ARTHUR ANDERSEN FAVORS EASING 500-HOUR 'MATERIAL PARTICIPATION' TEST; SUGGESTS ELIMINATION OF 'SIGNIFICANT PARTICIPATION' RULES.

Gotliboski argues that the 500-hour test should be lowered to 250 or 300 hours and should include hours spent in providing management services. He argues that there are "several types of activities in which an individual can materially participate without spending more than 10 hours per week," including ownership and operation of a retail clothing store, a fast food franchise, a service station, and a car wash. Gotliboski argues that the Committee Reports recognize that "the fact that an activity is not an individual's principal business is not conclusive in determining material participation," and he suggests that greater emphasis should be placed on the facts and circumstances test set forth in regulation section 1.469-5T(a)(7).

The significant participation test should be eliminated as contrary to congressional intent, according to Gotliboski, who argues that the rule "has nothing whatsoever to do with sheltering activities." Finally, while Gotliboski agrees that "an arbitrary criteria such as the 120 percent standard" used in applying the substantially appreciated property rules is desirable for administrative purposes, he argues that "gain 'built-in' at the time property is contributed to a passive activity should not be treated as passive activity income where the disposition occurs prior to the expiration of the prescribed holding period and the contribution was made to create passive income." Rather, he contends, "gain that is attributable to the period during which the property is used in the passive activity, regardless of the length of time, should be allocated to the passive activity."

We are writing with respect to a notice of rulemaking relating to the promulgation of regulations under Internal Revenue Code Section 469. In response to that notice, we respectfully submit the attached memorandum which describes in detail our comments concerning various aspects of the proposed regulations. Specific comments with respect to the effect of these regulations in the oil and gas and real estate industries are being presented under separate cover.

In general, we believe that certain provisions in the proposed regulations do not fully consider the economic arrangements of taxpayers in their business endeavors. We also believe that parts of the regulations are either inappropriate explanations of the statute or constitute departures from congressional intent. Notwithstanding our disagreement with certain provisions of the proposed regulations, we believe that overall, the regulations evidence a commendable effort to interpret a very complex concept.

The attached memorandum addresses the following areas.

I. MATERIAL PARTICIPATION

The proposed regulations adopt a series of six objective tests and one subjective standard for determining material participation. The "more than 500 hours" test will be the rule generally applied. We believe that "more than 500 hours" is unrealistically high when applying an overall test of regular, continuous and substantial involvement in operations. We respectfully suggest that a 250 to 300 hours per year test would constitute a reasonable standard and certainly be sufficient to accomplish the purposes of the statute.

The subjective standard based upon facts and circumstances is essential to cover situations that are within the spirit of the statute but do not fall within one of the six objective standards. We believe that the bias against considering management services should be removed from the regulations.

II. RULES FOR SIGNIFICANT PARTICIPATION PASSIVE ACTIVITIES

The special rule for significant participation has gone beyond the intent of Section 469 in that it creates a third category of activities that is neither a material participation activity nor a passive activity. We respectfully recommend that this entire concept be stricken from the regulations. It has no foundation in either the statute or the Committee Reports.

III. DISPOSITION OF SUBSTANTIALLY APPRECIATED PROPERTY FORMERLY USED IN A NONPASSIVE ACTIVITY

The proposed regulations require that gain from the disposition of substantially appreciated property used in a passive activity and formerly used in a nonpassive activity be treated as not from a passive activity unless a prescribed holding period is satisfied. This regulation ignores the important fact of WHEN the property appreciated. The passive activity should be credited with that portion of the gain properly allocable to the period during which the property was used in the passive activity. It is respectfully recommended that the regulations be modified to treat as nonpassive income only that portion of the gain "built-in" at the time of contribution to the passive activity.

We appreciate your consideration of these comments and the opportunity to submit them.

Very truly yours,

WASHINGTON, D.C.

Comments Submitted by

The purpose of this memorandum is to discuss several specific areas addressed by the Regulations: first, material participation; second, the rules for significant participation passive activities; and third, disposition of substantially appreciated property formerly used in a nonpassive activity. The following paragraphs discuss each of these matters and where appropriate include a discussion of the statute and legislative history in support of the comments.

