Attention: This is a machine-generated transcript. As such, there may be spelling, grammar, and accuracy errors throughout. Thank you for your understanding!
Jeremy Wells: When a client brings you facts and their own research that believes supports their position, the client thinks they have a good case for the position they want to take in a tax return. How should you respond to that? So consider a client that comes to [00:00:30] you. Let's call her Donna. And she earns about $300,000 from her corporate job is W-2 wages. She says she's got a new short term rental, and this generated a $120,000 loss the prior year. Let's say there was a cost segregation study, done a lot of first year depreciation. And so that rental is providing her with about $120,000 loss. Now, of course, right after looking at some blog [00:01:00] posts and social media content, and maybe even asking an artificial intelligence model that she uses. She has a. She has it in her mind that she can take that loss from that rental and offset the rest of her income, including those wages. There's a lot of content out there on social media about this, so it's pretty easy to understand where this particular client would get this idea from. But now this case is sitting on your desk, [00:01:30] and it's up to you to decide how to prepare this return and how to respond to this client wanting to take this position on the return. Right. So this client wants to see this deduction on the return for this episode. We're going to look at these kinds of tough situations. And it's not just talking about short term rentals or taking passive and nonpassive losses.
Jeremy Wells: It's all of these kinds of situations where client comes to us, or a taxpayer comes to us and [00:02:00] wants to take a specific position on a return that we're just not sure about. And so how do we, as tax professionals determine what the correct approach to these situations are? How do we even start going about that process? So what we're going to talk about is the research process and where we should actually be looking to find answers as tax professionals. Now, if you've listened to several of these or any of these episodes of Tax [00:02:30] Inaction podcast, throughout these episodes, you have heard me give citations for some of the claims that I've made on this show. So when I'm explaining the particular tax treatment of a certain kind of transaction, or I'm explaining why a certain kind of event is treated a certain way for tax purposes, I will often use a citation to something like the Internal Revenue Code to a Treasury regulation, to a court case, and present [00:03:00] that citation as some sort of backing for that particular claim that I'm making. Where does that come from? Why do we look at that kind of information? What kind of information can we look at? What kind of information should we not look at when it comes to doing tax research? So as return prepares and as tax practitioners.
Jeremy Wells: What makes a convincing case for a tax position, and when should [00:03:30] we question the positions that clients want us to take on a return and do some tax research to come up with a justifiable position on that return? So when you finish listening to this episode, you should be able to determine when a, uh, what we're going to talk about as an understatement is substantial and how substantial authority or disclosure affects what is the [00:04:00] substantial understatement penalty under section 66? 62. And it's this penalty in particular that really makes it important that we, as tax practitioners, understand the positions that are being taken on returns, and that we understand the tax research process that goes into being confident about those positions that are being taken on that return. We're going to distinguish substantial authority from reasonable basis. These are two different levels [00:04:30] of confidence about those positions that we can take on a return. And we're also going to look at them more likely than not standard. So these are the three sort of levels of of confidence in a position on a return. And there are going to be different treatments for a position depending on which of those levels of confidence we're at. We're going to evaluate whether a research source constitutes authority and weigh relevant [00:05:00] authorities supporting and opposing a position. Basically, we're going to talk about what tax research looks like and what kinds of sources we should be looking at when we're conducting that research.
Jeremy Wells: And then finally, we're going to look at how to apply a diligent tax research process to develop the facts, analyze the law, document the conclusion, and then ultimately advise the client on the position to be taken on a return. So where does all of this come [00:05:30] from? Where is the impetus for us as tax practitioners to be concerned about the positions being taken on in return? Should we prepare returns the way clients and taxpayers want them returned? And if so, then what do we need to understand about those positions being taken on that return. So in general, practitioners can rely in good faith on information provided by clients. However, circular [00:06:00] 230 gives us a process for responding when the facts or the conclusions require scrutiny. In other words, when the position that the client wants to take that the taxpayer wants to take on that return doesn't quite seem right. And it's at that instant, right, when it doesn't quite feel right to us that we need to do a little bit more work at that point, that reliance in good faith [00:06:30] on the client, on the taxpayer that's no longer in play at this point. Once we have that sense that something isn't quite right, we need to step in and we need to do a little bit more work. So what does that work look like? Well, first of all, we need to inquire. We need to ask questions.
