Using the Material Participation Rules to Establish Corporate Substance

As I have previously noted, the concept of corporate "substance" is a poorly developed area of law.  In this post, I wanted to expand the concept for the practitioner with the intent of borrowing from other legal areas in the hopes of providing further guidance.  I want to note upfront that the analysis I am about to offer has to my knowledge not been proposed or offered in any case law or law review article (if a reader knows of this, please post it in the comments); it's merely presented as a way to broaden the concept and provide high level guidance.

Establishing corporate substance is incredibly difficult for the small to medium size business owner for two reasons: (1) they typically work long hours building their business but (2) they have insufficient staff to document their actions in order to establish the requisite paper trail proving corporate substance.  Compare this to a larger company which either has in-house legal or an ongoing relationship with an outside firm that continually monitors and documents the company's legal developments in real time.  The former situation could leave a company vulnerable to a veil piercing claim in the event of lawsuit with the lack of a contemporaneously created record adding fuel to the fire.  But an alternative approach does exist which borrows from tax law, using the concept of material participation.

The material participation rules were added to the tax code in reaction to the tax shelter industry of the 1970s and 1980s, where promoters put together limited partnerships that primarily invested in assets with high interest deductions or depreciation expenses.  A deeper examination of these deals usually revealed a remarkable lack of business substance, and included things such as phantom loans, circular cash flows and massively overstated basis.  These deals were sold to high net worth individuals who were looking for ways to obtain losses to offset income; they wouldn't "materially participate" in these deals, instead acting as the classic "silent partner" exemplified by their legal status as a limited partner. 

As a result, Congress passed section 469 of the tax code, which divided income into passive and active income.  "Usually, passive activity losses can be offset only against passive activity income." William Hoffman, Corporations, Partnerships, Estates and Trusts, page 10-35 (c) 2008, West.  Hence, limited partners would now need to have passive gains against which to offset their passive losses, essentially shutting down this type of tax shelter.

But just as important as passive activity is active activity, which is established by a person "materially participating" in the enterprise.  Under section 469, "[a] taxpayer shall be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis which is—
 

(A) regular,
(B) continuous, and
(C) substantial. 

The regulations provide some guidance on the actual definition of these terms.  Here are three basic facts patterns from the accompanying Treasury Regulations that would apply to most individuals:

(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;

Arguing material participation is prima facia evidence of corporate substance has one powerful benefit: counsel is not advancing a new, untested concept, but instead relying on a well-established and now well-developed area of law to prove his point.  

The three fact patterns would apply to a broad swath of entrepreneurial activities.  Assuming a 40 hour work week (which grossly understates the hours worked by most business owners), fact pattern 1 would account for 3 1/2 months of work.  Fact pattern two would be appropriate for any individual who is self-employed and has filed entity status (and when combined with fact pattern 1 would be extremely powerful) while fact pattern 3 would apply to most lightly staffed companies.  

More importantly, all three fact patterns should establish a sufficient amount of corporate substance as they indicate a fair amount of activity -- at least enough to give a potential veil piercing claim pause.