Originally published on Forbes.com.
Having a judge refer to an IRS regulation as “goofy” is not a good thing. Fortunately, it has only happened once and not that long ago. In 2016 Judge Richard Posner in overturning a Tax Court decision in the case of Merrill Roberts wrote:
We mustn’t be too hard on the Tax Court. It felt itself imprisoned by a goofy regulation (26 C.F.R. § 1.183-2, Treas. Reg. § 1.183-2: Activity Not Engaged in for Profit Defined; (Emphasis added)
Merrill Roberts had a horse racing business, the classic hobby loss case. The Tax Court had ruled it a hobby for the first two years acknowledging that it later became a business. That is an unusual result, but this post, the second in my series on Section 183, commonly referred to as the hobby loss rule, is about the goofiness of the regulation that the IRS issued in the early seventies rather than that specific decision.
The Nine Factors
I’ve been buried in Section 183 case law as I prepare for a CPE course I will be giving for the Boston Tax Institute. I now have 269 decisions in my spreadsheet. And I have to say that the goofiness is strong. Whether it is inherent in the regulation or just in the way it is applied is difficult to determine.
The regulation outlines nine non-exclusive factors to consider in determining whether an activity is carried on for the purpose of making a profit. Unfortunately, it is not a simple matter of getting at least five of them or, if they are not all relevant getting more than the other team.
In determining whether an activity is engaged in for profit, all facts and circumstances with respect to the activity are to be taken into account. No one factor is determinative in making this determination. In addition, it is not intended that only the factors described in this paragraph are to be taken into account in making the determination, or that a determination is to be made on the basis that the number of factors (whether or not listed in this paragraph) indicating a lack of profit objective exceeds the number of factors indicating a profit objective, or vice versa.
The nine factors are:
(1) Manner in which the taxpayer carries on the activity.
(a) business-like manner including accurate books and records
(b) manner similar to other activities of the same nature which are profitable
(c) change operating methods, adopt new techniques, abandon unprofitable methods
(2) The expertise of the taxpayer or his advisors
(3) The time and effort expended by the taxpayer in carrying on the activity
(4) Expectation that assets used in activity may appreciate in value
(5) The success of the taxpayer in carrying on other similar or dissimilar activities
(6) The taxpayer’s history of income or losses with respect to the activity
(7) The amount of occasional profits, if any, which are earned.
(8) The financial status of the taxpayer.
(9) Elements of personal pleasure or recreation
The Goofy Part
Here is where it gets goofy. You will note that the first factor is broken down into three sub-factors. It ends up making the second factor kind of redundant since it is not very businesslike to not know what the hell you are doing.
They never seem to get real coherent about the fifth factor. At least in litigated cases, there are usually no profit years and usually, a long string of loss years making factors 6 and 7 close to IRS giveaways.
On the eighth factor, they wouldn’t be there if there was not other income to shelter with the hobby loss. And activities that superficially seem to be fun or have some sort of allure or romance to them predominate. Of my 269 cases, 59 are horse cases. Twenty involve vehicles or airplanes. And then there are the stand-alone ones like searching for the perfect steak or researching legal prostitution.
The decisions don’t always march through the nine factors, but it is a common approach. And even though, the decision is not supposed to be determined by the factor count, it will always work out that the high count wins. My tentative conclusion is that for the most part, the factor analysis is being spun to fit the decision.
Who Does It Favor?
In the full drill, we will learn whether a factor “favors the petitioner” (i.e. the taxpayer), “favors the respondent” (i.e. IRS) or is neutral. And this is where the spinning comes in. Take the fourth factor – appreciation. If the activity has no assets that will appreciate does the fourth factor score for the respondent or as neutral? It can go either way.
The common long string of losses seems to favor the respondent, but there are all these external circumstances. Especially in the horse cases. Everything I know about horse breeding businesses, I have learned from reading Section 183 cases. And the activity seems to be just one GD thing after another. Misfortune succeeded by calamity account for the long string of losses turning the sixth factor neutral. Or they don’t and the factor favors the respondent.
Not only will the pleasure in the activity count against you in the ninth factor, it can cancel out the third factor. Or it can be neutral because everybody enjoys their job somewhat? You know how great it feels when you have a lot of adjusting entries and you post them to the worksheet and extend them and it all balances. Actually, you probably don’t, but that’s the idea.
One Factor To Rule Them All
So other than alerting you to the potential for the IRS making a hobby loss attack on your client, is there any point in knowing about these factors, given the way they can be spun? Here is my conclusion. Of the nine factors, the only one that matters is the first. There are two reasons for this. The first reason is that that is the only factor that you can really do anything about.
The second reason is even more interesting. In my generous sample of cases, I have found that taxpayers who win the first factor win the 183 issue. Taxpayers who lose the first factor lose the 183 issue. I only found one exception – Robert Dickson, a 1983 memo decision. So the key to winning in the hobby loss area is to focus on “the manner in which the activity is carried on”.
That’s the big reveal that I promised in the first post of the series. The one factor to rule them all. In our next post, we will examine the elements that go into winning on that on that factor.
Different Approach
Judge Posner suggests a different approach rather than applying the “goofy” regulation.
Considering that most commercial enterprises are not hobbies, the Tax Court would be better off if rather than wading through the nine factors it said simply that a business that is in an industry known to attract hobbyists (and horse racing is that business par excellence), and that loses large sums of money year after year that the owner of the business deducts from a very large income that he derives from other (and genuine) businesses or from trusts or other conventional sources of income, is presumptively a hobby, though before deciding for sure the court must listen to the owner’s protestations of business motive.
It makes a lot of sense, although it is kind of taxpayer unfriendly, so let’s hope it does not catch on.
Judge Posner And Goofy
This is not the first time that Judge Posner has created a stir by using the word “goofy”. Nina Totenberg of NPR interviewed him in 2012 and got this gem.
Posner expressed admiration for President Ronald Reagan and the economist Milton Friedman, two pillars of conservatism. But over the past 10 years, Posner said, “there’s been a real deterioration in conservative thinking. And that has to lead people to re-examine and modify their thinking.”
“I’ve become less conservative since the Republican Party started becoming goofy,” he said.