I. MATERIAL PARTICIPATION --

The proposed regulations adopt six objective tests and one subjective test for determining material participation. The "more than 500 hours" test contained in Section 1.469-5T(a)(1) will be the rule generally applied. We believe that 500 hours is unrealistically high and unnecessary when applying an overall test of regular, continuous and substantial involvement in an activity. We believe that a standard of 250 to 300 hours per year would be completely adequate to accomplish the purposes of Section 469. The subjective standard based upon facts and circumstances is essential in situations that are consistent with the purposes of Section 469 but do not fall within one of the six objective standards. Additionally, we believe that the bias against considering management services performed by individuals in determining material participation should be stricken from the regulations.

Section 469 was added by the Tax Reform Act of 1986 to ". . . curb the expansion of tax sheltering and to restore to the tax system the degree of equity that is a necessary precondition to a beneficial and widely desired reduction in rates." (S. Rep. No. 313 (Part 2), 99th Cong., 2d Sess. 714.) The Senate Finance Committee clearly states its belief as to the underlying reason for the change in the law as follows

"The committee believes that, in order for tax preferences to function as intended, their benefit must be directed primarily to taxpayers with a substantial and bona fide involvement in the activities to which the preferences relate. The committee also believes that it is appropriate to encourage nonparticipating investors to invest in particular activities, by permitting the use of preferences to reduce the rate of tax on income from those activities; however, such investors should not be permitted to use tax benefits to shelter unrelated income. "There are several reasons why it is appropriate to examine the materiality of a taxpayer's participation in an activity in determining the extent to which such taxpayer should be permitted to use tax benefits from the activity. A taxpayer who materially participates in an activity is more likely than a passive investor to approach the activity with a significant nontax economic profit motive, and to form a sound judgment as to whether the activity has genuine economic significance and value." (S. Rep. No. 313 (Part 2), 99th Cong., 2d 716.)

In essence, the Senate Finance Committee is saying that in order for a reduction in rates to be possible, the use of TAX SHELTER losses must be significantly limited. It is clear that for purposes of restricting tax shelter activities, Congress has chosen to divide each taxpayer's business activities between those the income or losses from which can be included in the determination of taxable income in the traditional sense and those for which the tax treatment of income and losses must be restricted. Congress selected the degree to which the taxpayer participates in the business activity as the dividing line. If the taxpayer materially participates in the activity, Section 469 is inapplicable. If the taxpayer does not materially participate in the activity, the deduction of any loss from such activity is restricted under Section 469. Thus, material participation or lack thereof is the salient factor in determining whether Section 469 is applicable.

Obviously, defining material participation is both a difficult and extremely important function. The pertinent language of Section 469(1) states "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 . . ., material participation, . . . for purposes of this section,. . . ."

The objective approach taken in the Regulations for determining material participation is unfortunately the most understandable and administrable means of approaching a very difficult problem. However, the "more than 500 hours" test in section 1.469-5T(a)(1) is unrealistically high when considering the several types of activities in which an individual can materially participate without spending more than 10 hours per week. For example, an individual who chooses to own and operate a retail clothing store while holding down a full time job until his/her retail clothing operation can support his/her family might be able to do so spending five or six hours per week if he/she employs conscientious and trustworthy employees. This would also be true in situations involving fast food franchises, gasoline service stations, automatic car washes, and various other endeavors. We believe that a 250 to 300 hours per year test would be more realistic. The concept that material participation requires involvement in operations on a regular, continuous, and substantial basis should not be offended by an individual spending five to six hours each week of the year once he/she has the business up and going. The Committee Reports recognize that ". . . the fact that an activity is not an individual's principal business is not conclusive in determining material participation. An individual may materially participate in no business activities (e.g., someone who does not work or is retired) or in more than one business activity (e.g., a farmer who lives and works on his/her farm and "moonlights" by operating a gas station)." (S. Rep. No. 313 (Part 2), 99th Cong., 2d Sess. 733.) Additionally, an individual may form a partnership with one or more other individuals to own and operate a business of the type described above with each individual contributing five to six hours per week. This prospect would have nothing to do with sheltering motives and should constitute material participation. It is respectfully suggested that the "more than 500 hours" test be changed to a "more than 300 hours" test. This change would enable taxpayers who desire to start their own businesses to do so while continuing full time or heavy part time employment elsewhere.

