## Facts

- Stephen P. Hardy, a pediatric reconstructive plastic surgeon, practiced through a wholly owned professional LLC; his wife served as its chief operating officer.
- Hardy held a minority membership interest in Missoula Bone & Joint Surgery Center, LLC (MBJ), an LLC taxed as a partnership that earned facility-fee income by providing surgery-center facilities.
- Hardy performed surgeries at various facilities, including MBJ, but MBJ did not compensate him for medical services; his MBJ receipts were solely distributive shares of MBJ facility-fee income.
- Hardy had no day-to-day management responsibilities or operational decision-making authority at MBJ.
- For years before 2008, the taxpayers reported MBJ income as nonpassive; beginning in 2008, they reported MBJ income as passive and used it to absorb unrelated passive losses, while also claiming a passive activity loss (PAL) carryover.
- The IRS issued a deficiency notice for 2008–2010, treating MBJ income as nonpassive under I.R.C. § 469, asserting accuracy-related penalties under § 6662(a), and treating MBJ income as subject to self-employment tax (SECA).
- At trial, the taxpayers amended their pleadings to claim overpayments of self-employment tax for 2008–2009.

## Issues

1. Whether the taxpayers could treat Hardy’s distributive share of MBJ income as passive under I.R.C. § 469 for 2008–2010.
2. Whether the Commissioner could group Hardy’s medical practice activity with his MBJ ownership activity as a single activity under Treas. Reg. § 1.469-4, thereby making MBJ income nonpassive.
3. Whether the taxpayers could deduct a claimed PAL carryover in 2008 related to MBJ.
4. Whether Hardy’s distributive share of MBJ income was net earnings from self-employment or excluded under § 1402(a)(13) as limited-partner income.
5. Whether the taxpayers were liable for § 6662(a) accuracy-related penalties (negligence or substantial understatement).

## Decision

- The court held the taxpayers could treat Hardy’s MBJ income as passive for 2008–2010.
- The court held the Commissioner could not regroup Hardy’s medical practice and MBJ ownership activities into a single activity under § 469.
- The court disallowed the claimed 2008 PAL carryover deduction because the loss should have been deducted in the year incurred.
- The court held MBJ distributions were not subject to SECA for 2008–2009 because Hardy received them as a limited partner acting as an investor.
- The court held the Commissioner failed to satisfy the burden of production for negligence penalties; substantial-understatement penalty exposure depended on computations, but the taxpayers established reasonable cause and good faith reliance on a tax professional for the PAL carryover and related positions.
- The court ordered Rule 155 computations to determine deficiencies and any overpayments.

## Legal Principles

- Under § 469 and Treas. Reg. § 1.469-4, taxpayers may group activities into an appropriate economic unit; the Commissioner may regroup only in limited circumstances, including when a grouping is not an appropriate economic unit or is principally intended to circumvent § 469.
- Where more than one reasonable method of grouping exists and the taxpayer’s grouping is not principally aimed at avoiding § 469, the Commissioner may not force regrouping to convert passive income into nonpassive income.
- Distributive share income from a partnership (including an LLC taxed as a partnership) may be passive when the taxpayer does not materially participate in the entity’s operations and the income is economically distinct from the taxpayer’s service income.
- Under § 1402(a)(13), a limited partner’s distributive share (other than guaranteed payments for services) is excluded from net earnings from self-employment; an LLC member may be treated as a limited partner for this purpose when acting as a non-managing investor receiving returns on capital.
- For § 6662(a) penalties, the Commissioner bears the initial burden of production under § 7491(c); penalties may be avoided if the taxpayer shows reasonable cause and good faith, including reasonable reliance on a competent tax professional.

## Conclusion

The Tax Court sustained passive treatment of a physician’s surgery-center LLC income and barred IRS regrouping under § 469, disallowed a mis-timed PAL carryover, held the LLC income exempt from SECA under the limited-partner exclusion, and declined to sustain accuracy-related penalties based on the Commissioner’s proof and the taxpayers’ reasonable-cause defense.


Hardy v. Comm’r, T.C. Memo. 2017-16 (2017)