana University School of Law and an LL.M. in Taxation from New York University School of Law.

David R. Jojola is a Certified Tax Law Specialist who, for 11 years before entering private practice, was a senior trial attorney with the IRS. David represents clients in tax controversies involving income, gift, estate, excise and employment tax matters. He also has extensive experience in successfully representing individual taxpayers seeking innocent spouse relief.

More about Frazer Ryan's tax controversy practice