Tax Court Leaning Harder On The Little Guys In Hobby Loss Cases

Two Tax Court decisions last month emphasize the wisdom of keeping separate accounts for your losing side gig.  Donald Swanson  had a charter fishing business. Susan & James Mercier played slots. In neither case were they able to establish that their activities were businesslike enough to avoid the curse of Section 183, commonly referred to as the hobby loss rule.  Separate accounts probably would not have won the case for either of them, but it got a good bit of emphasis.  I have a real concern about the Swanson case as it seems to be confirming an odd interpretation of one of the other regulatory factors that is disadvantageous to the little people.  We’ll talk about the slots first.

Jackpot

According to the opinion of special trial judge Eunkyong Choi, the Merciers had studied video poker enough to consider themselves professional gamblers.  Ms. Mericer is an accountant and she prepared the couple’s 2019 return.  Initially she included gambling winnings from Form W-2G.  Gambling losses taken as itemized deductions did not offset the winnings because of the standard deduction.  Judge Choi remarks:

“Petitioners believe the law regarding the deduction of gambling losses is unfair. They do not believe they should be required to pay taxes on their gambling winnings when they had a net loss for the year.”

I would refer them to Reilly’s First Law of Tax Planning – It is what it is.  Deal with it. The way of dealing with it was to argue for professional gambler status which would put both winnings and losses on Schedule C.  In turning them down, Judge Choi took special note of the lack of record keeping.

“Petitioners did not personally keep track of their gambling activity in 2019 choosing, instead, to rely on third-party information from casinos, even though they further acknowledge that the casinos record may be incomplete, as only jackpot winnings, not smaller winnings, are reported. Petitioners also did not keep a separate bank account to manage gambling winnings and expenses, but used their personal account, which is further evidence of the casual nature of their gambling.”

I did not find this opinion all that noteworthy but preceding the Swanson case, the emphasis on record keeping and separate accounts is important.

The Charter Boat

Donald Swanson was facing deficiencies totaling nearly $60,000 for the years 2014, 2015 and 2016. The main issue was whether Mr. Swanson’s Happy Jack Charters was a trade or business that generated deductible losses.  The main Happy Jack asset was a 22-foot Boulton Sea skiff which had been designed to fish for halibut.  The issue is whether Swanson was taking people out on the fishing boat to make a profit or just for the halibut,

Judge Cary Douglas Pugh marched through the nine factors listed in the regulations after genuflecting to the notion that “Neither a single factor, nor the existence of even a majority of the factors is controlling; rather all the facts and circumstances should be evaluated.” In the hundreds of 183 opinions that I have reviewed I have not found one where the factor score did not support the outcome and only one where the taxpayer lost on the first factor and won the decision. Maybe it will happen one of these days.  Regardless the nine factors are:

” (1) the manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or the taxpayer’s advisers; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar activities; (6) the taxpayer’s history of income or loss with respect to the activity; (7) the amount of occasional profits, if any, which are earned; (8) the financial status of the taxpayer; and (9) whether elements of personal pleasure or recreation are involved.”

The Records Issue

The final score was 8-0-1 in favor of the IRS.  Judge Pugh called the fourth factor – expectation that assets might appreciate – neutral. The first factor, manner in which the activity is carried on, which despite protestations to the contrary tends to be determinative, did not go well at all.  The records seemed to be pretty much just receipts to document deductible items.  There is a note that record keeping is also a matter of using records to improve profitability.

An interesting observation was that he did not have a separate account for Happy Jack but instead “used Square” to track his income from the fishing charter activity.  I think the reference is to  this point of sale service.  In analyzing the first factor-businesslike behavior-, the first sub factor is “complete and accurate books and records”. A practical way to help achieve complete and accurate books and records is a separate account or accounts for the business activity.  With good software, in principle, it might not be necessary, but failure to have separate accounts is a stumbling block.  I have noted only one case in which the taxpayer won without having a separate account for the business.

Substantial Income

Judge Pugh really piled on the owner of Happy Jack giving the IRS 8 of the nine factors, so we don’t need to go into all of them.  Her holding on the eighth factor deserves some commentary.  Here it is in full:

“Substantial income from sources other than the activity may indicate that the activity is not engaged in for profit.

Mr. Swanson did not rely on income from Happy Jack Charters as his main source of income, although he hoped that one day he would. Mr. Swanson received income from a retirement pension, Social Security retirement, and rental properties. He used his purported losses from the fishing charter activity to reduce his income from other sources. Because Mr. Swanson did not receive substantial income from his fishing charter activity, he was spending his income from other sources to fund it. This factor also weighs against Mr. Swanson.”

I always think of the eighth factor as kind of a gimme to the IRS.  If there is not some income being sheltered by the activity, there is not going to be a deficiency.  We don’t have the numbers from the opinion, but I doubt that a bus driver’s pension is what we would think of as a really big number. Compare that to the decision in the case of William Huff whose miniature donkey breeding operation on his New Jersey farm was found to be for profit.

‘During the years at issue, the Huffs plainly had substantial income from other sources. The losses from the miniature donkey operation during the years at issue (again, $87,236 in 2013 and $47,039 in 2014) were dwarfed by the Huffs’ adjusted gross income of $21,469,246 and $29,814,468 in 2013 and 2014, respectively. This case consequently does not present the situation where a taxpayer is engaged in generating paper losses for the purpose of sheltering unrelated income or enlisting the Government as an unwilling partner in a hobby.”

It seems the Tax Court is turning Factor Eight on its head in this decision. Also if Judge Pugh believes “Mr. Swanson did not rely on income from Happy Jack Charters as his main source of income, although he hoped that one day he would.”  then he should have won, since that constitutes an honest objective.

The Moral

There are two morals to this story.  One is to make a point of having a separate account for the business and do your best to run all the business through it.  This will mean the inconvenience of feeding that account, but it is really worth and makes life much easier.  The other is that if you are really well off you can probably win a hobby loss attack if you do the work to operate in a businesslike manner.

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Bryan Camp discusses the Swanson case among others in Lessons From The Tax Court: Freedom, Taxes, And Hobbies on TaxProf Blog.