Originally published on Forbes.com.
Taxpayers can and do win hobby loss cases and advisers can guide them in going into the game with a winning hand. That’s my conclusion from a pretty deep dive into Code Section 183-Activities not engaged in for profit. I have been writing about Section 183 cases since my earliest blogging days and it has been mostly about taxpayers losing often in a spectacularly amusing manner, but those losses are not what to watch. Look at the people who have won.
Background
To dramatically reduce your tax liability, the best thing to do is to dramatically reduce your reported gross income. This hardly obscure observation is at the hear of the last half century’s war against tax shelters. The collateral damage from that war is nasty complexity that people who are not really trying to get away with anything have to cope with. The effects of the tax shelter war are expressed in Reilly’s Third Law of Tax Planning –
Any clever idea that pops into your head probably has (or will have) a corresponding rule that makes it not work.
There are a series of hoops that must be jumped through in order to post a negative number in your gross income calculations. Recently added is excess business losses, which is a really high-class problem and before you have to worry about that you need to get past passive activity loss rules, at-risk, basis and allocation regulations.
Before you get to any of those hoops, there is a tough one. Implemented by the Tax Reform Act of 1969 – Code Section 183 – Activities not engaged in for profit. The section strikes at the heart of tax sheltering since if you are doing something for tax losses, you don’t get the tax losses.
Because You Can
The original focus of Section 183 and much of the activity in that area is not so much things that people do to reduce taxable income, but rather things that people do because they feel like doing them and can make some sort of plausible case that there is a business going on. That is why the rule is commonly referred to as the hobby loss rule. And hobby loss cases, as opposed to straight-up shelters, has been much of the focus of Section 183 litigation.
I have been studying hobby loss cases to try to discern how people can win them. This is the third and possible final post in my hobby loss series. Although, I will, of course, continue to cover new cases as they arise.
In my first post I suggested that advisers are too conservative in discouraging clients from taking losses from legitimate side gigs. In the second post, I discuss the IRS regulation that interprets Section 183 agreeing with Judge Posner of the Seventh Circuit that the regulation is “goofy”. The big reveal of my second post is my conclusion that only one of the nine factors will either make you or break you. And it is the one factor that is most under your control:
(1) Manner in which the taxpayer carries on the activity. The fact that the taxpayer carries on the activity in a businesslike manner and maintains complete and accurate books and records may indicate that the activity is engaged in for profit. Similarly, where an activity is carried on in a manner substantially similar to other activities of the same nature which are profitable, a profit motive may be indicated. A change of operating methods, adoption of new techniques or abandonment of unprofitable methods in a manner consistent with an intent to improve profitability may also indicate a profit motive.
Note that it is actually three factors – record keeping, following the example of people who make money and making changes based on feedback. Sometimes considered a fourth factor and other times considered a reflection of the second is having a business plan.
How To Set Up A Winning Hand
So here is your client situation. Robin is a plastic surgeon making $700,000 per year. Terry, Robin’s spouse is a racecar driver. I don’t know if that has something to do with how they met and I’m not going to ask. Robin has won some races and obtained some sponsorships, but losses continue. Anywhere from $30,000 to $70,000 per year.
I wouldn’t rule out just letting it go, but if Terry is up for it, it is reasonable to go for those losses. Fundamentally what is important is that Terry have an honest objective of making a profit. If you can’t get that from Terry with a straight face, you really should not be putting the losses on their returns.
On the record keeping definitely open a separate account for the racing activity. Have a separate credit card for the racing activity. This will require regular transfers of cash into that account. This is the 21st century so producing a general ledger and statements pretty well follows along from the separate account. Have substantiation for all the expenses. And try to see that the records being kept are being scrutinized to control expenses.
Make sure Terry is talking to people who know how to make money racing cars, which is not necessarily the same as being good at racing cars. At the beginning of each year have some sort of plan showing where revenue might be coming from. At the end of the year review what actually happened and then get Terry to consider what might be done differently in the next year.
Write all this stuff down.
To restate. There should be some sort of stated path to profitability. If the stated path turns into a blind alley, a new path should be selected. Document this contemporaneously.
Decisions to read where there is excellent execution on the first factor overcoming otherwise challenging facts are Finis Welch and Lee Storey. Welch is a horse farm case where staggering losses are allowed and Storey is about the making of a documentary about Up With People.
You will be ready for a hobby loss audit and have a good chance of winning. But what if Terry doesn’t listen? Can you win anyway?
Winning With The Hand You Are Dealt
So I have gone through 270 hobby loss decisions. The main takeaway, as I have noted, is that if you win on the first factor you win. If you lose on the first factor you lose. That is unless you are Robert Dickson. So if Terry has been thoroughly unbusinesslike remember Robert Dickson, a yacht chartering case from 1983. No separate account. Didn’t advertise enough. Factor 1 went to the IRS, but he won anyway.
When it comes to the business plan and consulting on how to get money, there are quite a few decisions you can use to argue your way out of a problem, but Susan Crile is one of the best. The case is one in which we see that a business plan can be displayed in action without writing it down.
Although petitioner did not have a written business plan, she had a business plan and she pursued it consistently. Petitioner understood the general factors that affect the pricing of art –a history of sales, gallery representation, solo exhibits, positive critical reviews, and prestigious awards, fellowships, and residences. She then worked to enhance her credentials and professional stature in each of these respects, in an effort to increase the value of her art.
Separate accounts are a really, really good idea, but if your client didn’t keep one, winning is still possible as we see in William Daugherty.
Although petitioner maintained a single checking account for the farm and his personal use, the farming activities were posted to a separate ledger maintained solely for the farm operation.
I have over sixty other winners in my spreadsheet – horses and cattle – airplanes and boats – film – even dogs. Pretty much everything you can think – except Amway – Don’t get me started.
Be Bold But Be Prepared
If you or your client has an honest objective of making a profit, then claiming the losses is the right thing to do. The magnitude of losses or their continuation for a long period do not disqualify you. Just be ready.