Jeremy Wells: Ask reasonable questions about incomplete or inconsistent information. So if the information provided by the client doesn't fully explain the transaction [00:07:00] or the situation in which the client engaged in that transaction, or the source of the income or the nature of the expense. All of these kinds of facts and circumstances that give us a complete picture of the tax treatment of that particular transaction, or bit of income or expense, whatever it might be. We need to start asking more questions and then research. We have to obtain [00:07:30] the knowledge needed to handle the issue competently. We need to understand what the law actually says when it comes to that particular question that is now raised based on the information provided by the client. And then we have to evaluate, we have to relate the applicable law and authorities to the actual facts. Sometimes there is gray area in tax law and sometimes the [00:08:00] answer isn't blatantly obvious. And so we have to dig into the law. We have to understand what parts of the law we should be looking at. And when we find different parts of the law that may be in conflict with each other or may not completely answer the question in front of us, we need to think about where else we could be looking, or how we're going to take a position based on law that doesn't completely answer the question the way we hoped it would. [00:08:30] And then finally, we advise, we explain the potential ramifications of taking a position that we're uncertain about to the client.
Jeremy Wells: We also need to be aware of and explain to the taxpayer the potential penalties and costs of taking that position. If it's not correct, or if the IRS or the courts don't agree with that position. And then finally, if we are going to take [00:09:00] that position, what we need to do to disclose that position, if we're not sure that it is fully supported in the law. Now, I mentioned circular 230. Here. Circular 230, of course, applies to what we call enrolled practitioners. So these are going to be enrolled agents, certified public accountants, attorneys. And then there are a few other titles that are included under circular 230 tax practitioners who are not credentialed or [00:09:30] not licensed. They may not be subject to circular 230 however, in general, circular 230 provides best practices to the tax return preparer and tax profession tax professional industry. And so regardless of whether circular 230 specifically applies to a particular tax return preparer practitioner or not, we're still going to use that as the basis for thinking about what [00:10:00] we as tax practitioners need to be doing and thinking about when we get these situations in our office, when we have clients, when we're working with taxpayers who want to take positions that we're just not sure about, that we're not certain about. Now, I mentioned earlier the substantial understatement penalty.
Jeremy Wells: So what do we mean by a substantial understatement? Well, a return understates income tax when the tax required to be shown exceeds [00:10:30] the tax that's actually shown on the return. Now how do we know the tax that's required to be shown. Well there's going to be a difference between the tax required to be shown and the actual tax on the return. When a taxpayer takes a position that is incorrect, and when that incorrect position results in putting tax on the return, that is less than it should have been. That [00:11:00] causes an understatement. There is a specific penalty under section 6662 of the Internal Revenue Code that imposes a penalty on a substantial understatement. So an understatement for an individual is substantial. If it exceeds the greater of either 10% of the tax required to be shown. And that would be 5% if the taxpayer claims a section [00:11:30] 199 cap a deduction. So that's the qualified business income deduction. So it's either 10% of the tax required or 5% if the taxpayer claims the qualified business income deduction or $5,000. So it's the greater of either one of those. The percentage of the tax required to be shown, or $5,000 if the amount of the understatement is greater than either one of those, whichever one is greater, then [00:12:00] that is a substantial understatement. And when there is a substantial understatement, that can result in a 20% penalty for the taxpayer on the related underpayment.
Jeremy Wells: Now this is where it can get a little confusing because the penalty is not necessarily assessed on the understatement itself. The understatement [00:12:30] determines whether that statutory threshold is crossed. In other words, whether the penalty is triggered. But the penalty itself is 20% of the portion of the underpayment attributable to that substantial understatement. Now, usually these two amounts will be equal. However, it could be the case that they are not. For example, when tax has previously been [00:13:00] assessed or collected without assessment or a taxpayer failed to claim withholding or other payments on a return. So, for example, let's just work through an example here. Let's say that the correct tax that was required to be shown on the return was $25,500, but the tax actually shown on the return is $18,000, right? So the tax [00:13:30] that was supposed to be shown $25,500. 10% of that is just $2,550. So that does not meet the threshold to trigger the penalty. Right. The tax shown on the return was $18,000. So the understatement there is $7,500. Now that does exceed $5,000. So that is triggering the 20% [00:14:00] penalty. Now let's say that there was some tax that was previously collected right through some unclaimed withholding, because a lot of times with these returns that might be subject to this kind of penalty, there's not just one thing wrong with it. There might be multiple things wrong. And so the taxpayer forgot to include not only income, but maybe there was some withholding that went along with that income.
