A Technical Advice Memorandum issued by the IRS after the audit ended was cited by the Tax Court to the IRS’s detriment in the case of Hardy v. Commissioner, TC Memo 2017-16. The issue involved was whether a surgeon materially participated in a surgical center in which he owned a minority interest—with the IRS at court pushing for finding that the surgeon had to combine that activity with his regular medical practice for purpose of determining material participation.

The surgeon this case is a plastic surgeon, specializing in pediatric reconstructive surgery, who operated on patients in his office and in some local hospitals. The surgery must take place outside of his office if the surgery requires general anesthesia. The doctor was finding that at times he was having difficulty obtaining space at the local hospitals for his procedures due to a limited number of available operating rooms.

To solve this problem the doctor decided to look into building and operating a surgery center. While they took initial steps to start their own center, when approached by representatives of other proposed surgery centers to invest as a partner in their centers Dr. Hardy determined that going that route would be far more cost effective.

The center Dr. Hardy invested in (MBJ) was described as follows by the Court:

MBJ is professionally managed. MBJ hires its own employees and does not share any employees with Northwest Plastic Surgery. Like hospitals, MBJ directly bills patients for facility fees. MBJ then distributes to each of its members his or her share of the earnings based on the facility fees less expenses. MBJ uses a third-party accounting firm to prepare the Schedules K-1, Partner's Share of Income, Deductions, Credits, etc., for the members. MBJ does not pay physicians for their procedures.

Dr. Hardy held a 12.5% interest in the surgery center in question. His relationship with the center was described as follows in the opinion:

Dr. Hardy has never managed MBJ, and he has no day-to-day responsibilities there. Although he meets with the other members quarterly, he does not have any input into management decisions. He generally is not involved in hiring or firing decisions. His role and participation in MBJ have not changed since he became a member.

Dr. Hardy performs surgeries on patients at MBJ on Mondays. Rarely, Dr. Hardy will operate at MBJ on other days of the week. Dr. Hardy does not pay rent to perform surgeries at MBJ; the patients pay the facility fees directly. In 2008 and 2009 Dr. Hardy performed 11% of the surgeries at MBJ. In 2010 Dr. Hardy performed 9% of the surgeries at MBJ. He also had designated alternating Tuesdays as his surgical days at two area hospitals. On the other days of the week, Dr. Hardy continued to perform surgeries at his medical practice. He performed approximately 50% of his surgeries at his office, 20% at MBJ, and the remainder at other facilities.

Dr. Hardy receives a distribution from MBJ regardless of whether he performs any surgeries at the surgery center, and his distribution is not dependent on how many surgeries he performs at MBJ. MBJ does not have a minimum surgery requirement to receive a distribution.

Initially Dr. Hardy’s return treated the income from MBJ as income from an activity in which Dr. Hardy materially participated. The taxpayer’s position for those years was based on the tax professional’s review of the K-1s received from the entity which showed income from a trade or business and reported this income was income from self-employment.

Because of that treatment, the taxpayer’s Form 8582 reported passive losses in excess of income of $58,786 in 2006 and $119,615 in 2007 (which included the carryover from 2006). The income that flowed to Dr. Hardy from MBJ was well in excess of the disallowed losses.

In 2007 the tax professional, after becoming aware of additional information regarding this investment, determined that Dr. Hardy did not materially participate in the surgery center—rather his interactions were simply as an investor and a provider making use of the center on the same terms as nonowner surgeons.

The IRS examined the Hardys’ 2007 and 2008 returns, challenging the treatment of that income as passive. The IRS had two theories under which the income should be treated as material participation income from Dr. Hardy’s surgery activity. First, the IRS argued that the taxpayer, by reporting the income as material participation income in 2006 and 2007, had grouped the surgery center with Dr. Hardy’s medical practice for purposes of Reg. §1.469-4(c) and were, under the regulation, prohibited from changing that grouping. Second, the IRS argued that, in any event, the only valid “appropriate economic unit” for grouping purposes under the regulation was to combine the surgery center activity with Dr. Hardy’s medical practice.

The Tax Court rejected the IRS’s view that the reporting of the activity as a material participation activity in 2006 and 2007 constituted a grouping with Dr. Hardy’s surgical practice in those years. The Court noted the tax professional testified that he had relied on the Form K-1 information for the years in question to determine the taxpayer was materially participating and had not made the determination based on grouping the activities under Reg. 1.469-4.