The test set forth under Regulation section 1.469-5T(a)(2) which treats an individual's participation in an activity for the taxable year as material participation if such participation constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interest in the activity) for such year is an appropriate standard because that test takes into account those business activities that do not require significant amounts of time. The tests set forth in Regulations section 1.469-5T(a)(3), (4), (5), and (6) are appropriate standards in that they recognize material participation by taxpayers in situations where abuses are not a likely factor.

The facts and circumstances test set forth in section 1.469- 5T(a)(7) is an excellent concept that will permit material participation to be recognized in those unique situations in which an individual makes significant contributions to an activity without meeting the objective standards contained in the other six tests. The facts and circumstances test will be difficult to administer as are all subjective determinations. However, it would be inappropriate to ignore the contributions of an individual who possesses unique talent, knowledge and experience the application of which can mean the difference between success and failure of a business activity.

The restriction prohibiting the consideration of management activities for purposes of determining material participation under the facts and circumstances test of section 1.469-5T(a)(7) is inappropriate in that it expresses a bias against management services that is unwarranted. Sound management is always one of the most important factors in causing a business activity to function efficiently and economically. In most businesses and professions, the most skilled workers ultimately rise to the level of management. This is usually because they possess unique management skills and have exhibited the ability to perform most of the tasks performed by those individuals that work under their supervision.

In summary, the objective or quantitative test set forth in Regulation section 1.469-5T(a)(1) through (6) are appropriate tests for determination of material participation if modified as recommended above and the subjective standard set forth in Regulation section 1.469-5T(a)(7) is certainly appropriate in those situations involving individuals capable of making unique contributions including management services.

II. RULES FOR SIGNIFICANT PARTICIPATION PASSIVE ACTIVITIES --

We respectfully recommend that this entire concept be stricken from the regulations. It has no foundation in either the statute or the Committee Reports. Section 469(a) disallows PASSIVE ACTIVITY LOSSES. Section 469(c) defines the term "passive activity" to mean any activity which involves the conduct of a trade or business and in which the taxpayer does not MATERIALLY participate. The language in Section 469 pertains exclusively to material participation. There is no mention of the term significant participation in the statute. The special rule for significant participation (Regulations section 1.469-2T(f)(2)(i)) has not only gone beyond the scope of Section 469 but misinterpreted its meaning as well. Generally, the special rule for significant participation provides that a taxpayer must aggregate all of his/her significant participation passive activities for the taxable year to determine whether there is net income from such activities. If such aggregation results in net income, an amount of the taxpayer's gross income from each significant participation passive activity for the taxable year equal to a ratable portion of the taxpayer's net passive income from each activity is treated as not from a passive activity thus eliminating the possibility of offsetting such net passive activity income with losses from other passive activities which are not significant participation passive activities.

In essence, the special rule for significant participation creates a third category of activities that is neither a material participation activity nor a passive activity. The regulation carves out a special category of passive activities and affords them a treatment similar to that accorded publicly traded partnerships as set forth in the amendments to Section 469 in the Revenue Act of 1987. The term "significant participation passive activity" is defined in Regulations section 1.469-2T(f)(2)(ii) to mean "any trade or business activity (within the meaning of section 1.469-1(T)(e)(2)) in which the taxpayer significantly participates (within the meaning of section 1.469-5T(c)(2)) for the taxable year but in which the taxpayer does not materially participate (within the meaning of section 1.469-5T) for such year." Briefly stated, a significant participation passive activity is an activity in which the individual participates more than 100 hours during the taxable year but does not materially participate. It is impossible to reconcile the special rule for significant participation with either the statute or the spirit of the statute as set forth in the explanations provided in the Committee Reports. The Committee Reports provide that if a taxpayer materially participates in an activity, Section 469 should not apply. If the taxpayer does not materially participate, Section 469 should apply. The Committee Report states "the bill provides that deductions from passive trade or business activities, to the extent they exceed income from all such passive activities (exclusive of portfolio income), generally may not be deducted against other income." (S. Rep. No. 313 (Part 2), 99th Cong., 2d Sess. 718.) The word "all" in the above sentence is very important. The Committee did not say "the bill provides that deductions from passive trade or business activities, to the extent they exceed income from all such passive activities OTHER THAN NET INCOME FROM SIGNIFICANT PARTICIPATION ACTIVITIES (exclusive of portfolio income), generally may not be deducted against other income." The clear intent of the statute is to group ALL passive activities for special treatment unless statutorily excepted from such treatment such as the exception for a working interest in an oil or gas property.

