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A ruling by the United States Court of Appeal, Fourth Circuit, has upheld the Internal Revenue Service's ("IRS") position that a taxpayer cannot deduct passive-activity losses from nonpassive gains, or "PAL Netting."
David Hillman ("Taxpayer") was the sole shareholder of Southern Management Corporation ("S Corp"), which was a corporation taxed under Subchapter S of the Internal Revenue Service Code ("Code"). The Taxpayer had an ownership interest in a number of properties ("Properties") that were leased, and for which the S Corp provided management services. In 1993 and 1994, the Taxpayer did not perform any services for the Properties but did perform management services through the S Corp. On his tax returns for those two years, the Taxpayer deducted the management fee expenses that he incurred for the Properties from the income that he received from the S Corp for his management services. The IRS disallowed this deduction. The Taxpayer contested the disallowance of the deduction, and the Tax Court ruled in favor of the Taxpayer. The IRS appealed.
The Fourth Circuit reversed the Tax Court. The Taxpayer argued that Code section 469(a) should not apply because, at the time of enacting Code section 469, Congress directed the IRS to create regulations which exempted from section 469(a) self-charged management fees resulting in no growth to the taxpayer's actual wealth, which is the type of deduction the Taxpayer attempted. These regulations have never been created by the IRS. The Tax Court accepted the Taxpayer's argument, ruling that the Taxpayer should not have to bear the consequences of the IRS's failure to enact regulations that Congress directed them to create.
The Fourth Circuit rejected the Taxpayer's argument and reversed the Tax court, ruling that the plain language of section 469(a) mandated that passive activity losses could not be deducted from nonpassive gains. A "passive activity" is generally defined as a business activity in which the taxpayer does not "materially participate," and rental activity is defined as a passive activity (with some exceptions). The court stated that it was required to look at the plain meaning of the Code sections in determining whether the deduction was permissible, not regulations which don't exist, and ruled that section 469(a) barred this type of deduction. The plain meaning of a statute can only be circumvented in two very narrow situations, neither of which applied here. Thus, the Tax Court was reversed and the IRS's position against PAL Netting was affirmed. The case was remanded back to the Tax Court for the consideration of an alternative argument made by the Taxpayer, over the objections of one member of the appellate panel.
Hillman v. IRS, 263 F.3d 338 (4th Cir. 2001).
TO COMPLY WITH CERTAIN U.S. TREASURY REGULATIONS, WE INFORM YOU THAT, UNLESS EXPRESSLY STATED OTHERWISE, ANY U.S. FEDERAL TAX ADVICE CONTAINED IN THE TEXT OF THIS COMMUNICATION, IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, BY ANY PERSON FOR THE PURPOSE OF AVOIDING ANY PENALTIES THAT MAY BE IMPOSED UNDER THE INTERNAL REVENUE CODE.