The IRS issued a Technical Advice Memorandum[1] that looks at whether, to put it simply, if meeting the material participation test for an activity for five straight years by using the significant participation activity (SPA) test found at Reg. §1.469-5T(a)(4) means the activity cannot be included as an SPA in year six. And the IRS concludes that answer is yes, which could cause the taxpayer to lose material participation status for other SPAs for the year in question.

Material Participation Rules – SPAs and 5/10 Test

The memorandum deals with an issue that arose in an examination related to two of the seven methods where a taxpayer will be treated as materially participating in an activity found at Reg. §1.469-5T(c). Specifically, this TAM looks at the:

Significant participation activities test (Reg. §1.469-5T(a)(4)) and
Five of the prior ten years test (Reg. §1.469-5T(a)(5).

The significant participation activity test provides a taxpayer materially participates in an activity if:

(4) The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;[2]

The regulation goes on to define a significant participation activity as follows:

(1) In general.

For purposes of paragraph (a)(4) of this section, an activity is a significant participation activity of an individual if and only if such activity--

(i) Is a trade or business activity (within the meaning of section 1.469-1T(e)(2)) in which the individual significantly participates for the taxable year; and

(ii) Would be an activity in which the individual does not materially participate for the taxable year if material participation for such year were determined without regard to paragraph (a)(4) of this section.

(2) Significant participation.

An individual is treated as significantly participating in an activity for a taxable year if and only if the individual participates in the activity for more than 100 hours during such year.[3]

The five of the prior ten years test provides a taxpayer materially participates in an activity 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;[4]

Normally this test prevents a taxpayer from, say, retiring from a business the taxpayer has been working in that is a passthrough, but continuing to hold an equity interest and treat that as income from a passive activity until the sixth year after the taxpayer ceases participation.

But the question presented in the case the memorandum considers is this: does participation via the SPA rule count for purposes of the five of ten years test? Because, if it does, then if a taxpayer qualified as materially participating in an activity via the SPA test in five of the prior ten years, that activity would now qualify for material participation under the five of the prior ten years test in the sixth year.

And, if that is so, then the activity could not be considered in computing total hours in all SPAs for the year in question. The exclusion of this particular activity from the total hours for all SPAs for a year could cause the hours to fall below 500 hours for all SPAs (meaning none of the SPAs will qualify as having the taxpayer materially participate), while if this activity is included in the SPA group there would be more than 500 hours of participation for all activities (resulting in the taxpayer materially participating in all of the activities in the year in question).

The Facts of the Situation Under Exam

We are looking at an IRS Technical Advice Memorandum (TAM). A TAM is issued when, in the course of an exam, the taxpayer and the IRS agent agree to submit a question of law to the IRS National Office for a ruling after the facts of the matter are developed and generally agreed to that would impact the application of the law.

In this case, the facts are described as follows:

Taxpayer, through multiple grantor trusts, wholly owns Corp, an S corporation. Taxpayer reported each trusts’ allocable share of Corp’s income on * * * individual income tax return. Corp owned multiple entities, the activities of which are treated as separate ungrouped activities for purposes of § 469. For Year 1 through Year 2, Taxpayer reported the activities as nonpassive. For those activities in which Taxpayer asserts * * * participated more than 100 hours and less than 500 hours, Taxpayer reported these activities as having satisfied the SPA requirements under §1.469-5T(c) and, based on the aggregate of all time Taxpayer spent on SPA activities, Taxpayer claims to have materially participated in those activities under § 1.469-5T(a)(4). For the remaining activities, Taxpayer acknowledges having participated less than 100 hours in each of the activities but reported them as nonpassive based on the 5/10 test in § 1.469-5T(a)(5).

During an examination, Exam concluded that certain activities of Taxpayer, which Taxpayer classified as SPAs, instead met the 5/10 test for material participation in the reviewed year by virtue of these activities having satisfied § 1.469-5T(a)(4) (SPA test) in five of the preceding ten years. Based on this conclusion, Exam reclassified these activities because the activities no longer satisfied the SPA requirements under § 1.469-5T(c). This reclassification reduced the number of SPAs in the audit year, such that Taxpayer’s aggregate hours for the remaining SPA activities failed to meet the 500 hour requirement of § 1.469-5T(a)(4). Thus, Taxpayer was no longer treated as materially participating in those activities and they were passive activities under section 469.[5]

In essence, this case presents the problem noted above—the taxpayer needs to be able to include activities that qualified for material participation in prior years under the SPA test to be able to have other SPA activities qualify for material participation in the year under exam. The agent’s position is that those activities must be excluded, so the SPAs remaining must be treated as passive activities for the year in question, presumably resulting in disallowed passive activity losses.