The preamble to the regulations generally states that special treatment should be accorded situations involving activities wherein the taxpayer's participation does not constitute material participation but is significant in generating the income from the activities. The special treatment provided in the regulations is to deem NET income from such activities to be nonpassive. However, net losses from significant participation activities will be treated as nonpassive only if the taxpayer's participation in all activities exceed 500 hours for the taxable year. (Section 1.469-5T(a)(4)) Although the collective 500 hour criteria is applicable to a group of significant participation activities that result in net income, its application is meaningless because net income from significant participation activities is treated as nonpassive under Section 1.469-2T(f)(2)(i) regardless of whether the "more than" 500 hours standard of Section 1.469-5T(a)(4) is met. This disparity can effectively treat taxpayers with the same level of participation in their significant participation activities differently depending upon whether they result in net income or net losses. The significant participation rule has nothing whatsoever to do with sheltering activities. There is absolutely nothing to indicate that Congress intended for such a rule to exist in the law.

In addition to the question of validity of the regulations, the significant participation rule might also inhibit taxpayers from making contributions of time to activities that could mean the difference between success and failure to a business venture. In many instances, investors are knowledgeable and/or experienced in the businesses in which they invest, notwithstanding that some other individual may have primary responsibility for business operations. The significant participation rule could cause a capable investor to be concerned as to whether he should engage in conferences or meet with the primary operator to assist when unusual problems arise in the business endeavor. The tax law should not include provisions that can inhibit economic growth. It is recommended that the significant participation passive activity rule contained in Regulations section 1.469-2T(f)(2)(i) be removed from the regulations. An alternative, though far less desirable solution would be to include in the significant participation passive activities rule the aggregate 500 hour concept contained in Regulations section 1.469-5T(a)(4). This would at least treat net income and net losses from significant participation activities consistently.

In summary, the special rule for significant participation passive activities as presently stated is an unwarranted expansion of the statute and is thus inappropriate to carry out the provisions of Section 469.

III. DISPOSITION OF SUBSTANTIALLY APPRECIATED PROPERTY FORMERLY USED IN A NONPASSIVE ACTIVITY

It is certainly appropriate that the regulations should prevent taxpayers from transferring substantially appreciated property to a passive activity with a view to disposing of such property to create passive income. It is also understandable that an arbitrary criteria such as the 120% standard used in Regulations section 1.469- 2T(c)(2)(iii)(D) is desirable for feasible administration of the tax law.

Regulations section 1.469-2T(c)(2)(iii)(D) deems property to be substantially appreciated if the fair market value of such property exceeds 120% of the adjusted basis of such property. However, when this definition is used in Regulations section 1.469- 2T(c)(2)(iii)(A), the result is inappropriate.

The operative section of the regulations (section 1.469- 2T(c)(2)(iii)(A)), causes ANY gains from the disposition of "substantially appreciated property" to be treated as not from a passive activity unless the prescribed holding period is satisfied. This regulation ignores the important fact of WHEN the property appreciated. A more accurate measure of what portion of a taxpayer's gain upon disposition of property is associated with a particular activity would take into account the time period during which the property actually appreciated. The passive activity should be credited with that portion of the gain properly allocable to the period during which the property was used in the passive activity. Obviously, gain "built in" at the time property is contributed to a passive activity should not be treated as passive activity income where the disposition occurs prior to the expiration of the prescribed holding period and the contribution was made to create passive income, but gain that is attributable to the period during which the property is used in the passive activity, regardless of the length of time, should be allocated to the passive activity.

It is understood that this approach may cause difficulties in administration since it will be necessary to determine the fair market value of the property at the time the property is contributed to the activity. Nevertheless, a proper measure of the allocation of gain is essential to an appropriate determination of income from a passive activity. Consequently we believe the Regulations should be modified accordingly.

In summary, the above comments are offered to assist Treasury in formulating regulations that will best explain and administer the new passive activity concept provided in Section 469 in a manner that will take into account the problems facing taxpayers who conduct businesses without a view to participating in investments that are dominated by tax shelter motives.

Thomas J. Gotliboski