In the case of Rogerson v. Commissioner, TC Memo 2022-49[1] the taxpayer argued that, following a reorganization of the S corporation he owned 100% of into multiple corporations, he had not materially participated in the activities of one of these resulting corporations for the three years following the reorganization. He took this position despite not separating this particular activity from other activities of the prior corporation in earlier years, treating the operations of that S corporation as a single activity in which he actively participated.

With that view, the income from the operation of this corporation (Rogerson Aircraft Equipment Group, referred to as RAEG in the opinion) was treated as passive income on those returns, enabling the deduction of losses from other passive activities.

The IRS disagreed, asserting that Mr. Rogerson was materially participating in RAEG under Temp. Reg. § 1.469-5T(a)(5). The Tax Court ultimately agreed that Mr. Rogerson did materially participate in RAEG, and that this would be true even if the temporary regulations in question were invalid, based on the application of the provisions of IRC §469 itself.

Passive Activities and the Temporary Regulations

A key issue for dealing with the passive activity provisions of §469 is identifying whether or not a taxpayer materially participates in a business activity. Only if the taxpayer does not materially participate in an activity will it be deemed to be a passive activity whose income can be offset by losses from other passive activities.

IRC §469(h)(1) provides the following definition of material participation:

(h) Material participation defined. For purposes of this section--

(1) In general. A taxpayer shall be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis which is--

(A) regular,

(B) continuous, and

(C) substantial.

In this case, Congress specifically authorized the IRS to issue regulations to define what is material participation. IRC §469(l)(1) provides:

(l) Regulations. The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out provisions of this section, including regulations--

(1) which specify what constitutes an activity, material participation, or active participation for purposes of this section, …

The key regulation provision that the IRS will raise in this case is found at Reg. §1.469-5T(a)(5). This is one of the seven defined ways a taxpayer will be found to materially participate in a trade or business and reads:

(a) In general.

Except as provided in paragraphs (e) and (h)(2) of this section, an individual shall be treated, for purposes of section 469 and the regulations thereunder, as materially participating in an activity for the taxable year if and only if—

…

(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year; …

Reg. §1.469-5(j)(1) provides a method for applying this rule when the activities change in some form:

(j) Material participation for preceding taxable years.

(1) In general.

For purposes of section 1.469-5T(a)(5) and (6), a taxpayer has materially participated in an activity for a preceding taxable year if the activity includes significant section 469 activities that are substantially the same as significant section 469 activities that were included in an activity in which the taxpayer materially participated (determined without regard to section 1.469-5T(a)(5)) for the preceding taxable year.

The point of the “five of the last ten years rule” was to prevent taxpayers from using active participation to make an activity profitable and then scaling back their hours (perhaps due to retirement) but continuing to receive an income stream that would now be available to free up passive losses. One of the IRS’s key areas of focus in putting together these regulations following the enactment of IRC §469 was eliminating what had been termed “passive income generators” better known by the acronym of PIGs.

The Facts of the Case

In this case, Mr. Rogerson had owned and been deeply involved in running Rogerson Aircraft Corporation for over 40 years. In 2014 he separated this existing business into different entities based on the type of product produced.

One of those entities was Rogerson Aircraft Equipment Group (RAEG) that manufactured analog products. Mr. Rogerson retained 100% ownership of RAEG. He also remained the chief executive officer of RAEG.

The opinion describes the nature of Mr. Rogerson’s interaction with RAEG and the related companies during the years in question:

While other company employees, including a small number of executives, ran the day-to-day operations of each corporation, Mr. Rogerson was actively engaged with them all, including RAEG, in particular by monitoring operations and production, communicating with management on employment issues, and taking a hands-on approach to sales and customer relations.[2]

The opinion discussed the general nature of his involvement:

With respect to RAEG specifically, Mr. Rogerson received regular reports on the company’s results, attended meetings to discuss the results, and took action when they fell below expectations. He ordered the Kratos Instruments move from Pasadena to Irvine and oversaw its progress, including setting the timeline, making decisions with respect to staffing matters, and deciding on the wording of materials explaining the move to employees and customers. As one company executive put it when discussing the phrasing of an employee offer letter: “Michael gets the last word.” Mr. Rogerson directed executives as to which engineers within the Rogerson companies could work on Kratos Instruments projects. He approved capital expenditures and provided input on accounting issues. He also was involved in the refurbishment of the Irvine facilities to accommodate the Kratos Instruments move.[3]

Mr. Rogerson was deeply involved with employees of RAEG:

On employment matters, Mr. Rogerson hired and fired executives, set department budgets, and weighed in on staffing at all levels of the company. During the years at issue, he was asked to approve all bonuses and even an hourly rate increase of $0.50. Generally, not even the president of RAEG was authorized to increase salaries or provide bonuses to RAEG employees — those decisions were made by Mr. Rogerson.

Consistent with his authority over staffing matters, Mr. Rogerson knew employees by their first names, communicated with them directly, and weighed in on how and when they should be replaced. When one employee was out on medical leave, Mr. Rogerson directed that his replacement should be hired from outside the company rather than promoted from within, citing “mid management depth” that was “too thin.” Mr. Rogerson alerted executives when he felt certain employees were not pulling their weight, noting in one instance that an engineer “did not carry his own load during the [Kratos Instruments] move” and that Mr. Rogerson “[did not] see rewarding him by having [another engineer] doing his job now.”[4]

Mr. Rogerson also was deeply involved in sales and customer relations:

During this period, Mr. Rogerson was perhaps most extensively involved in sales and customer relations. On multiple occasions, he personally met with RAEG customers and potential customers and participated in customer negotiations. He traveled to visit customers, including internationally, and also hosted customers at RAEG’s offices. He drafted press releases, received reports on customer visits that he did not attend, and got personally involved when disputes with customers arose. More than once, Mr. Rogerson told RAEG executives that he would resolve a problem by meeting personally with the customer involved. And customers sometimes reached out directly to Mr. Rogerson with complaints. His approval was required for any bid provided to a customer with an aggregate value over $100,000; in one month in 2016, that approval was requested at least a dozen times.[5]

Finally, the opinion discussed Mr. Rogerson’s interaction with other executives of RAEG:

As part of his activities, Mr. Rogerson discussed RAEG with company executives, both in person and on the phone. During the years at issue, he communicated with RC and RAEG executives regarding RAEG’s finances, its operations, the Kratos Instruments move, and the potential sale of the company. The RAEG president and the Rogerson companies’ chief financial officer, together or separately, spent at least 10 to 15 hours per month with Mr. Rogerson on RAEG financial and operational matters. Mr. Rogerson also communicated with those individuals and others via email, including on weekends and holidays.[6]

As the opinion concludes about Mr. Rogerson’s activities:

In short, Mr. Rogerson was an actively engaged CEO throughout the years at issue. And his level of involvement in RAEG in particular and in the Rogerson companies more generally during those years was substantially the same as it was during the years preceding the 2014 reorganization.[7]

Applying the Regulations to Mr. Rogerson’s Situation

The court notes that Mr. Rogerson’s CPA only looked to the hours Mr. Rogerson participated in the activity for the years in question in determining that he did not materially participate in it. It seems very possible that the CPA had overlooked the five of the previous ten year rule. Or, at the very least, the CPA believed that by forming new entities out of the old ones Mr. Rogerson would be able to ignore the history of materially participating in the predecessor entity.

The IRS, not surprisingly, asserted that Mr. Rogerson had materially participated in what was this activity for more than 5 of the preceding 10 years and, thus, materially participated in this activity in 2014, 2015 and 2016, the years under examination. The Tax Court agreed that the five of ten test meant Mr. Rogerson would be materially participating in RAEG in those years even if he had absolutely zero hours of participation in the activity in those years.