IRS Position for Removing These Activities from SPA Status

The memorandum outlines the following, rather straight-forward, position of the agent regarding why these activities must be excluded from the SPA calculation in the year under exam:

Exam bases their adjustment on the language of § 1.469-5T(c)(ii). Exam's position is that an activity cannot be a SPA if it meets any of the other six tests for material participation in § 1.469-5T(a). Here, because Taxpayer is treated as materially participating under the 5/10 test (§ 1.469-5T(a)(5)) for those activities that were SPAs in five prior years, the same activities are not SPAs in the audit year.[6]

While this result appears somewhat unfair and, at least at first glance, more of an accidental than an intended result of the regulation text, it does appear to follow the clear wording of the regulation. The agent is arguing that the law requires these activities to be excluded from the SPA category.

Taxpayer’s Arguments for a Contrary Position

The taxpayer had included these activities in its SPA hours for the years in question on their return. The TAM outlines the general argument of the taxpayer for a result contrary to that pushed by IRS exam:

Taxpayer argues that the language in § 1.469-5T(c)(1)(ii) turns on the meaning of the phrase “if material participation for such year were determined without regard to paragraph (a)(4) of this section.” Taxpayer states that this phrase requires a hypothetical determination of whether a taxpayer would be treated as materially participating in an activity in a given year if the material participation tests for such year were applied without regard to the SPA test in § 1.469-5T(a)(4). Taxpayer’s asserts that for purposes of the hypothetical determination, material participation for the taxable year must be determined without regard to the application of § 1.469-5T(a)(4) in the taxable year and any other year that is relevant to determining material participation for the taxable year at issue. Taxpayer advocates that because the activities were SPAs and together satisfied the SPA test for material participation under § 1.469-5T(a)(4) in prior years, Taxpayer’s prior year material participation is not relevant.[7]

The taxpayer notes the undesirability of the result that exam is advancing:

Taxpayer argues that Exam's position leads to the undesired result of having SPAs alternate between the SPA test and the 5/10 test and would create difficulties and inconsistencies for serial entrepreneurs with long standing businesses.[8]

The taxpayer argues that the IRS interpretation ignores what the taxpayer sees as a significant difference between “is” and “would be” in the wording of the regulation:

Taxpayer states that the Service’s interpretation of § 1.469-5T(c)(1)(ii) asks whether the activity is an activity in which the taxpayer materially participates for the year, where the regulation asks whether the activity would be an activity in which the taxpayer materially participates if determined without regard to (a)(4). Taxpayer believes that the word choice used in § 1.469-5T(c)(1)(ii) demonstrates that the drafters believed that there would be a situation in which the taxpayer materially participated in the activity under another test but would not materially participate if the determination was made without regard to (a)(4).[9]

The question of whether this interpretation is inconsistent with the intent of the regulation is also raised by the taxpayer:

Taxpayer also cites to the preamble to the regulations, which provides, with respect to the SPA test, that

[t]his rule is included because the Service believes that an individual who devotes more than 500 hours during a taxable year to several activities, each of which is a significant activity of such individual, should be treated similarly to an individual who devotes an equivalent amount of time to a single activity.

T.D. 8175, 1988-1 C.B. 194. Thus, Taxpayer reasons, it is inconsistent with the intent of the regulation to use another test to prevent a taxpayer from being treated as materially participating under the SPA test, as the tests were created to assist taxpayers who would have difficulty demonstrating material participation under one of the other tests. Taxpayer also argues that because 500 plus hour activities can qualify under both § 1.469-5T(a)(1) and (a)(5) in the same year, treating SPAs differently frustrates the intent by treating a taxpayer engaged in multiple activities in a different manner than a taxpayer involved in a single activity. To demonstrate this frustration, TP cites to the preamble to the regulations in discussing the 5/10 test, which provides that the 500 hour test of § 1.469-5T(a)(5) was included because

. . . the Service believes that an activity in which an individual has materially participated over a long period of time or a personal service activity in which an individual has participated for a substantial period of time is likely to represent the individual's principal livelihood rather than a passive investment . . .

T.D. 8175, 1988-1 C.B. 194. Taxpayer also argues that the 5/10 test was intended to cause a taxpayer to be treated as materially participating in a longstanding activity in order to prevent such activity from being characterized as passive after the taxpayer ceases to materially participate in the activity.[10]

Finally, the taxpayer notes that courts have not looked at the SPA test when interpreting the five of ten years test:

Taxpayer further points out that in the few reported court opinions which analyze whether a given activity is a SPA, the courts have looked at whether the taxpayer was otherwise treated as materially participating in the activity under § 1.469-5T(a)(1) through (a)(3), but no court has deemed it relevant to discuss whether the taxpayer in such cases was also treated as materially participating in the activity for the year at issue under the 5/10 test. Taxpayer infers from this that the courts did not deem such analysis as relevant to the inquiry because the 5/10 test did not apply. Taxpayer argues that its position is further supported by Example 4 in the regulations which fails to provide facts to exclude material participation under the 5/10 test.[11]

TAM’s Analysis and Decision

The TAM begins by agreeing with the taxpayer that the courts have not directly addressed this issue, but did note that courts have referenced the other six tests when discussing the five of ten test, which would include SPA qualification:

There are no court opinions addressing whether an activity meets the 5/10 test solely by having been a SPA for the requisite number of prior years. Although not directly on point, the Tax Court has discussed the SPA test in relation to the other six tests. In Scheiner v. Commissioner, T.C. Memo 1996-554 at *8, the Court provides a general explanation of the SPA rules, stating, “[a] significant participation activity is one in which the taxpayer participates for more than 100 hours, but which fails to constitute material participation under one of the other six tests [emphasis added].” In Gregg v. United States, 186 F.Supp.2d 1123, 1130 (D. Or. 2000), the District Court held that one of plaintiff’s activities was not a SPA as the plaintiff exceeded the 500-hour minimum standard of § 1.469-5T(a)(1), and thus the activity could not be a SPA under § 1.469-5T(a)(1).[12]

The TAM states that the plain language of the regulation supports exam’s view in this case and does not support the taxpayer’s view:

Section 1.469-5T(c) provides the requirements to ascertain whether an activity is a significant participation activity for purposes of determining material participation under § 1.469-5T(a)(4). Section 1.469-5T(c)(1) clearly states that an activity is a significant participation activity “if and only if” such activity meets the two requirements in (c)(i) and (ii). The parties agree that Taxpayer’s activities are trade or business activities and meet the requirement of subparagraph (c)(1)(i). As to the second requirement, we agree with Exam’s conclusion. For those activities in which Taxpayer materially participated under § 1.469-5T(a)(4) in any five years during the preceding ten years, * * * cannot satisfy the requirement under § 1.469-5T(c)(1)(ii) because Taxpayer is otherwise treated as materially participating in each of those activities under § 1.469-5T(a).

Taxpayer’s position that the language in § 1.469-5T(c)(1)(ii) provides that material participation for a taxable year is determined by disregarding whether Taxpayer satisfied § 1.469-5T(a)(4) in the tested taxable year and any other relevant year, is unsupported by the language. The language of § 1.469-5T(c)(1)(ii) specifies that the relevant inquiry is whether the taxpayer materially participated for “the taxable year” and that determination is being made “for such year” without taking § 1.469-5T(a)(4) into account. Section 1.469-5T(c)(1)(ii) does not say to disregard § 1.469-5T(a)(4) for every previous year where a taxpayer was treated as having materially participated under that test.[13]

The TAM also argues that there is a justification for this result based on the structure of the regulation:

The Service acknowledges that § 1.469-5T(c)(1)(ii) imposes an additional requirement on SPA activities, one that potentially removes an activity from being treated as a SPA in the current tax year based on participation in prior years, as is the case here. The additional requirement in §1.469-5T(c)(1)(ii) results in a significant participation activity shifting out of the SPA test and into the 5/10 test because under §1.469-5T(c)(1)(ii) an activity cannot be both a SPA and satisfy another material participation test. In contrast, for example, an activity that satisfies the 500 hour test also satisfies the 5/10 test in the same year because there is no similar restriction. The difference in treatment is a direct result of the SPA test having a separate qualifying section in § 1.469-5T(c)(1), where there is no such additional qualifying section for (a)(1).[14]

For these reasons the TAM holds:

Section 1.469-5T(c)(1)(ii) provides that an activity is a significant participation activity only if such activity would be an activity in which the individual does not materially participate for the taxable year if material participation is determined without regard to the SPA test in § 1.469-5T(a)(4). Under this rule, where an activity satisfies one of the other six tests for material participation under § 1.469-5T(a) (excluding § 1.469-5T(a)(4)), the activity does not satisfy the requirements to qualify as a SPA under § 1.469-5T(c)(1), even though the remaining requirements (trade or business and hours) are met.[15]

The memorandum notes:

…[A]n activity that met the requirements of § 1.469-5T(a)(4) in any five of the last ten taxable years satisfies the 5/10 test under § 1.469-5T(a)(5) for material participation in the taxable year and no longer satisfies the requirement in § 1.469-5T(c)(1)(ii). Once the activity no longer meets the 5/10 test, the activity may, provided it otherwise meets the requirements of § 1.469-5T(c)(1), again be classified as a SPA.[16]

[1] IRS TAM 202229036, July 22, 2022, https://www.irs.gov/pub/irs-wd/202229036.pdf

[2] Reg. §1.469-5T(a)(4), https://www.taxnotes.com/research/federal/cfr26/1.469-5T/cvdl-0000006

[3] Reg. §1.469-5T(c), https://www.taxnotes.com/research/federal/cfr26/1.469-5T/cvdl-0000018

[4] Reg. §1.469-5T(c)(5), https://www.taxnotes.com/research/federal/cfr26/1.469-5T/cvdl-0000007

[5] IRS TAM 202229036, July 22, 2022

[6] IRS TAM 202229036, July 22, 2022

[7] IRS TAM 202229036, July 22, 2022

[8] IRS TAM 202229036, July 22, 2022

[9] IRS TAM 202229036, July 22, 2022

[10] IRS TAM 202229036, July 22, 2022

[11] IRS TAM 202229036, July 22, 2022

[12] IRS TAM 202229036, July 22, 2022