Reclassification Rule Makes S Corporation’s Income Not Passive, Despite Taxpayers’ Lack of Participation

Passive activity rules can allow a taxpayer to reduce his or her tax obligation if the activity qualifies. Sometimes, though, even when a taxpayer meets the standards for not materially participating in a business, the law allows the Internal Revenue Service to reclassify that income as nonpassive anyway. That’s what happened recently in a US Tax Court case involving a couple who owned a medical supply business and a real estate corporation.

BEK Real Estate Holdings, LLC was an S corporation 100% owned by Larry and Dora Williams. The couple also owned BEK Medical, Inc., a C corporation. During the tax years of 2009 and 2010, the husband worked for BEK Medical full-time and was a material participant in its activities. BEK Real Estate leased commercial real estate to BEK Medical during 2009 and 2010, but neither the husband nor the wife was a material participant in BEK Real Estate’s activities.

Small businesses that elect S corporation status are often exempt from corporate tax filings. Instead, the business is a passthrough entity, and shareholders of the corporation report the corporation’s income on their own returns, in proportion to their percentage ownership of the corporation. BEK Real Estate was such an entity, so its income was reported on the Williamses’ return.

BEK Real Estate’s leasing business generated $101,000 in income across the 2009-2010 period. The couple claimed the real estate company’s rental income as passive, but the IRS reclassified it as nonpassive.

A shareholder must treat passive income as nonpassive, even if the taxpayer does not participate materially in the business, if a business’ commercial rental activity comes from a piece of property and that parcel is leased for use in a trade or business in which the taxpayer does materially participate. That’s what happened in the Williamses’ case. Even though neither spouse materially participated in BEK Real Estate, BEK Real Estate’s income arose from the leasing of a commercial space that was to be used in the medical supply business, which was a business in which the husband actively participated.

The couple advanced two unsuccessful arguments against the IRS determination. The couple contended that the passive activity regulations did not apply in their case because Section 469 of the tax code did not expressly include S corporations in the group of entities to which that section applied. Since S corporations like BEK Real Estate are passthrough entities and do not directly pay tax, the statute was not required to refer to them as covered taxpayers, the court reasoned.

The couple’s second argument, which was that the income should not have been reclassified given that the landlord, BEK Real Estate, did not engage in the medical supply business, also failed. In order for the income to be reclassified as nonpassive, it was the taxpayer, and not the lessor, that was required to be engaged in the business in question. The husband did materially participate in the medical supply business, so the reclassification was valid.

Certain tax rules, such as S corporation elections, passthrough entities, and passive activity rules, can be used to a taxpayer’s advantage in some situations. In order to maximize your advantages, consult the tax attorneys at Samuel C. Berger, P.C. and CPAs at S.C. Berger, P.C. To reach our attorneys and CPAs, contact us online or call (201) 587-1500 or (212) 380-8117.

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