Jeremy Wells: So for example, from a retirement plan distribution, right? Sometimes those 1099 hours [00:14:30] just get forgotten about the taxpayer forgot that they took that distribution out of the retirement plan. It shows up on the taxpayer's income, wage and income. Transcript. But they forgot to give the tax return preparer the 1099 R and so that income isn't reported on the return, but neither is the withholding. So let's say that there was $1,500 of withholding in this case, but there was a $7,500 understatement. So the penalty is [00:15:00] triggered based on that $7,500 understatement. But the actual underpayment was only $6,000, or that $7,500 minus that $1,500 of missed withholding. So the penalty would be 20% of the underpayment or $1,200 20% of $6,000. So this is kind of a little bit of a case that that fits the explanation I'm trying to give, but it's it's totally reasonable given [00:15:30] the fact that sometimes, like I said, when tax is understated on a return, there could be, for example, missed withholding that goes along with that as well. How can you reduce an understatement or a potential understatement on a return then? So for most tax positions, the tax attributable to a disputed item and the disputed item is what might generate that [00:16:00] understatement. It's possible to exclude that from the understatement calculation through one of two ways. First is substantial authority supporting the tax treatment.
Jeremy Wells: If that disputed tax, either in terms of a transaction or the way a particular transaction is reported, if that disputed transaction has substantial authority for the way it was reported [00:16:30] on the return. Then that is not included in the calculation of the understatement. The second route here is adequate disclosure of the relevant facts. When that position has a reasonable basis. So that's another, uh, sort of hurdle that the taxpayer can try to cross in order to, uh, have that disputed position not [00:17:00] included in the calculation of the understatement. Now, it's possible on a return that multiple positions were taken. Several of those positions are disputed. Some of those positions may have the backing of substantial authority. Some of them may have the backing of reasonable basis. And whether those positions were actually disclosed or not is going to be in question. Some of them may not have a reasonable basis at all. Substantial authority, though, does not require [00:17:30] disclosure. So if the position is taken with substantial authority behind it, then there's no reason for the taxpayer to disclose the position. If the position merely has reasonable basis, then there is a reason to disclose it. And we'll talk about what that disclosure looks like here in a little bit. But first of all, what do we mean by substantial authority? So the regulations, Treasury regulations put substantial authority between two [00:18:00] other standards of certainty or standards of confidence in taking tax positions. So the the highest level of confidence that is listed out in the regulations is more likely than not.
Jeremy Wells: This is the more likely than not standard. If it's greater than a 50% likelihood of being upheld for [00:18:30] the position, then that meets the more likely than not standard. Now what does that actually mean in practice? In practice, it's still a bit of a subjective standard. I think that more likely than not, right. I think that greater than 50% of the time that taking this position will work out just fine. If right, uh, that position were ever disputed. Now, what's that based on? Well, it's based on your [00:19:00] confidence in position. It's based on your reading of the law. It's based on your analysis of how IRS or the courts might view that position taken. But that is the highest standard that you can have for a position taken on a return that could be disputed. Just below that is substantial authority. So the supporting authorities are substantial relative to contrary. Authorities. Now, [00:19:30] this is not necessarily the more likely than not standard. And so at this point, we're dealing in a world where most of the time. Right. A majority of the time this position, if disputed, may not be upheld. However, from our read of the law, we have a greater weight of authority supporting the position [00:20:00] than contrary authority. And then below that level or that standard of confidence is reasonable basis, which is still relatively high, but it's lower than substantial authority.