The Hardys never explicitly stated that they had grouped the activities and, under the law in place at the time were not required to do so. [1]

The Court found:

There is no evidence that the Hardys grouped Dr. Hardy's ownership interest in MBJ with his medical practice activity for 2006 or 2007. Accordingly, the Hardys did not regroup their activities for 2008 when they began reporting the income as passive. They have consistently treated the activities as separate economic units.

But even if they weren’t previously grouped, the IRS argued for the right to regroup them into a single unit in 2008 under the authority found in Reg. §1.469-4(f). Under that regulation the IRS may change a taxpayer’s grouping if:

…any of the activities resulting from the taxpayer's grouping is not an appropriate economic unit and a principal purpose of the taxpayer's grouping (or failure to regroup under paragraph (e) of this section) is to circumvent the underlying purposes of section 469.

But the Court found that the IRS could not meet the two requirements provided in that regulation to authorize a grouping. The regulation notes that more than one grouping could be appropriate, and while grouping the surgery center with Dr. Hardy’s practice is an appropriate grouping, it is also appropriate not to group the activities.

The IRS argued that an example found in the regulations at Reg. §1.469-4(f)(2) covered this situation exactly.

Taxpayers D, E, F, G, and H are doctors who operate separate medical practices. D invested in a tax shelter several years ago that generates passive losses and the other doctors intend to invest in realestate that will generate passive losses. The taxpayers form a partnership to engage in the trade or business of acquiring and operating X-ray equipment. In exchange for equipment contributed to the partnership, the taxpayers receive limited partnership interests. The partnership is managed by a general partner selected by the taxpayers; the taxpayers do not materially participate in its operations. Substantially all of the partnership's services are provided to the taxpayers or their patients, roughly in proportion to the doctors' interests in the partnership. Fees for the partnership's services are set at a level equal to the amounts that would be charged if the partnership were dealing with the taxpayers at arm's length and are expected to assure the partnership a profit. The taxpayers treat the partnership's services as a separate activity from their medical practices and offset the income generated by the partnership against their passive losses.

The example concludes that the IRS has a right to regroup the taxpayer’s activities.

However, the taxpayers argued that their facts were not those presented in that example, having key differences.

They argue that Dr. Hardy's ownership interest in MBJ and his medical practice do not constitute an appropriate economic unit as a single activity because the activities are different types of businesses: MBJ is a rental surgical facility and Dr. Hardy's practice is an active medical practice. Additionally, they argue that they did not have a principal purpose of circumventing section 469 when they treated the activities as separate because Dr. Hardy did not join MBJ to artificially create a passive activity loss. They contend that he had a business purpose in joining MBJ.

Undermining the IRS’s argument was the fact that after the trial the IRS released a Technical Advice Memorandum (TAM 201634022) that dealt with the same issue—and, in facts very similar to those faced by the taxpayer, concluded the IRS did not have the authority to require a regrouping.

The Tax Court found that the IRS did not have the authority to regroup in this case. The Court concluded that the taxpayer’s treatment of the activities of separate economic units was not inappropriate and, as well, the structure was not entered into to circumvent the purposes of IRC §469—and thus the IRS failed to meet either of the criteria that needed to be met by the agency to regroup the activities.

However, things did not go as well for the taxpayers with regard to being able to deduct the carryover losses on the 2008 return when they first treated the activity as a material participation activity on their tax returns.

The Tax Court notes:

We have concluded that the Hardys did not group Dr. Hardy's ownership interest in MBJ with his medical practice for 2006 or 2007. And we have concluded that Dr. Hardy may treat his ownership interest in MBJ as passive. That leads us to the inescapable conclusion that the Hardys erroneously treated Dr. Hardy's income from MBJ as nonpassive for 2006 and 2007. The Hardys reported a total unallowed loss of $58,786 for 2006. For 2007 they reported unallowed losses of $119,615, which included the $58,786 carryover from 2006. The Hardys reported Dr. Hardy's distributions from MBJ of $279,988 and $199,121 as nonpassive for 2006 and 2007, respectively. Had the Hardys properly reported the MBJ income as passive for 2006 and 2007, it would have fully absorbed their passive losses and there would have been no passive loss to carry forward to 2008.

The opinion does go on to note that the taxpayers attempted to argue that the doctrine of equitable recoupment should apply in this situation in their opening brief. The issue was not raised in their petition to the Court. The Court found that the issue was not raised in a timely manner and thus did not make a determination if that doctrine could have saved the carryover deduction.

[1] Today Revenue Procedure 2010-13 does require a taxpayer to attach a statement to a tax return when he/she is grouping two or more trade or business activities for purposes of the passive activity rules. But this procedure only applies to groupings first made in tax years beginning after January 25, 2010.