The taxpayer in the case of Padda v. Commissioner, TC Memo 2020-154,[1] was able to show material participation in various restaurants by use of the significant participation activity test found in Reg. §1.469-5T(a)(4).

We did cover this case in another article for the separate issue of the taxpayer’s unsuccessful attempt to avoid a late filing penalty for the year under exam. But the taxpayer’s arguments for claiming material participation in the restaurant activities were found far more persuasive by the court, with the taxpayer prevailing on the issue.

At first glance some of the facts of this case make it look a lot like many of the cases that have proven to be easy victories for the IRS in the Tax Court. Both spouses were physicians in Missouri. Dr. Padda, the key spouse in this case, had a number of other businesses he owned in addition to his medical practice. He worked the largest chunk of his hours in his medical practice, but also spent between 210 and 220 hours each year working in a medical billing service he also ran.

In addition, Dr. Padda operated five restaurants and a brewery, the activities at question here. The taxpayers had regularly failed to file their tax returns on time in recent years, a fact discussed in our earlier article on this case regarding the late filing penalties.[2]

Based on those facts, and being aware of prior cases, you might assume that:

The taxpayer’s evidence to show participation would be poor—after all, quite often taxpayers who annually get information together late in the process are some of the least organized taxpayers advisers see and
Given the time Dr. Padda would be expected to spent in a medical practice and running the billing company, it seems unlikely he’d be able to find time to qualify to materially participate in the restaurants and brewery.

But in this case, those assumptions would not hold true. And it was via using the significant participation activity test, along with what turned out to better corroborated evidence than we tend to see in these passive activity cases to bolster Dr. Padda’s level of activity in these undertakings, that the Court found he did materially participate in each of the activities.

As the Tax Court notes, one of the ways a taxpayer can show he/she materially participated in an activity is via the significant participation activity test:

A taxpayer can establish material participation in an activity by satisfying any one of seven tests set forth in section 1.469-5T(a), Temporary Income Tax Regs., 53 Fed. Reg. 5725-5726 (Feb. 25, 1988). Paragraph (a)(4) provides that the fourth test is met if the “activity is a significant participation activity * * * for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours”. A significant participation activity is a trade or business activity in which the individual participates for more than 100 hours during the year. Id. para. (c), 53 Fed. Reg. 5726.[3]

Although not mentioned by the Court, since the IRS was not disputing this point, another requirement is that none of the activities can be ones that the taxpayer would otherwise be found to be materially participating in under any other test.[4]

The Tax Court assumed that each of the five restaurants and the brewery were separate activities.[5]

To establish the hours Dr. Padda worked in these activities, first Dr. Padda testified about his work:

Padda presented testimony to establish his hours spent on the restaurant and the brewery activities. He personally testified for an entire day of trial, explaining in detail his nontravel involvement in each restaurant and the brewery. Padda stated the nontravel hours he spent working on the restaurants and the brewery each year.

…

Padda’s testimony was also directed to how many hours he spent on each activity for each year. For example, Padda testified that he spent 400 hours in 2011 on Cafe Ventana, of which 200 hours were spent on renovations.[6]

If that had been the only evidence offered, though, we’d expect the Tax Court to make its standard statement that the Court is not required to accept a taxpayer’s self-serving and uncorroborated testimony. But Dr. Padda had a number of individuals that separately could testify about Dr. Padda’s involvement with the activities:

Following Padda’s testimony, 12 individuals testified regarding Padda’s nontravel involvement in the restaurants and the brewery. They explained how Padda was involved in every aspect of the restaurants and the brewery. This included hands-on work and onsite instruction.[7]

The Court found the combination of Dr. Padda’s testimony and those of the other witnesses to be persuasive:

On the basis of the testimony we described from Padda and the corroborating witnesses, we find that the nontravel time Padda spent on each activity exceeded 100 hours for each year at issue.

Because there are six activities involved in this calculation, our finding means that Padda annually devoted more than 600 hours (i.e., 6 × 100 = 600) of nontravel time to the five restaurants and the brewery. This conclusion is valid despite the IRS’s skepticism that Padda could have spent significant time on the restaurants and the brewery given the demands of his work at his medical practice (which was highly successful) and the lack of documentary evidence of his personal involvement in the restaurants and the brewery. These reasons for skepticism might be well placed in another case. But the record in this case is consistent with our conclusions about Padda’s hours. Padda did not use correspondence or emails with respect to the restaurants and the brewery. Instead he used the telephone and face-to-face meetings. Using these means of communications, Padda exercised tight control of many aspects of the restaurants and the brewery. In particular, he paid close attention to the quality and ingredients of the food and beverages. He also rigorously controlled the decor and appearance of the establishments. His employees confirmed his heavy involvement. They complained in their testimony about his micromanagement. Perhaps as a result of Padda’s efforts, the restaurants and the brewery were lavishly appointed. The food and beverages were of the highest quality. The restaurants and the brewery were also costly to operate. Year after year, they produced massive financial losses that largely wiped out Padda’s profits from his medical practice. Thus it was that Padda was a successful doctor and at the same time spent significant time on the restaurants and the brewery.[8]

The Court also considered records of time Dr. Padda spent traveling between these locations, finding he had spent an additional 25 hours of travel time for each restaurant each year in addition to the more than 100 hours the Court had previously given him credit for in each activity.

The Court concluded:

For each activity for each year (i.e., for each of the restaurants and the brewery), Padda’s hours exceeded the 100-hour threshold required for an activity to be a significant participation activity. This is because for each activity and for each year his nontravel hours exceeded 100 hours and his travel hours exceeded 25 hours. Each activity was therefore a significant participation activity for year Padda had at least these six significant participation activities, his aggregate participation in all significant participation activities during the year exceeded the 500-hour threshold of section 1.469-5T(a)(4), Temporary Income Tax Regs., supra. The five restaurants and the brewery were not passive activities.[9]

The evidence Dr. Padda presented should be taken with an understanding that the Court clearly found Dr. Padda to be believable—he was a good witness, and knew many details of the activities that lent credence to the belief he was deeply involved in each. Similarly, the supporting witnesses also were believed by the Court and did not seem to have a reason to stretch the truth on Dr. Padda’s behalf.

It would likely have been better had Dr. Padda had detailed time records to back up his assertion regarding his involvement—the existence of such records might have allowed the case to be resolved at the exam level, saving the taxpayer a lot of time and expense. Nevertheless, this case does demonstrate the types of information that can be used to back up a claim of material participation.

[1] Padda v. Commissioner, TC Memo 2020-154, November 16, 2020, https://www.ustaxcourt.gov/UstcInOp2/OpinionViewer.aspx?ID=12359 (retrieved November 18, 2020)

[2] Ed Zollars, CPA, “Taxpayer Hit With Late Filing Penalty When Accounting Firm Submits Return Seconds After the Filing Deadline,” Current Federal Tax Developments website, November 17, 2020, https://www.currentfederaltaxdevelopments.com/blog/2020/11/17/taxpayer-hit-with-late-filing-penalty-when-accounting-firm-submits-return-seconds-after-the-filing-deadline (retrieved November 18, 2020)

[3] Padda v. Commissioner, TC Memo 2020-154, p. 11

[4] Reg. §1.469-5T(c)(1)(ii)

[5] Padda v. Commissioner, TC Memo 2020-154, p. 11

[6] Padda v. Commissioner, TC Memo 2020-154, pp. 12-13

[7] Padda v. Commissioner, TC Memo 2020-154, p. 13

[8] Padda v. Commissioner, TC Memo 2020-154, pp. 13-14

[9] Padda v. Commissioner, TC Memo 2020-154, pp. 16-17