Jeremy Wells: Now, those These standards measure the positions merits, not the likelihood of an audit. And it's critical to understand that what we're talking about here with [00:20:30] these standards are not whether we think IRS will challenge them or not, not whether we think a revenue agent would allow this position or not. What we're basing this analysis on is the actual merit of the position relative to tax law. So if we're just straight up reading tax law, then does this position uphold? If [00:21:00] so, if it would uphold most of the time, then that meets the more likely than not standard. If not, but we think that the weight of the authority supporting the position outweighs the Or or is relatively high compared to any contrary authorities, then that meets the substantial authority standard. And if we think that it's reasonable to take this position, but we're not quite sure [00:21:30] if we have substantial authority or not, then that meets the reasonable basis standard. So what matters here is the level of confidence that we have in the position relative to actual law. What does not matter here is the taxpayer's confidence in the conclusion, based on what they may have come across in [00:22:00] social media or advice that they've gotten elsewhere. What our task is here, once we have this position in front of us that we need to evaluate, is to look at the authorities objectively not looking at other potential sources.
Jeremy Wells: What we're doing here is we're weighing authority. We're not necessarily counting them. This is not a quantitative approach. It's more of a qualitative [00:22:30] one. So every relevant authority, whether it's supporting or contrary to the position we want to take, needs to be included in the analysis. And the weight of that authority is going to depend on how relevant it is to the actual facts and issue that we're dealing with, the persuasiveness of the reasoning of the application of that authority to this particular case, and then the type of authority and whether it that type of authority [00:23:00] is still current and still good law relative to any changes that may have occurred since it was established. Okay. So a well-reasoned construction of the applicable statute might provide substantial authority, even if we don't have some other kind of authority, such as a court case or a revenue ruling, for example, directly on point. However, we [00:23:30] need to look at the total of the various kinds of authorities that could potentially weigh on this particular case. In other words, we can't cherry pick the sources that we want, the ones that sound good and say, well, this bit of authority sounds like we can do what we want, so we're just going to focus on that. That's not what we should be doing as good tax practitioners, trying [00:24:00] to consider whether we want to take these kinds of positions on a return.
Jeremy Wells: Ultimately, we have to come back to the motivating question here. Right. So is the weight of the supporting authorities substantial in relation to the weight of the contrary authorities and and that's the way we need to be thinking throughout this entire research process. Whenever we have a position that we're trying to determine whether [00:24:30] it's a position that is worth taking on a return, that is going to avoid a potential understatement penalty. That's the the standard we need to be looking at, right? Is the weight of the supporting authorities substantial in relation to the weight of the contrary authorities? So what do we mean by authorities? What actually counts? What should we be focusing on as tax practitioners? There's a lot [00:25:00] of information out there about what counts, what doesn't count, uh, how we should be doing things for tax purposes. But there's only a specific list of sources that count as authoritative when it comes to tax law. So regulation section 1.66624 provides a closed list of recognized authorities. In other words, if it if this kind of [00:25:30] authority, if this kind of research that you're looking at is not included in this list, then it is not authoritative. Right. It will not be useful in meeting that substantial authority standard. Now, that's not to say that it's wrong. And it's also not to say that it can't be useful at some stage of the research process. What it does say is that if you're trying to make a case that a disputed [00:26:00] position has substantial authority and therefore should not be Included in the determination of whether there's an understatement on a return, then those sources are not going to be helpful.
Jeremy Wells: So what sources are going to be helpful? What is substantial authority statutes? So actual laws passed by Congress, not bills, not rumors of what Congress might do, actual laws that have been [00:26:30] passed by Congress and actually enacted on the books proposed temporary and final Treasury regulations. Now, there is some distinction made between proposed and temporary versus final regulations. Ultimately, if we have final regulations, we prefer to use final regulations. Sometimes Treasury drops the ball with regulations and [00:27:00] has proposed or temporary regulations, and for whatever reason, never actually gets around to formalizing those regulations and getting them into a final version. Now, just because a regulation is proposed or temporary doesn't mean that we shouldn't use it. In fact, some of the most widely used and most important regulations that we have [00:27:30] are still in their proposed or temporary state. So in particular, for this question that we're talking about with taking passive losses, one of the most important sources of authority when it comes to whether a taxpayer can take a passive loss against nonpassive income or not, is actually in a temporary regulation. Section 1.4695 T. So [00:28:00] there is a section 1.4695. There are just a lot of gaps in it, and some of those gaps are filled, and especially the ones that are relevant to a case like the one we're talking about in this episode.
