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FRY, ERNEST DEAN & LOIS (1985)(F)(ST)

Topic Code: E126Equipment Lease, H006Health Promotion of Livestock (ST), P071Penalty/Interest, S341Specific Mobile Equipment (ST), U091Use Tax on Vehicles (ST)          Document Reference:

RE: ERNEST AND LOIS FRY Docket No. 93-20-1-0225 Letter of Findings

Harvey Horn, CPA

P.O. Box 38

Montezuma, Iowa 50171

Dear Mr. Horn:

The Iowa Department of Revenue and Finance has considered the above- captioned Protest and issues the following Departmental Letter of Findings as authorized by Chapter 7 of the Department's Rules of Practice and Procedure. This Letter of Findings constitutes the Department's legal and factual determination of the issues raised in your Protest at the informal stage of the appeals process. If you are dissatisfied with the Letter of Findings, you have the right to a contested case evidentiary hearing as provided by Chapter 17A, Code of Iowa and Chapter 7 of the Department's Rules of Practice and Procedure. Based upon its review of the applicable law and the facts and evidence presented, the Department denies your Protest for the following reasons.

According to your protest, the taxpayer-husband worked as a manager in the fertilizer business and leased equipment to ConAgra in the 1990 tax year. In 1990, the rental equipment was sold, generating ordinary income and long- term capital gain income. The maximum Iowa capital gain deduction of $7,875 was calculated and claimed on the 1990 Iowa income tax return. The Department disallowed the capital gain deduction because capital gain from the sale of assets of a rental activity generally does not qualify for the Iowa capital gain deduction. The assessment was issued May 25, 1 993.

Iowa Code Section 422.7(21)(1993) provides in part:

"21. Subtract forty-five percent of the net capital gain from the following:

a. Net capital gain from the sale of real property used in a business, in which the taxpayer materially participated for ten years, as defined in section 469(h) of the Internal Revenue Code, and which has been held for a minimum of ten years, or from the sale of a business, as defined in section 422.42, in which the taxpayer was employed or in which the taxpayer materially participated for ten years, as defined in section 469(h) of the Internal Revenue Code, and which has been held for a minimum of ten years. The sale of a business means the sale of all or substantially all of the tangible personal property or service of the business."

Iowa Administrative Code 701-40.38(1) provides in part:

"Net capital gains from sales or exchanges of real property, tangible personal property, or other assets of a business owned by the taxpayer and in which the taxpayer has materially participated for a minimum of ten years. Net capital gains from the sales or exchanges of real property, tangible personal property or other assets from a business the taxpayer has owned for ten years and in which the taxpayer materially participated as defined in Section 469(h) of the Internal Revenue Code for ten years qualify for the capital gain deduction on limited amounts of capital gains provided in rule 40.38(422)."

a. Business, A business includes any activity engaged in by a person with the object of gain, benefit, or advantage, either direct or direct. In addition, a business for purposes of the capital gains deduction in rule 40.38(422) must have been owned by the taxpayer for at least ten years and the taxpayer must have materially participated in the business for at least ten years.

c. Material participation in a business if the taxpayer has been involved in the operation of the business on a regular, continuous, and substantial basis for ten or more years at the time assets of the business are sold or exchanged. If the taxpayer has involvement in a business which meets the criteria for material participation in an activity under Section 469(h) of the Internal Revenue Code and the Treasury rules for material participation in 1.469-5 and 1.469-5 T, for ten years or more immediately before the sale or exchange of the assets of a business, the taxpayer shall be considered to have satisfied the material participation requirement for this subrule....

7. Rental activities or businesses. For purposes of this subrule 40.38(1), the general rule is that a taxpayer who actively participates in a rental activity or business which would be considered to have been material participation in another business or activity would not be deemed to have had material participation in the rental activity..." (Emphasis added.)

According to the 1990 Iowa income tax return, the capital gain and ordinary income arose from the sale of the leased property. None of the property sold was placed into service before 1983. 1983 was the year that the taxpayer went from being a manager for Amoco Fertilizer Company to be a manager of Schoular Fertilizer Company and a lessor of equipment and facilities to Schoular Fertilizer Company. The Taxpayer entered into a owner- operator plan with the Cropmate Company, which had acquired the Schoular Fertilizer Company, in 1985.

The protest states that the taxpayer was required to purchase the equipment in order to be employed by Schoular and Cropmate and also lease the equipment to Schoular and Cropmate. The Cropmate Company's Owner Operator plan reads that the owner is "normally offered employment with Cropmate." This would indicate that the taxpayer would have the option of accepting employment if he leases equipment to Cropmate, but it does not mandate the linkage of employment and equipment rental. The taxpayer could possibly rent the equipment without being an employee. Therefore, the rental of the equipment is an activity separate from being employed as a manager.

In order to qualify for the Iowa capital gain deduction for the 1990 tax year, the taxpayer must materially participate in the business. Section 469(c)(2) of the Internal Revenue Code provides that the term "passive activity" includes any rental activity. Temporary Regulation 1.469-4 T(b)(2)(ii)(B) provides that an individual cannot materially participate in the activities of a C Corporation, and therefore rentals to a C Corporation are activities in which an individual cannot materially participate. Therefore, based upon the information available, the taxpayer could not materially participate in the rental activity since the rentals were made to two C Corporations, Schoular and Cropmate.

A further requirement to qualify for the Iowa capital gain deduction is that the taxpayer had materially participated in the business for ten years. The rental of equipment and property began in 1983. The property involved was sold in 1990. Even if the taxpayer had materially participated in the business of the rental equipment, the business did not last for ten years.

Therefore, based upon the information available, the Department assessment disallowing the Iowa capital gain deduction on the 1990 Iowa income tax return was proper because (1) the rental of equipment to a corporation is a separate and distinct activity from that of being an employee of the corporation (2) the taxpayer cannot materially participate in the activities of the C Corporation to whom the equipment is rented (3) even if the taxpayer did materially participate, the rental activity did not meet the minimum statutory term of ten years as outlined in Iowa Code Section 422.7(a)(1993).

Please advise me of your position in light of the enclosed Findings within thirty days of the date of this letter. If you agree, or choose not to pursue the Protest, please inform me in writing. That letter and receipt of the amount due which is $1,081.44 with interest calculated through January 31, 1995 directed to my attention, will serve as authority for the administrative law judge to close the Protest. Please note that interest accrues at $6.29 per month.

If the Protestor is in disagreement with the Findings and chooses to pursue the Protest, the Department will file an Answer to the Protest pursuant to rule 701 IAC 7.12 (17A), thereby initiating contested case proceedings. The administrative law judge will then notify all parties of a time and place for an evidentiary hearing to be held on this matter. If no response is received within thirty (30) days of the date of this letter, the Department will construe this inaction as failure to pursue the Protest and will request dismissal of the Protest pursuant to department rule 701 IAC 7.11(2).

If you have any questions with regard to this matter, do not hesitate to contact Kent Taylor at (515) 281-8033. Please direct your written response to the following address: Kent Taylor, Iowa Department of Revenue and Finance, Appeals Section, P.O. Box 10457, Hoover State Office Building, Des Moines, Iowa 50306.

Sincerely, David L. Casey Manager, Audit Services Compliance Division 515/281-6163