Gregg v. U.S., No. CIV 99-845-AA.
| Decision Date | 29 November 2000 |
| Docket Number | No. CIV 99-845-AA. |
| Citation | 186 F.Supp.2d 1123 |
| Parties | Stephen A. GREGG and Kristina K. Gregg, Plaintiffs, v. UNITED STATES of America, Defendant. |
| Court | U.S. District Court — District of Oregon |
Marc K. Sellers, Schwabe, Williamson & Wyatt, P.C., Portland, OR, for plaintiffs.
Kristine Olson, United States Attorney, District of Oregon, Portland, OR, Jian H. Grant, Trial Attorney, Tax Division, U.S. Department of Justice, Washington, D.C., for defendant.
Plaintiffs, Stephen A. Gregg and Kristina K. Gregg, bring this action for refund of income taxes and penalties plus interest under the Internal Revenue Code, 26 U.S.C. § 1 et seq. Pursuant to Fed. R.Civ.P. 56, defendant filed a motion for summary judgement seeking to dismiss plaintiffs' complaint. Plaintiffs filed a cross-motion for summary judgment. For the reasons set forth below, the defendant's motion is denied, the plaintiffs' cross-motion is allowed, and this case is dismissed.
Plaintiff Stephen A. Gregg ("plaintiff") was a member of Cadaja, L.L.C. ("Cadaja") in tax year 1994. Cadaja is a limited liability company formed pursuant to the limited liability company statutes of the State of Oregon on November 4, 1994. The tax year for Cadaja in 1994 commenced on November 4, 1994, and ended on December 31, 1994. For tax year 1994, Cadaja filed a U.S. Partnership Return (Form 1065) with the Internal Revenue Service ("IRS"); and plaintiffs filed a joint federal income tax return.
Prior to forming Cadaja, plaintiff was the CEO for Ethix Corporation. He worked five days a week, at least eight hours per day for the corporation, until he sold his stocks in Ethix Corporation on November 4, 1994. Prior to the stock sale, plaintiff had held sixty percent ownership interest in the corporation since 1990. According to plaintiff, Ethix Corporation was a managed health care company formed to establish networks of physicians. Insurance companies then used the networks to gain access to professionals and obtain their services. Specifically, Ethix Corporation was a service company that provided consulting, marketing, networking, and business services to the health care industry. Plaintiff alleges that capital is not a material income-producing factor in its business operations. Affidavit of Plaintiff in Support of Plaintiffs' Motion for Summary Judgement ¶ 3.
In November 1994, plaintiff created Cadaja with an intent to transfer the business techniques he had developed in traditional medicine into fields of alternative medicine. Plaintiff solicited the participation of other members: Candace Cappelli and Judith Fleming. Both Cappelli and Fleming were employees of Ethix Corporation before they joined Cadaja on November 4, 1994. Plaintiff was the sole financier of Cadaja; the other two members contributed no cash or property to Cadaja, however, according to plaintiff, their investment was "know-how." Both Cappelli and Fleming worked at least 40 hours per week for Cadaja in 1994 with an annual salary of $75,000. In 1994, plaintiff worked approximately 100 hours for Cadaja, but did not receive compensation for services he provided, because plaintiff thought it illogical for him, as the sole financier of Cadaja, to take money out of the business on one hand and return it to the business on the other hand.
Although Cadaja was formed in 1994, it had no offices until 1995. Each of the individuals employed by Cadaja worked from their homes and from the offices of Ethix Corporation until early 1995. In addition, Cadaja did not have an Operating Agreement until May 1995, after it changed its name to "Alternaré Group, LLC" in February 1995. The effective date of the Operating Agreement relates back to November 4, 1994.
According to plaintiff, Cadaja was formed to create a network of credentialed alternative medicine practitioners and develop management capability for alternative medicine clinics. Like Ethix Corporation, Cadaja is a service company, providing consulting, marketing, networking, and business services in the alternative medicine and alternative health care industry. Plaintiff alleges that capital is not a material income-producing factor in Cadaja's business operations. Affidavit of Plaintiff in Support of Plaintiffs' Motion for Summary Judgement ¶ 14.