Jeremy Wells: Some of those gaps are filled by a temporary regulation. So sometimes we do need to rely on proposed temporary regulations. If there's not a final regulation that's applicable to the case that we're looking at, and there are other rules about when proposed temporary regulations are useful or not. But for now, [00:28:30] just know that they are included in the list of substantial authority tax treaties are another one. So if you deal with, uh, US citizens who are living abroad, then a lot of times determining whether income earned in a foreign country is taxable in the US. And if so, how. So? Some of that might come down to reading the tax treaty between those two countries. Court [00:29:00] cases are another source of substantial authority. And in fact, court cases can be really helpful because what court cases do is they will take a specific set of facts and circumstances from the individual involved or the company involved in that particular court case, and will apply the relevant statute regulations and other sources of authority to that particular case. So a lot of times court cases and reading through the opinion, [00:29:30] especially if they're relatively recent and if they're relevant and on point with your particular client's facts, those court cases can provide a very useful summary of the authority as applies to your particular client's facts.
Jeremy Wells: Now, some court cases are going to be what we call precedential. In other words, we can use them as precedent. So if a court was dealing with a similar case in the future. [00:30:00] That court could then rely on that particular opinion in order to help determine its opinion in this future case. But some are what we call non precedential. So some tax court opinions for example memorandum opinions or summary opinions. Those are non precedential. There's also some other IRS determinations that are non precedential. So private letter rulings for example pills [00:30:30] are non precedential meaning that they can't be applied to any other taxpayer's particular case appeal or only applies to the named taxpayer in that ruling. However so reading through a PLR can be helpful for getting an idea of what the IRS position might be on a similar case in the future. So just [00:31:00] because a an authoritative source is non precedential doesn't mean that it can't be helpful. It just won't necessarily have substantial authority for your client's particular facts. Revenue rulings, revenue procedures, notices, announcements and other published IRS pronouncements are authoritative. What is not authoritative when it comes to the IRS is unfortunately, the IRS website [00:31:30] itself. And IRS publications, capital P publications. So the IRS produces a lot of publications on topics. And those publications can be helpful, especially for providing lay person explanations of particular applications of tax law, especially to clients. So in my own practice, I will occasionally reference a a topic or a publication that is [00:32:00] on the IRS website to a client to provide them with a plain language explanation of the application of the law.
Jeremy Wells: But before I do that, I'm always going to make sure that what I'm sharing with them from the IRS website or from that publication does actually fit with substantial authority. But you cannot rely on the IRS website or its publications directly as authority. What is authoritative from the IRS is what [00:32:30] is published by the IRS, especially in what's known as the Internal Revenue Bulletin. So that's going to include things like revenue rulings, revenue procedures, and then along with notices and announcements, right. Also, uh, legislative materials. And this is going to include committee reports and the Joint Committee on Taxation, blue books. These can be helpful for understanding Congress's thinking and intent when it comes to statute. So [00:33:00] if the law, if the actual statute, if a section of the Internal Revenue Code says one thing, it may not be completely obvious whether it applies to a particular taxpayer's set of facts and circumstances, or it may not be completely obvious why that statute was written the way it was. Sometimes we can go back and look at the committee reports [00:33:30] and the JCT blue books for when those tax laws were actually being written by Congress, and get a little bit better understanding of the logic that was going into it.
Jeremy Wells: Now, sometimes that might help a taxpayer. Sometimes it's just relatively interesting material to read. So, for example, I have an episode on qualified business income deduction, and I've been teaching some courses on that lately. Well, going back and reading the blue book that [00:34:00] was published around the time of the Tax Cuts and Jobs Act. There are several pages in that issue of the Blue Book that explain Congress's thinking and the logic behind introducing the section 109 cap, a qualified business income deduction. It's kind of interesting to understand why Congress thought we needed this deduction. Is there anything in there that might help a particular taxpayer if they had a position [00:34:30] that was challenged by the IRS? Maybe. Um I'm not sure. Might might be a little doubtful. Uh, but then there are other cases, particularly in court cases where you will find the court actually go back into, uh, those, those legislative records and try to understand what Congress was intending there. So I have another episode where I talk about the limited partner exception for self-employment [00:35:00] income and self-employment tax. Well, that is a case where the courts have gone back through what Congress was thinking when it wrote into the tax code, the phrase limited partner as such. And so what did Congress actually mean by the as such? Well, the only way to understand that is to go back into the congressional records around that. So that might be a case where you see a taxpayer take a position and use those legislative materials, [00:35:30] use those committee reports, those JCT blue books, use those congressional explanations of the statute itself to try to understand what Congress meant and try to justify taking a position that helps the taxpayer.
