In several previous posts, we noted the importance of determining, in the case of a family or other closely-held business, where the goodwill for the business resides: in the business, in the shareholder-employees,  or in another employee.  In the absence of an employment agreement or non-compete, we noted that it may be possible to demonstrate that some portion of the goodwill does not belong to the business.  Rather, we have seen that the  “attributes” of goodwill may be personal to a shareholder or other individual.

 In a recent decision,Wade v. Commissioner, T.C. Memo 2014-169, the Tax Court considered a different manifestation of  individually-owned “business goodwill.” The issue examined by the Court did not involve the sale or other transfer of such goodwill, nor did it explicitly require the determination of where such goodwill resided. Nonetheless, the factors on which the Court based its decision were the same factors that would have been considered in any other dispute concerning the situs of the goodwill of a business.

Wade v. Commissioner

In 1980, the Taxpayer founded Company in Louisiana to conduct the business of acquiring plastic waste from chemical companies and converting it into usable products. The Taxpayer developed the manufacturing processes used by  Company and established and managed its industrial facilities.

Many years later, in 1994, Taxpayer’s son (“Son”) began helping Taxpayer with the management of the business. Son periodically received stock in Company and, by 2008, owned a significant portion of the issued and outstanding shares. Taxpayer owned the remaining shares. With Son there to handle day-to-day management, Taxpayer became more focused on product and customer development. He did not have to live near the business operations to perform these duties, so Taxpayer moved to Florida. After the move, he continued to make periodic visits to the facilities in Louisiana and regularly spoke on the phone with plant personnel.  At no point did the Court state that Taxpayer was party to an employment agreement with Company.

In 2008, the business began struggling financially as prices for its products plummeted and revenues declined significantly. Taxpayer’s involvement in the businesses became crucial during this crisis. To boost employee morale, he made trips to Company’s industrial facility in Louisiana, during which he assured the employees that operations would continue. He also redoubled his research and development efforts to help the business recover from the financial downturn. In addition to his research efforts, Taxpayer ensured Company’s financial viability by securing a new line of credit. Without his involvement in Company, the business likely would not have survived.

In 2008, the Taxpayer claimed a deduction for non-passive losses from flow-through entities (including Company) totaling almost $4 million. In 2009 Taxpayer requested a refund for the 2006 and 2007 tax years resulting from the carryback of the 2008 losses.

The IRS determined that the losses were passive losses. Accordingly, the IRS disallowed the deduction claimed by the Taxpayer.

Under Sec. 469 of the Code, individuals may not deduct passive activity losses for the year in which they are sustained. A “passive activity loss” is the amount by which the aggregate losses from all passive activities for a taxable year exceed the aggregate income from all passive activities for such year.

A “passive activity” is any activity that involves the conduct of any trade or business in which the taxpayer does not materially participate. IRS Regulations provide a series of tests under which one may evaluate whether a taxpayer materially participated in a given trade or business. In Wade, the IRS argued that Taxpayer did not satisfy any of these tests with respect to Company and, so, did not materially participate in its activities.

Taxpayer claimed that he satisfied two of the regulatory tests. First, Taxpayer claimed that he spent more than 500 hours in 2008 working on Company’s activities. Second, Taxpayer contended that he participated in Company’s activities on a regular, continuous, and substantial basis during 2008.

The Court agreed with Taxpayer’s second contention.

According to the Court, a taxpayer materially participates in an activity for a given year if, “[b]ased on all of the facts and circumstances * * * the individual participates in the activity on a regular, continuous, and substantial basis during such year.” A taxpayer who participates in the activity for 100 hours or less during the year cannot satisfy this test, and more stringent requirements apply to those who
participate in a management or investment capacity.

The record reflected that Taxpayer spent over 100 hours participating in the business during 2008, and his participation consisted primarily of non-management and noninvestment activities. Son managed Company’s day-to-day operations, while Taxpayer focused more on product development and customer retention.

Although Taxpayer took a step back when Son became involved in Company’s management, he still played a major role in its 2008 activities. He researched and developed new technology that allowed the business to improve its products. He also secured financing for Company that allowed it to continue operations, and he visited the industrial facilities throughout the year to meet with employees about their futures. These efforts were continuous, regular, and substantial during 2008. Accordingly, the Court held that Taxpayer materially participated in the business.

The Court noted that Company was a complex business that Taxpayer had built from the ground up and in which he continued to play a vital role. He was not merely a detached investor, as has often been the case when the Court has found that a taxpayer did not materially participate. The Court said that Taxpayer “brought something to Company that no one else could have, and the business could not have continued to operate without his contacts and expertise.” Accordingly, the Court held that the IRS erred in classifying Taxpayer’s losses from Company as passive.

The foregoing analysis has implications on many different fronts, some more obvious than others. Clearly, for purposes of the passive loss rules, a founder’s or parent’s continued involvement in the business may be critical. In the context of a sale of the business, how will the buyer approach the situation of a founder who has withdrawn to some extent from the business, but whose contacts, etc., remain vital to its well-being? The same issue may arise for estate valuation purposes as to an interest in the business. Finally, how will a state taxing authority view a founder, like Taxpayer, who has moved away from the state yet continues to play an important role in the business?  As is so often the case in tax planning, what may be good for one issue may be bad for another. It is usually impossible to foresee every eventuality, so it behooves a taxpayer to do what makes the most business or personal sense and to “tax plan” around that.