The Court first looked at Mr. Rogerson’s involvement in the aerospace industry in activities that eventually found their way to RAEG. The opinion states:

Turning first to Mr. Rogerson’s tax reporting, we have found at his request that all the results of his aerospace business, including the RAEG-related activity, were reported on RAC’s income tax returns from 2005 to 2013. We have further found, again at Mr. Rogerson’s request, that no effort was made during these years to separate the various activities of the Rogerson companies for purposes of the passive activity loss rules. In other words, RAC treated the aerospace business, including the activities that became part of RAEG, as a single, undifferentiated activity on its tax returns and when it issued Schedules K-1 to Mr. Rogerson. Mr. Rogerson reported his involvement in this [*20] consolidated activity as nonpassive on his personal income tax returns and similarly did not attempt to separate the activities. Cf. Treas. Reg. § 1.469-4(d)(5)(i) (providing that a shareholder of an S corporation may not treat activities grouped together by his corporation as separate activities). According to his own tax returns, therefore, Mr. Rogerson maintained that he materially participated in his aerospace business as a whole from at least 2005 to 2013.

Mr. Rogerson does not seem to dispute that his involvement in the overall business was nonpassive during those years; indeed, he maintains that Rogerson Kratos, which also was part of the aerospace business from 2005 to 2013, required large amounts of his time, and that he was involved with product development, manufacturing, and sales for the Rogerson Kratos product lines. Mr. Rogerson continued to report his activity with respect to Rogerson Kratos (i.e., RAC), as well as RC, as nonpassive during the years 2014 to 2016. And Mr. Chang, Mr. Rogerson’s tax return preparer, testified with respect to the consolidated RAC activity that “it was pretty clear [Mr. Rogerson] was involved in that business.”[8]

The Court then noted that the activities now carried out in RAEG were a significant part of the overall activity of what had been reported as a single activity in which Mr. Rogerson materially participated in the prior years:

There also is no dispute that, for the years 2005 to 2013, the product lines that ultimately were combined into RAEG in 2014 were a significant part of the consolidated RAC activity that Mr. Rogerson characterized as nonpassive. As described above, for purposes of applying the five of ten test, a taxpayer is treated as materially participating in an activity (here, RAEG) during a preceding year if the activity was included in an activity, or substantially overlaps with an activity (here, the aerospace business as a whole), in which the taxpayer materially participated for the preceding year. Treas. Reg. § 1.469-5(j)(1).

There can be no question there is substantial overlap between RAEG’s activities in 2014 and later years and the activities of the overall aerospace business before 2014. Documentary evidence and the testimony of multiple witnesses confirms that the products, employees, and customers of the Rogerson companies were generally the same before and after the 2014 reorganization. In other words, the business activities that became part of RAEG were the same before and after the reorganization, but organized differently. And each of the RAEG product lines had been part of the RAC consolidated activity since long before the relevant ten-year period. As Mr. Rogerson states in his opening brief: “[T]he RAEG Activity that commenced in 2014 is really the compilation and consolidation of multiple product lines from various entities that had been conducted on a historical basis.” Pet’r’s Simultaneous Opening Br. 73.[9]

The taxpayer did attempt to argue that, despite the above analysis, the RAEG activity was truly a brand new activity. He first claims that, in fact, the activity (which is not the same as an entity) truly did not exist prior to 2014:

In support of his first proposed alternative — i.e., that for purposes of the five of ten test, RAEG did not exist as activity before 2014 — Mr. Rogerson states as follows:

It is clear that the Rogerson companies did not actually segregate [R]AEG as a separate “activity” before 2014. No position was taken on any RAC return before 2014 reflecting anything other than a single activity. [Mr.] Chang[10] clearly believed no such determination was appropriate because everything related to the Rogerson companies was reported on a single RAC return.