Jeremy Wells: And then finally, there are certain written determinations. Irs information releases, press releases, these sorts of things. A lot of times those individualized determinations will qualify as authoritative. And I mentioned [00:36:00] private letter rulings. Polls already. Also technical advice memoranda. Those will be authoritative for the particular taxpayer that they're addressed to, though. Then there's a lot of other sources out there. I already mentioned IRS publications. The forms and instructions themselves are non-authoritative. So relying on form instructions might help you prepare [00:36:30] the form. But you can't justify, at least not in terms of substantial authority, a position taken on a form based on the form's instructions itself. And the same goes for IRS publications as well. Research treatises, tax research services, articles, continuing education materials those are all non-authoritative. They might provide useful research [00:37:00] opportunities and guide you to authoritative sources. So those treatises, those articles, the hopefully the continuing education content like this show that you're, uh, that you're consuming. Hopefully they point you to the answers in an authoritative source, but by themselves, they're not authoritative opinions or advice from tax professionals, of course, is not going to be authoritative, whether that [00:37:30] is you saying that in your experience, this position should hold up, or whether a taxpayer says that they got the advice from a tax professional, that generally is not going to hold up as authoritative.
Jeremy Wells: And then finally blogs, podcasts, social media, and of course AI output. Again, this can all be useful information for helping tax professionals as well as taxpayers, uh, better understand [00:38:00] the application of tax law, but it's not going to be authoritative by themselves. I mentioned earlier, uh, the reasonable basis standard of support for a disputed position, reasonable basis requires disclosure. If we have substantial authority to justify a position, we don't need to disclose the position on the tax return. So [00:38:30] there's nowhere on the return to indicate that a position has substantial authority supporting it. However, for a position that lacks substantial Authority, but has a reasonable basis of support. In those cases. We do need to disclose those positions on the return. And this is the second route that section 6682 provides for avoiding [00:39:00] a substantial understatement penalty. So tax attributable to an item can also be excluded from an understatement when the position has a reasonable basis and the relevant facts are adequately disclosed. So what is that disclosure look like? The IRS provides form 8275, or for a position that is contrary to Treasury regulations form 8275 R, [00:39:30] and those forms are where the taxpayer discloses the position taken on the return. Now, an annual revenue procedure or product identifies items adequately disclosed on the return itself.
Jeremy Wells: But disclosure can never cure inadequate legal support or substantiation for a position. So in other words, just using 80 form 8275 to disclose a position doesn't [00:40:00] magically make that position defensible. The position still has to have a reasonable basis. So if the position doesn't have reasonable basis disclosing, it doesn't help the taxpayer out any. That position might still be subject to an understatement. It also doesn't help when the taxpayer fails to maintain adequate books and records, especially if those records are required for strict substantiation, such [00:40:30] as those under section 274. This is going to be directly relevant for the case study that we're looking at here with with Donna who wants to claim this loss, uh, this, this rental loss against her non passive income. So even a legally supportable position on material participation requires evidence of what she did and approximately how long she spent [00:41:00] doing that. That's what the material participation rules require. Now, disclosure can't compensate for an unreliable or a missing record of material participation, for example, or for a missing mileage log if the taxpayer claims automotive expenses on a business return. So just disclosing the position doesn't cure [00:41:30] those kinds of failures when it comes to a a tax return. I'll briefly mention that tax shelters and reportable transactions face stricter rules. Generally, this is not something I deal with in my practice. But if you have a tax return that includes a tax shelter or a listed or certain reportable transaction, then those understatement penalties can be [00:42:00] higher.