The IRS audited the plaintiffs' 1994 joint income tax return. It disallowed plaintiffs' characterization of a flow-through loss from Cadaja in the amount of $230,723 as an ordinary loss, and re-characterized that loss as a passive activity loss. On March 3, 1998, the IRS issued a Notice of Deficiency to plaintiffs, setting forth a deficiency amount of $91,366 and an accuracy-related penalty of $18,273.20 pursuant to 26 U.S.C. § 6662(a). On July 27, 1998, the IRS made assessments of the audit deficiency, accuracy-related penalty under § 6662(a), and interest on deficiency against plaintiffs for tax year 1994, in the amounts of $91,366, $18,273.20, and $36,281.76, respectively.
On August 13, 1998, plaintiffs paid the deficiency assessment of $91,366. On January 11, 1999, in response to plaintiffs' claim for refund of $91,366, the IRS issued a Claim Disallowance. On August 26, 1999, plaintiffs paid $26,530 toward the accuracy-related penalty assessment. On November 10, 1999, in response to plaintiffs' claim for a refund of $26,530, the IRS issued a Claim Disallowance.
Summary judgment is appropriate "if the pleadings, depositions, answers to interrogatories, and admissions on file, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that the moving party is entitled to a judgement as a matter of law." Fed.R.Civ.P. 56(c). The materiality of a fact is determined by the substantive law on the issue. T.W. Elec. Serv., Inc. v. Pacific Elec. Contractors Assoc., 809 F.2d 626, 630, (9th Cir.1987).
The moving party has the burden of establishing the absence of a genuine issue of material fact. Celotex Corp. v. Catrett, 477 U.S. 317, 323, 106 S.Ct. 2548, 91 L.Ed.2d 265 (1986). If the moving party shows the absence of a genuine issue of material fact, the nonmoving party must go beyond the pleadings and identify facts that show a genuine issue for trial. Id. at 324, 106 S.Ct. 2548.
Special rules of construction apply to evaluating summary judgment motions: (1) all reasonable doubts as to the existence of genuine issues of material fact should be resolved against the moving party; and (2) all interferences to be drawn from the underlying facts must be viewed in the light most favorable to the nonmoving party. T.W. Elec. Serv., 809 F.2d at 630.
Limited liability companies ("LLCs") are hybrid entities that are, under state law, neither partnerships nor corporations. For federal income tax purposes, an LLC can be treated as either a partnership or a corporation. To avoid double tax for corporations, most LLCs are carefully structured to be treated as partnerships for federal income tax purposes and file annual information tax returns for partnerships using Form 1065. In this case, Cadaja filed a Form 1065 for tax year 1994, and was, therefore, treated as a partnership and subject to a single tax on its earnings, as well as deduction on losses, at the member or partner level rather than on the entity level.
The issue in this case is whether plaintiff's ratable share of the flow-through operating loss from Cadaja should be characterized as ordinary loss or passive activity loss in plaintiffs' joint tax return for tax year 1994.
Ordinary losses can be applied against any income; however, passive activity losses can be applied only against passive activity income. Passive activity losses that are not currently deductible are carried forward to the next taxable year. See 26 U.S.C. § 469(b). Defendant characterized plaintiff's flow-through loss from Cadaja as a passive activity loss, thus limiting any deductions to applicable passive gains. I disagree.
Passive activity loss rules pursuant to 26 U.S.C. § 469 apply to individuals. See 26 U.S.C. § 469(a). "Passive activity" means any trade or business in which the taxpayer does not "materially participate." 26 U.S.C. § 469(c)(emphasis added). "A taxpayer shall be treated as materially participating in an activity only if the [taxpayer's involvement] in the operation of the activity [is] regular, continuous, and substantial." 26 U.S.C. § 469(h)(1).
The regulations promulgated for Section 469 further interpret the "material participation" standard by instructing that a taxpayer materially participates in an activity if the taxpayer meets one of the seven tests set forth in Temporary Treasure Regulation § 1.469-5T:
(1) The individual participates in the activity for more than 500 hours during such year;
(2) The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;
(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;
(4) The activity is a significant participation activity for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;
(5) The individual materially participated in the activity for any five taxable years during the ten taxable years that immediately precede the taxable year;
(6) The activity is a personal service activity, and the individual materially participated in the activity for any three taxable years preceding the taxable year; or
(7) Based on all of the...
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