Pet’r’s Simultaneous Suppl. Br. 25. Accordingly, Mr. Rogerson appears to contend that before the 2014 reorganization, the aerospace business as a whole (as reflected on RAC’s returns) was the relevant activity under the regulations and that RAEG should therefore be treated as a new activity for 2014, 2015, and 2016. If RAEG was a new activity starting in 2014, Mr. Rogerson further contends, then the five of ten test cannot apply, because Mr. Rogerson would have no history of involvement in the activity.[11]

However, the Court notes that the regulations that look at predecessor activities clearly cover this particular situation:

Mr. Rogerson’s argument is foreclosed by Treasury Regulation § 1.469-5(j)(1). As discussed in detail in Opinion Part II.B.1 above, that rule does not require the taxpayer’s precise activity to have existed in prior years for purposes of applying the five of ten test. Indeed, the entire point of the rule is to address situations in which circumstances change over time. The rule applies as long as the taxpayer’s current-year activity (here, RAEG) “includes significant section 469 activities” (here, the RAEG product lines or RAEG as a whole) “that are substantially the same as significant section 469 activities there were included in [a preceding-year activity] in which the taxpayer materially participated” (here, the aerospace business as a whole). In other words, all that is required is substantial overlap between the current and preceding-year activities. The record here leaves no doubt that the activity conducted by RAEG in 2014, 2015, and 2016 overlaps substantially with the “single activity” reflected on RAC’s prior returns — i.e., the aerospace business as a whole.[12]

Mr. Rogerson also argues that even though his involvement with the combined operation as a whole in prior years (RAC) may have met the material participation test, his involvement with the RAEG products lines did not meet that test.

The Court begins analyzing this point as follows:

Mr. Rogerson’s second alternative — that his involvement in the RAEG product lines was passive even before 2014 — faces a factual problem. There is no question that before 2014 Mr. Rogerson’s involvement in the aerospace business as a whole was nonpassive. Similarly, there is no dispute that Mr. Rogerson reported his involvement in the aerospace business as a whole, including the activities that became part of RAEG, as nonpassive. In light of Treasury Regulation § 1.469-5(j)(1), these facts are sufficient to satisfy the five of ten test with respect to RAEG in 2014, 2015, and 2016.[13]

The opinion describes how Mr. Rogerson sought to avoid having this treatment of RAC taint RAEG:

In an attempt to escape the implications of his prior reporting, Mr. Rogerson contends that neither he nor RAC ever made an affirmative decision to group the RAEG product lines with his other aerospace activities. According to Mr. Rogerson, RAC’s returns made no effort to indicate whether they reported “one activity or many activities, grouped or not.” Pet’r’s Simultaneous Answering Br. 34. The implication seems to be that, if the product lines that became part of RAEG were not formally grouped with RAC in prior years, then Mr. Rogerson’s reporting and activity with respect to RAC as a whole would be irrelevant in applying the five of ten test to the RAEG product lines in subsequent years.[14]

[1] Rogerson v. Commissioner, TC Memo 2022-49, May 12, 2022, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/aerospace-business-income-nonpassive%3b-yacht-activity-was-passive/7dh6g (retrieved May 13, 2020)

[2] Rogerson v. Commissioner, TC Memo 2022-49, May 12, 2022

[3] Rogerson v. Commissioner, TC Memo 2022-49, May 12, 2022

[4] Rogerson v. Commissioner, TC Memo 2022-49, May 12, 2022

[5] Rogerson v. Commissioner, TC Memo 2022-49, May 12, 2022

[6] Rogerson v. Commissioner, TC Memo 2022-49, May 12, 2022

[7] Rogerson v. Commissioner, TC Memo 2022-49, May 12, 2022

[8] Rogerson v. Commissioner, TC Memo 2022-49, May 12, 2022

[9] Rogerson v. Commissioner, TC Memo 2022-49, May 12, 2022

[10] Mr. Chang is Mr. Roberson’s CPA who advised him on this issue.

[11] Rogerson v. Commissioner, TC Memo 2022-49, May 12, 2022

[12] Rogerson v. Commissioner, TC Memo 2022-49, May 12, 2022

[13] Rogerson v. Commissioner, TC Memo 2022-49, May 12, 2022

[14] Rogerson v. Commissioner, TC Memo 2022-49, May 12, 2022