Jeremy Wells: And neither substantial authority nor disclosure with reasonable basis reduces the section 6662 understatement for a tax shelter. Right. And then those listed and reportable transactions, those actually have a 30% penalty if the taxpayer fails to adequately disclose them under section 6662 cap A. So ultimately, what is good research look like here? So first of all, [00:42:30] as the tax practitioner, we're going to define the issue and verify the material facts. We're going to get started by. Understanding what the actual question here is and what we know about the question. And then based on that, we need to narrow the scope of our search to the actual controlling law. Usually this is going to start with a particular section of the Internal Revenue Code. And once we get there, because the Treasury regulations are organized around the code sections, [00:43:00] we can usually then go to those Treasury regulations. Now at that point, if you're not using a tax research service, it might be difficult to know where to go from there. And this is why tax research services and databases can be so valuable, because those will also include things like revenue rulings and revenue procedures or court cases. And by including that information as [00:43:30] well, it makes it a lot easier for us to drill down and find sources of substantial authority that might more directly apply to our clients or the individual taxpayers particular circumstances.
Jeremy Wells: And that's going to help us identify those supporting and contrary authorities. Remember, we're not only cherry picking the things that we think help our client. We're also looking at those contrary authorities. Where have there been court cases [00:44:00] where the taxpayer lost with a similar set of facts and circumstances? We need to understand those as well, if not even better, than we understand the court cases that we think help our taxpayer. And then finally, we're going to relate the authorities to the facts and weigh them. Once we have done all of that research, right? So once we have assembled all of that information from those authoritative sources, we need to look at what's there and start weighing those sources against [00:44:30] them. And one way of weighing them is just thinking about which ones more directly apply or have similar facts and circumstances to what our particular client or this particular taxpayer is dealing with. Once we've done that, we can determine whether the position has substantial authority or not. And if it doesn't have substantial authority, can we at least claim that it has reasonable basis? And if so, can we disclose that position [00:45:00] on the return? And at the very end of the process here, we need to document all of this analysis. And the sources arrive at a conclusion. Include all of that in that client's file. And then if there's any remaining uncertainty or doubts, we also need to acknowledge that and then advise the taxpayer on what we've come up with.
Jeremy Wells: So looking at Donna's case in particular, she had for her short term rental that she purchased [00:45:30] 15 customer stays that averaged six days. Now, an activity with an average customer use period of seven days or less is not a rental activity for section 469 purposes. And this is where we get that term short term rental. Now a lot over the last several years, we've had a lot of interest in short term rentals, especially from taxpayers who want to use short term rentals to [00:46:00] reduce their tax liabilities. And this is often described on social media as the short term rental loophole. But using those phrases can become misleading because that term, short term rental doesn't actually show up in tax law anywhere. What we have to do is look at the particular facts and circumstances of the case in front of us and determine where they fit within actual tax law. So because Donna [00:46:30] is operating this activity that has average customer stay of less than seven days, it doesn't qualify as a rental under section 469. So Donna does not need to be a real estate professional to, uh, be able to treat this, uh, loss from the rental activity as potentially non passive. This is one issue that I see a lot of tax practitioners seem to misunderstand that the [00:47:00] real estate professional status, uh, which I need, I will at some point do an episode on 469 and real estate professional status, probably a few episodes on that.
Jeremy Wells: Uh, but real estate professional status doesn't apply if the rental is seven days or less. Or in other words, what we call a short term rental. So they only apply to long term rentals. In this case, Donna doesn't need to worry about that. So the activity is still passive. We haven't established that the loss from the activity is non passive yet, so we need to keep working. [00:47:30] We need to keep doing more research. We come across material participation. And like I said this is in a temporary section of the regulations temporary regulation 1.4695 T where we get the seven material participation test. And Donna might qualify under the third one, which is more than 100 hours of participation and at least as much participation as any other individual. Now, Donna told you told us that she [00:48:00] had 145 hours of participation in the activity. That sounds great. Sounds like she might meet the definition here. At least the first part of it. What about the second part? She says that she used a property manager to manage the actual property, and the property manager participated for 115 hours and no other individual was part of this or participated more than the actual property manager. So for now, [00:48:30] we think Donna has passed this third material participation test. However, if we keep reading in this regulation, we see that there's a limitation on what actually counts toward these material participation hours.
Jeremy Wells: So what the regulation calls investor hours don't count unless the taxpayers directly involved in the activities, day to day management or operations. Now, [00:49:00] she spent 35 of those 145 hours involved in reviewing financial reports, analyzing investment returns, researching tax benefits, reading these blog posts, listening to podcasts. All of that counts as investor work. And we know she's using a property manager. She's not active in the day to day management or operations of the property. So if we include those 35 [00:49:30] hours, then Donna passes that third material participation test. However, if we acknowledge that they don't actually count because their investor hours, then she fails that third material participation test. And that third material participation test is the only one that she had a shot at actually passing the other six. We've ruled out already. So what do we conclude from this? Well, Donna's position really lacks substantial authority. We can't [00:50:00] make a case based on the list of sources that the regulations allow us to include in this definition of substantial authority. We can't make a case that she actually qualifies to take the loss from that rental as non passive because she did not materially participate in that activity. She didn't materially participate because she failed the third material participation test, which says that she has to work at least 100 [00:50:30] hours on the activity and she has to work more than anyone else.
Jeremy Wells: Now, we could take the position that those 145 hours all count. However, we would not have substantial authority, and I also don't think we would even have a reasonable basis for claiming that those 35 hours of investor hours should count toward her material participation. So in that case, she fails that [00:51:00] third material participation test. So could we then maybe disclose that she wants to include those hours anyway? Well, if she doesn't even have a reasonable basis for claiming those hours, then disclosure won't help either. And at the same point, what. On what basis would we be making that claim now? Donna is presenting to us that, uh, she has read the [00:51:30] IRS publication. She's read blog posts, she's listened to podcasts, and AI output tells her that she should be able to take that non passive loss. However, we as tax professionals, we know that none of that really counts when it comes to reporting the kind of position she wants to take on the return. So even with that bit of research that she's done, there's not a reasonable basis. And there's definitely not substantial [00:52:00] authority backing up that position. And so in this case, disclosure wouldn't be of much help to her. So the research is done right. We understand the relevant law here. The only thing left is to actually act on the conclusion. Right? So we have to explain to the client why those 35 investor hours don't count.
Jeremy Wells: Why she fails that third material participation test, and how that loss [00:52:30] should be reported on the return. Now at this point, we have fulfilled our obligation under circular 230. The ball is now squarely in the taxpayer's court. It's up to the client whether they want to take the position that we know won't stand up, or to agree with our conclusion and take the position that we think the taxpayer should take. And it's at this point where you have to [00:53:00] decide, depending on how that client responds, whether you want to actually prepare and file that return for that taxpayer or not. Right. But you're doing that from a position of understanding what the law actually says and how it actually applies to this client's particular facts and circumstances. It's not based on vibes. It's not based on whims. It's not based on how you've done other returns. And it's especially [00:53:30] not based on what you think would or would not get audited if that position were taken on the return. So let's sum up what we've talked about in this episode. First of all, we always need to start off these kinds of situations where we have a potential position on a return that we have some uncertainty about. We first start by verifying the relevant facts before we start digging into the law. What could happen if you [00:54:00] start digging into the law before you get all the facts? Once you start accumulating an understanding of the law, you start asking for more facts.
Jeremy Wells: Well, once the facts start coming in, you realize you've not been looking in the right place in the law. And so the more facts we can get up front, the less time we potentially waste looking in the wrong parts of the law. We can use research aids and summaries to locate recognized authority, but we should [00:54:30] not rely on them. We should always evaluate the authority directly, especially if you are using AI based research tools. If those AI based research tools are providing you with sources and citations to actual authoritative sources, you still need to go read the authoritative sources directly yourself to make sure you're not relying on an AI generated summary that doesn't quite [00:55:00] apply the law correctly to your particular facts and circumstances. And again, we need to ask, is the weight of the supporting authorities substantial in relation to the weight of the contrary authorities? That should always be the guiding question when we're dealing with these kinds of situations. If not, we determine whether the position has a reasonable basis and if so, we determine [00:55:30] what disclosing the position would look like. And ultimately, we only want to be reporting positions on a return that we can support through substantial authority, through actual tax law. If you found value in this episode, please let me know by liking it and leaving a comment in your podcast application of Choice or on YouTube.